Introduction to Private Provision of Water and Electricity Service 

Part 1. Context

The idea of privatization first gained popularity and political support in the 1980s, during the rising tide neoliberalism under Reagan and Thatcher. Market enthusiasts considered state-owned enterprises (SOEs) in North American and Europe to be inefficient. The political class and voters became increasingly receptive to rolling back government ownership. This political trend became both an intellectual export and a condition for official development assistance in Latin America, Asia and Africa, where SOEs often lost money. Multilateral lenders, in particular, argued that selling them off to the private sector was best way to promote growth. 

This trend only intensified during the 1990s, as post-Soviet countries privatized thousands of enterprises created under communist rule. Everyone agrees that there cronyism and corruption were widespread. And in the case of bank privatization, several financial disasters required massive government bailouts that taxpayers are still paying for. However, many market economists argued that even poorly implemented privatization of SOEs was better than keeping them public.

While the 1980s is often remembered as the sunset for SOEs, it was also the beginning of privatization in traditional public sector services, like infrastructure, health care and education. In the mid-1990s, we saw acceleration of this trend. Privatization proponents argued that corruption or bad management made these services were inefficient, that they caused budget deficits, were unreliable, or excluding the poor. Large corporations that saw a unique opportunity to expand into new and profitable markets lobbied their governments to sell off services at home and pry them open abroad. 

In the 1990s, at the same time that business influence was rising and the reputation of government services was eroding, a new intellectual initiative sought to legitimize privatization as both economically rationale and socially just. Often called the New Public Management (NPM – Box 1), this school of thought argues that the government’s best role was simply to protect property rights, ensure competition, and regulate firms to protect consumers from a variety of “market failures.” That is, it should get out of the business of delivering services directly, leaving actual provision in the hands of private firms with the capabilities and incentives to improve quality and keep prices low.

The main rationales for privatizing basic public services are:

Poverty reduction. The private sector has access to far more capital resources than cash-strapped, deficit-ridden governments. Especially for sectors with high sunk costs, such as infrastructure, fiscal constraints cripple developing country governments’ ability to upgrade and expand services for low-income people.

Balancing budgets: Governments spend too much on subsidies because of inefficiency or political patronage to influential groups. By freeing up scarce budgetary resources, governments that sell off public assets or put them under private management can dedicate the proceeds and cost savings to other underfunded social programs. 

Improved efficiency and performance. Private providers have intrinsic incentives to cut costs and be responsive to customers, while the public sector is bound by bureaucratic inertia, lacks incentives to innovate, and is unaccountable to helpless consumers who have nowhere else to go. 

Making reform irreversible. Because new political leadership can reverse reforms, private provision offers policy stability by removes reform from future political agendas. It’s a lot easier to increase subsidies or add new workers than to re-nationalize private assets or expel private firms from the market.

Each of these rationales will be evaluated in Part 3.

B. Human Rights Perspective

Airplane tickets and cell phones have important social uses, but nobody claims that they are human rights. Market reformers make a valid case when they stress the primary goal of increasing efficiency in a vast array of economic activity. Basic public services, however, are qualitatively different. The same standards of economic performance that apply to most other productive sectors should not apply to services needed to fulfill basic human needs. This does not mean that efficiency should be ignored. But it does mean that it must be balanced against goals of equity, affordability and universal access. 

Essential services are central to a “social contract” between government and citizens. While social contracts vary considerably across countries, they generally promote equity and universality through redistributive mechanisms that ensure a minimum level of access to goods or services that are necessary for livelihood and dignity. Typical social contracts include sufficient primary education to ensure literacy, basic health care, and access to safe drinking water. More elaborate social contracts (in more developed countries) may also include sanitation services and household electricity.

The social contract is based on two related premises: first, that governments should be held accountable for delivery of basic services; and second, that individuals or communities can and should exercise their citizenship rights to ensure those services (at least in democracies). Life-sustaining services such as drinking water are increasingly the subject of national campaigns to guarantee human rights with special legislation or constitutional amendments. 

The human rights perspective on basic services has been articulated at a global level. In November 2002, the United Nations Committee on Economic, Social and Cultural Rights declared access to water to be a fundamental right. It also stated that water is a social and cultural good, and not only an economic commodity. The Committee emphasized that the 145 nations that have ratified the International Covenant on Economic, Social and Cultural Rights are now bound by the agreement to promote access to safe water “equitably and without Discrimination.” 

The implications for access and affordability put private provision at the heart of the debate over human rights. When poor households cannot afford access to drinking water, primary education or basic medical attention, the stakes of privatization policies loom as large as life itself. The impacts can result in death, disease, misery, or a stunted life, whereas the impacts of other key policies, such as trade liberalization or tax increases, while serious, are more indirect.

The direct linkage between basic services and human rights does not provide constitute a categorical argument against privatization. But if taken seriously, it changes the rules of the game for policy decision-making. A human rights perspective implies that privatization advocates must justify proposed reforms with more than increased efficiency, or improved quality for consumers able to pay commercial rates. Because markets alone cannot be expected to promote equity and access, efforts to privatize services equated with human rights should clearly demonstrate how these goals will be achieved.

Part 2. Key Concepts and Demystification

Public (merit) goods. Goods from which nobody can be excluded, such as national security or environmental protection, are called “public goods.” One never hears complaints that the armed forces “run losses” – even though they are financed entirely by tax revenue -- because there is broad consensus about the need for military defense. Infrastructure and social services differ from pure public goods because they can be rationed and are excludable. Like public goods, water and electricity provide benefits that extend well beyond the particular individuals who consume them, such as improved public health and greater economic productivity. However, unlike public goods, they can be rationed and denied to specific users. Many societies have decided, either for normative reasons of social justice or appreciation of wider benefits, that nobody should be excluded from at least a minimum level of service because of income or location. Economists sometimes call these “merit goods.” Wealthy countries whose governments provide essential services justify the decision largely because of market constraints to providing merit equitably.

Contracts and information. When a natural monopoly like water or electricity is privately provided, a contract is needed to spell out the rights and responsibilities of the firm, government and consumers. So-called “performance-based contracts” (PCBs) include measurable outputs that firms must deliver before they are paid. Enforcing contracts requires effective regulation, which is complicated by the “principal-agent problem.” When agents (firms or sub-contractors) have more information about service delivery than the principals (government or consumers), they may be able to withhold or manipulate that information to their own advantage. The only way to for the principal to overcome this problem is through adequate monitoring and evaluation of the agent’s output. However, this can be quite costly, and often forces the principal to reconsider whether those extra costs – and risks – are worth private provision in the first place. 

Generally speaking, the easier it is to observe and measure an output, the less costly it will be to enforce a performance-based contract. In economic jargon, the main constraint on enforcing contracts is transaction costs. As services become more complex – and as the economic and social outcomes they are supposed to achieve become more difficult to measure with simple indicators – the public sector inevitably gets involved. Governments often impose strict requirements on private firms regarding production processes and outputs, as well as information and reporting requirements. These details become part of excruciatingly complex and highly legalistic contracts, and end up raising the costs of producing the desired services.

Competition and regulation. Increased private participation is supposed to empower consumers by giving them choice – primarily the choice to buy from someone else offering better quality or better price. This is most valid for competitive sectors in which consumers have good information about the product. But infrastructure is not a competitive sector. In most settings, there can only be one energy grid or centralized water system, making the issue of choice irrelevant. Monopolies can use their position to charge excessive prices from consumers lacking alternative suppliers. When “natural monopolies” like water and electricity are privatized, claims of superior efficiency and performance are only realized when vigilant public regulators – not individual households – hold firms accountable. 
 
 

Part 3. Economic Policy in Practice

A. Evaluating the Rationales

Rationale No. 1 — Private provision reduces poverty

From a social perspective, the most important rationale for private service provision is that it reduces poverty. Private firms increase capital investment in services used by poor people, improving quality and expanding access. Especially where government has failed to invest in marginalized people – either because of budget constraints or political neglect -- private capital is claimed to be the only viable opportunity for reaching excluded citizens. Particularly in the capital-intensive utility sectors, cash-strapped governments are portrayed as unable to keep up even with basic maintenance, much less to expand or upgrade costly infrastructure, whereas large corporations and nimble capital markets can make major investments wherever needed. 

Incentives for serving the well-off

The notion that private providers improve services for the poor rests on an important premise: that the business is profitable. But economists have widely observed the a behavior they call “cherry picking:” companies tend to avoid “unprofitable people” and invest primarily in relatively affluent consumers. 

In the case of utilities, private providers like to expand household access (e.g., hook up water pipes, make connection to electrical grid) or upgrade services in urban areas, especially where middle class consumers demand more and better services. Firms avoid peri-urban, slum or rural areas, where topography is more difficult, per capita consumption is less, and most importantly, incomes are lower. Investment patterns within countries are replicated on a global scale. Of total foreign investment in private infrastructure, very poor countries have received only a tiny fraction of that capital.1

Cherry-picking incentives also constrain investment in social services. In the private health care sector, doctors prefer to serve patients with higher incomes, while insurance companies try to avoid sick customers, and drop those who develop conditions requiring medical attention (e.g., pregnant women). 

It is possible to induce the private sector to invest in the poor. But there’s a price tag involved. Incentives for serving low-income people don’t come from markets, but rather from public resources. The next section explores some of the fiscal issues involved in equitable private service provision.

Rationale No. 2 — Private provision helps balance budgets 

By freeing up scarce budgetary resources, governments that sell off public assets or put them under private management can dedicate proceeds as well as budget savings to macroeconomic discipline or under-funded social programs. This rationale has the greatest legitimacy for loss-making services that put significant pressure on budgets. (However, it should be noted that governments looking for one time gains have sold off well-functioning and even profitable public services.)

Subsidies

One of the reasons that privatization is supposed to improve fiscal balances is that governments often spend a lot to subsidize services. When a public service loses money because it’s inefficient, it makes sense to look at alternatives that provide the same services for less. Private provision may be one of those options. Others include administrative reforms and technical upgrading. 

Another reason that government services lose money is that they subsidize too many of the non-poor, especially influential middle class or business constituencies. In some cases, public infrastructure services are given away for free to other parts of government. In these cases, the root of the budget problem is political, not administrative. Private provision is one kind of solution, but government commitment to more progressive cross-subsidies can also balance budgets while having a much greater poverty-reduction impact. Making budgets transparent can help empower the poor to demand a more equitable share of public resources. 

Finally, government services sometimes lose money because they subsidize prices for a large number of poor people. Because privatization inevitably commercializes prices through user fees, government may be forced to keep subsidies for those who can’t afford market prices. In other words, private provision may still require public subsidies. 

Under traditional arrangements, government provides a direct subsidy to means-tested households, or to communities designated as poor. But there is no evidence that subsidy systems under private provision are any more effective than those under public provision. According to the World Bank’s Operations Evaluation Department, “getting the private sector to focus on the alleviation of poverty and to design tariffs in a way that does not discriminate against the poor has proved hard to achieve in practice . . .”2 Under “output-based” contracts, governments could pay the private provider a fee for each low-income customer served at reduced prices. But such arrangements require a profit margin for the private provider and force the government to spend resources on regulation and monitoring to ensure that services are provided at affordable costs or free to those unable to pay . 

It is possible that a subsidy scheme under private provision is more cost-effective than available alternatives for reforming a government service. However, this cannot and should not be taken for granted. Before a government privatizes a service in order to balance the budget, it should carry out an analysis of the fiscal costs involved in ensuring that private providers serve the poor. 

Attracting capital

The investments needed for capital intensive services like infrastructure are huge. Because cash-strapped governments have a tough time coming up with necessary resources from general revenue, privatization advocates argue that the private sector is the only game in town. And it’s true that private firms invest billions of dollars every year in developing country services.

The problem is that private firms tend to avoid risky markets. In fact, private investment in public services has actually been falling in developing countries, especially in infrastructure. It’s common to get just one or two serious bids for a major concession, hardly enough to generate meaningful competition. 

More and more, countries themselves are competing for private capital, not the other way around. When firms do invest in uncertain environments, they demand a risk premium – in other words, very high profits. Governments often have to promise incentives to attract any private participation at all. These include long-term tax holidays, grants, low-interest loans, full assumption of risk for exchange rate fluctuation, and commercial and political guarantees. 

Private investment may also require contractual terms that guarantee profit levels for firms, put all financial risks onto taxpayers or consumers, or leave the government responsible for major investments. These arrangements involve major fiscal obligations that can undermine budget discipline. Policy-makers should have a good idea of how high those costs can go – especially off-budget liabilities that are too often ignored -- and compare them to the costs for delivering similar services through the state. 

As a leader of the Global Water Partnership and a Latin American economists conclude: “Fundamentally, the preoccupation with ensuring stable levels of company income has led to the award of warranties and a stability that may eventually fail to motivate company efficiency, going as far as disassociating company performance from that of the rest of the economy, turning them into a regression factor. All this occurs within rigid contractual provisions and legal frameworks.”3

Private provision delivers better services for less. The public sector provider is often bound by bureaucratic inertia, lacks incentives to innovate, and is unresponsive to helpless consumers who have nowhere else to go. Private providers improve efficiency and expand service because of inherent incentives to cut costs and to satisfy a growing number of paying customers, while the state retains the role of regulator.

If economic gains were the only ones that mattered, privatization would be easier to assess and its results would be less controversial. That’s one reason why one rarely hears protests against the privatization of SOEs in traditionally competitive sectors. If these private firms serve customers badly or are mismanaged, they simply go out of business. There are two reasons that this isn’t a serious social problem: first, if there is true competition, customers can get their goods from someone else; second, if the private provider is not engaged in “essential” services, the welfare consequences for poor performance are mitigated. But as we’ll see, providers of essential services usually cannot be disciplined by markets, while poor performance – especially in non-economic outcomes – can have serious consequences for the poor.

There is a considerable number of cases supporting claims that privatized firms have performed better than the state-run services that they replaced. Research on privatization of state-owned enterprises (SOEs) reveals evidence of increased efficiency and profitability.4 Moreover, efficiency improvement in basic services has often been accompanied by improved service quality and access. 

There is no shortage of cases in which these improvements are not forthcoming. Indeed, a number of empirical studies of the U.S. and United Kingdom since the 1970s suggest that publicly-owned utilities are equally or even more efficient that privately-owned ones.5 Nevertheless, the observation of better performance in many cases in developing countries certainly merits consideration. 

Importantly, the main indicator for performance in most privatization studies is profitability or efficiency. However, profitability is an inappropriate measure for the performance of essential services, as it reflects the satisfaction of shareholders, not consumers. Essential services are expected not only to run efficiently, but also to provide high quality service and reach the poor. Yet poor people are often the most costly to serve, living in outlying, remote and physically cramped areas. Making matters worse, they are also the least profitable. In short, promoting equity goals may directly undermine efficiency.

The indicator of efficiency, such as labor productivity or number of outputs per cost unit, is a legitimate consideration – but it is not the only one. For example, in a country with few formal sector jobs, there is a trade-off between efficiency and employment, which itself may be a legitimate developmental goal in poor countries. Of course this does not justify gross over-employment, nor unproductive public sector workers. But it does suggest that the gains from efficiencies are not pure, and must be evaluated in the context of offsetting losses. 

Monopoly Services and Regulation

There is consensus that privatized monopolies require public regulation to prevent market failure. Private providers of water and electricity can raise profits by improving efficiency, but have no incentives for translating higher productivity into gains for consumers. For that reason, the state emerges as the unique institution to protect the public interest.

Some proponents of putting natural monopolies under private provision are enthusiastic about performance-based contracts (PBCs), which were traditionally used to improve the bottom-line of firms that contract out for goods and services that they used to produce internally. Analysis of the effectiveness of PBCs involves the “principal-agent” problem. When agents (sub-contractors) have much more information and knowledge about a given task than the principals (contracting firms), they may be able to withhold or manipulate that information to their own advantage. As a World Bank infrastructure specialist explains:

“The fundamental problem of regulation is one of asymmetric information between the regulated company and the regulatory agency. The regulated company will have a strong incentive to abuse [its] strategic advantage by under-supplying information or distorting the information supplied. It is therefore critical that the regulatory framework establishes the obligation of the regulated company to supply information to the regulator in the form required.”6

The only way to for the principal to overcome this problem is through adequate monitoring and evaluation of the agent’s output. However, this can be costly. At a certain point, those costs force the principal to reconsider whether it is worth subcontracting in the first place. Generally speaking, the easier it is to observe and measure an output, the less costly it will be to enforce a PBC. As outputs become more complex or subjective, the likelihood of undetected non-compliance or contractual disputes grows. 

The main constraint on performance contracts is transaction costs. As services become more complex, the public sector inevitably gets involved. Governments often impose strict requirements on contractors regarding production processes and outputs, as well as information and reporting requirements. These details become part of excruciatingly complex and highly legalistic contracts, and end up raising the costs of producing the desired services.

Not only does the state have to monitor outputs of private provision. It has to ensure that the outputs are equitably distributed and that the costs are appropriate. As a World Bank research note acknowledges: “Even if a [water] contract were bid on basis of perfect information about the current status of the water company’s assets and about new investments needed, the future would hold uncertainties that could not be handled by contract. And an initial contract is usually based on highly incomplete information.”7

Proponents of private provision point out that both public and private monopoly providers require regulation. And there is no shortage of evidence about the inability of public regulators to discipline failing public providers. As the 2004 World Development Report argues, there is sometimes a “conflict of interest” when one government entity is charged with controlling another. While there may certainly be cases in which adequate regulation of private providers is a viable option, it is important that policy-makers make their decisions based on the risks of pursuing such arrangements. At a minimum, they should ask how feasible it will be to establish a functioning, independent regulator, and the time horizon for doing so. Equally importantly, the decision about whether or how to privatize should be informed by an impact analysis of private provision under weak or non-existent regulation. 

Competitive Services and Choice

For services with low barriers to entry, the rationale for private provision is choice; consumers “shop around” based on price and quality. Here the government’s main role is to ensure adequate levels of competition that create viable choices for all citizens. 

Expanding private provision in competitive service sectors can certainly increase choice – but not necessarily for all consumers. As with utility services, firms in key social sectors engage in cherry-picking. Not only are poor people least able to pay commercial prices. They are often the most costly to serve, living in less accessible areas, more prone to getting sick, and transient.

Especially when existing public services are of low quality, expanding the choice of providers draws better off consumers into the private sector. However, those who are unable to afford commercially priced private services must remain with the state, thus creating a “two tier” system based on income. Public services that are funded through progressive cross-subsidies -- or where high-use customers account for the bulk of revenues -- are especially vulnerable to increased private sector participation, which reduces the public sector’s revenue base. 

If policy-makers do not address market failures associated with natural disincentives to serve vulnerable populations, improved efficiency may go hand in hand with increased social exclusion. Policy constraints inevitably raise issues of fairness. On one hand, neither middle class consumers (nor any anyone else) should be forced to use low quality services. If greater choice can improve quality and efficiency, such benefits should not be ignored. On the other hand, poor people are already marginalized politically. After addressing the interests of the more influential constituencies by increasing private provision, governments may be tempted to “move on” and neglect complementary policies needed to serve the poor.

Corruption

If there was ever a double-edged sword in the debate over reforming services, it’s corruption. Private provision proponents argue that front-line government service providers routinely engage in petty bribery and theft of supplies, and portray high ranking officials as perpetrators of massive graft. They have no shortage of evidence. Skeptics, in turn, can choose from a large and growing menu of non-transparent and criminal practices among firms that deliver essential services. Former World Bank Chief Economist Joseph Stiglitz once memorably referred to privatization as “briberization.” But rather than engage in stale debates about which is worse, policy-makers should assess existing or potential accountability mechanisms as they consider which kind of provider is more likely to serve public welfare.

Neither public officials nor private businesses are inherently honest. If not made accountable to service users, both try to get richer or more powerful at the expense of consumers. Information disclosure and external monitoring are therefore essential for both kinds of arrangements. Corrupt governments clean up their act only when they have to answer to citizens. Where policy-makers depend on privileged elites for political survival, or where citizens lack the information they need to evaluate the behavior of those entrusted to serve the public, accountability is hard to deliver. By contrast, private firms refrain from corruption when they have to answer to government – meaning an effective public regulator. 

If one accepts the premise that ungoverned profit-maximizing companies are no more philanthropic than their public sector counterparts, then state institutions become the weakest link in fighting corruption regardless of who the provider is. What tends to be lost in the debate over service reform is that regulatory integrity is the key to both effective public and private provision. Critics of privatization often point to a paradox: the same government officials that were too corrupt to deliver services to citizens are expected to be immune to the lucrative inducements of private firms. Public sector managers unable to control the behavior of front-line government agencies must somehow enforce compliance with standards of corporate responsibility.

While public service employees may steal from consumers, supply warehouses and budgets, private providers also have numerous opportunities for corruption and regulatory capture. These include the bidding process for public contracts, the establishment of contractual terms, enforcement of contract compliance (including tariff changes), and anti-competitive collusion. Corporate corruption is not an isolated phenomenon. There are countless examples of corruption in privatizations undertaken developing countries.8 Moreover, the more money is at stake, the greater the potential for corrupt behavior. For example, according to the World Bank itself, “transnational firms headquartered abroad are more likely than other firms to pay public procurement kickbacks.”9
 

Rationale No. 4 – Private provision makes reform permanent

The ebb and flow of the political system creates a certain degree of uncertainty. What one reformer accomplishes today may be undone by the next administration. Private provision can therefore be seen as a way to remove politics from the political agenda. It is much easier to increase subsidies or reverse employment cutbacks than to re-nationalize private assets or expel private firms from the market. Especially when the political system is inherently corrupt or overly responsive to rent-seeking interests, it’s better to prevent anyone from making policy changes than allow policy to be constantly subject to manipulation and political calculus.

Permanence has its attractions, but it’s risky to cast reforms in stone. Unfortunately, policy-makers often lack sufficient information and analysis to be able to predict the social and economic impacts of major reforms. So while it’s desirable to make effective reforms hard to reverse, it’s also dangerous to leave no exit door behind when policies are poorly implemented, have far deeper negative impacts than initially expected, or have major unintended consequences that were not originally considered. 

The most common way that government can tie its own hands in service reform is through privatization or long-term private concessions. Expropriating private property (and to a lesser extent breaching a legal contract) is typically considered a radical, populist and irresponsible act, especially by investors upon which governments depend to generate jobs and economic growth. Such actions can bring the wrath of multilateral and bilateral lenders, and lead private rating agencies to seriously downgrade sovereign credit risk. Because such pressures can lead to higher interest rates or even a cutoff of credit, private provision can effectively remove government from service provision for the foreseeable future.

Even in cases where it is politically feasible to take back control of essential services, over time private provision may make such an alternative impossible for more practical reasons. Especially when it comes to complex, integrated sectors such as utilities, surrendering the capacity to deliver services may make it impossible for the government to turn back the clock.

Liberalizing Trade in Services

Governments can also make public service reforms permanent through legally binding constraints. One of the most controversial of these is through the WTO’s General Agreement on Trade in Services. Once a government has made specific sectoral commitments under GATS, it may only reverse those commitments by negotiating acceptable compensation with all affected parties – a costly undertaking that virtually ensures continuity. The WTO itself declares that “because unbinding is difficult, [government] commitments [to a sector] are virtually guaranteed . . .”10This means that if subsequent events reveal serious negative social or economic effects, it may be too late to take corrective action.

GATS does not privatize services. However, if governments do not limit market access by foreign service providers, it does prevent governments from taking actions that affect the competitive position of foreign investors. GATS restricts government’s ability to regulate or subsidize service providers, especially in ways that provide advantages that might discriminate against an existing or potentially existing competitor. 

WTO officials routinely deny that GATS applies to basic public services. However, the ambiguity of existing language suggests otherwise. GATS exempts those services “supplied in the exercise of governmental authority,” but defines those services as being provided neither on a competitive nor commercials basis. Thus for services in which governments compete with private providers or charge cost covering fees, it’s quite plausible that they could fall under GATS jurisdiction. 

Moreover, in the Doha round of negotiations, northern countries made numerous requests for opening up water, electricity, health and education services, making it quite clear that governments are now being pressured to make commitments in essential services that would be fully subject to GATS disciplines.

Common sense suggests that governments should not make GATS commitments until they have conducted impact analyses of liberalization in a particular sector. Yet neither the WTO nor the multilateral lending institutions have prepared a framework for assessing even the economic – to say nothing of the social impact -- of opening services under GATS.11

B. Mechanisms for Promoting Private Provision

Since the mid-1980s the international financial institutions (IFIs) have been aggressively promoting private provision for utilities, and to a lesser extent for increased private participation in social services. In the mid-1990s, the IFIs got more serious about cost recovery. The 2004 World Development Report, which calls for the state’s continued involvement in delivering health care and primary education, while claiming that “there are few advantages” to government delivery of water and electricity. It is increasingly common for the World Bank and regional development banks to finance a series of reforms that lead up to transferring control of public assets to private firms. Typically these include:

• Decentralization: Basic services are devolved to local governments or even communities, which often lack experience or capacity to deliver them directly. In addition, when local governments face fiscal constraints imposed from the center, they lack budgetary resources needed to provide services, and as a result adopt private provision “by default.”
• Corporatization. As a way of taking public services off the general budget, services are corporatized as financially autonomous entities. Although still nominally public, they must fund themselves entirely through revenues generated through service delivery (e.g., user fees) and cannot count on general budget support.
• Unbundling. When there is explicit recognition that poor people cannot pay commercial rates, a service can be segregated into a profit-making business (that caters primarily to the middle class and well off) and a loss making one (that serves the poor). The profitable segment can be easily privatized, while government (without the benefits of cross-subsidies) retains responsibility for providing free or subsidized – and typically low quality -- service to the poor.
• Commercialization: Services are delivered on a full “cost recovery” basis. Consumers must therefore pay out-of-pocket “user fees” in order to have access. Commercialization is a common step prior to privatization, as it makes a public service financially much more attractive to prospective investors.

• Reduce or eliminate budget subsidies (and domestic credit) to services, especially utilities that operate in the red; 
• Limit fiscal transfers to local or state governments; 
• Allow the creditors of local governments to “intercept” transfers to local governments in order to collect debt-related obligations; 

¨ refrain from “bailing out” indebted local governments. 

Conditionality. Notwithstanding widespread evidence that loan conditions do not improve effectiveness of aid, they continue to be widely used by the IFIs. Conditions for commercialization and private provision can be found in policy “triggers” for lending in World Bank country assistance strategies, as well as “tranche release” criteria for structural adjustment loans. In the electricity sector, a World Resources Institute study of six countries found that reforms were driven by the immediate need for capital, usually as the result of the withdrawal of international donor support for the power sector. In Argentina, the IDB and World Bank withheld assistance to the provinces unless governments agreed to conform to federal pricing requirements. In Orissa, India, donors instructed consultants to “create a process that was irreversible.”12 In a study of ten cities by the Director of Water and Sanitation at the Asian Development Bank, only one (Macau) was found to have privatized of its own volition, having done so a century ago.13

Private Sector Development. The World Bank’s 1995 Annual Report referred to the institution’s shift toward direct support of private sector investment (as opposed to direct lending to governments) as “a dramatic departure from what had been Bank policy for half a century.” The Private Sector Development (PSD) Strategy, which was approved by the World Bank’s Board in February 2002, puts real power behind this shift. Under the PSD strategy, the World Bank’s private sector affiliate, the International Finance Corporation (IFC), is to team up with the International Development Association (IDA), the World Bank’s concessional loan arm, to privatize services in low-income countries, including “frontier” areas, such as social programs and basic infrastructure. The PSD strategy’s purpose is to transform much of the World Bank Group’s traditional operations into support for the role of the private sector. 

Output-based aid. The World Bank is scaling up the financing of infrastructure and social service projects through output-based aid (OBA) design. OBA projects delegate service delivery to private “third parties” under contracts that make payment conditional on outputs or services actually delivered. A Global Partnership for OBA was launched in 2003 by the World Bank Group, with support from DFID. It is now experimenting with and scaling up OBA schemes, some of which would provide subsidies to corporations when they deliver services or meet certain performance benchmarks. Examples of pro-poor OBA payments include one-time payment for expanding coverage (e.g., new water connections), or subsidies for lifeline consumption in poor households.

Community-driven development. An approach to private service provision that the World Bank has embraced with particular enthusiasm is community-driven development (CDD), which currently absorbs about half of IDA credits and grants. According to the Bank’s web site, CDD gives control of decisions and resources to community groups, not local governments. “These groups often work in partnership with service providers, local governments, the private sector, NGOs, and central government agencies . . .” A common type of CDD is the Social Fund, through which the Bank has channeled $3.7 billion in 57 countries, with donor and government co-financing brining the total to about $9 billion. Social Fund resources are distributed directly to communities, rather than local governments, and often contain thousands of sub-projects, which are bid out to private and non-profit contractors. The quality and extent of service provision depends largely on strong, effective local governments, but CDD funds bypass and weaken governments that are assuming responsibility for transparent privatization, regulation and financial management.14 Importantly, CDD efforts rarely finance public provision, so citizens are denied the full range of choice. Moreover, the Bank’s own record in CDD suggests that its enthusiasm may be poorly placed (see box).

LICUS. The World Bank addressed the special needs of “failed states” through its Low-Income Countries Under Stress (LICUS) program. LICUS turns the idea of improving governance on its head. Rather than building the institutions of governance, an external institution -- the independent service authority (ISA) — simply replaces the state’s essential functions altogether. ISAs are largely autonomous from government, with high standards of accountability directly to donors. They are wholesale institutions, contracting out services with multiple providers, including firms and NGOs, for retail services that they monitor and compare to ensure cost-effectiveness. 

Communications strategy. The Bank has financed “strategic communication campaigns” to persuade citizens in Borrowing countries of the soundness of privatization. For example, after negative publicity on water privatization in Ghana began to interfere with policy implementation, the Bank adopted a public marketing strategy. To deliver this message, the Bank and the Government each hired a full-time staff person (funded by Japanese bilateral aid) to carry out the “strategic communications” program. The World Bank’s External Relations department offers specific guidance for conducting such campaigns.15 In what appears to be a direct violation of the Bank’s own Articles of Agreement, which prohibit interference in domestic political affairs of borrowers, Bank staff are instructed on how to work with legislatures to overturn congressional or parliamentary opposition to privatization and ensure the passage of laws that would institutionalize a "customer focus" in government. 
 

C. Trends in Resource Flows

Since 1998, the developing world has become a net capital exporter to the developed world. At the same time, growth rates are declining in many countries. In 2000, the world community committed itself to a set of eight Millennium Development Goals (MDGs) that would, among other things, halve by 2015 the proportion of people whose income is less than one dollar per day. In the poorest countries, the shortage of capital is compounded by a reduction in official development assistance from bilateral donors. While donors and creditors publicly highlight the importance of meeting the MDGs, they are not providing the capital needed to raised investment levels to achieve these targets. For example:

Even more troubling than stagnating aid levels is the recent decline in private investment. If the overall FDI picture is bleak (as discussed below), when it comes to investment in basic services for developing countries, the situation is worse. Many multinational firms have been scaling back their investment plans. In January 2003, as part of its efforts to restructure massive debt, Suez announced that it would pull back from new water business in developing countries, and curtail investment in existing operations.16 The investment prospects for rural water service are particularly discouraging. 

According to International Rivers Network, “Water multinationals have little or no interest in rural drinking water systems. Corporations are rarely able to profit from poor and dispersed rural populations who mainly depend on local water sources such as wells, springs and streams.”17 Even small businesses appear hesitant to invest in the areas that need it the most. As a WaterAid study of rural water reform in Uganda explains, “communities that are disadvantaged by the terrain in their locality – where the more expensive technical options are required – are unlikely to benefit from [private sector] projects . . . Contracts to the private sector avoid expensive deep drilling operations.”18

The neglect of poor users is most apparent in Latin America, where private provision has had the greatest expansion over the last decade. Despite efforts to make the water sector function like a competitive market throughout the region, “coverage for the low income population has not significantly improved.”19

The fact that foreign direct investment levels were so much larger than official development assistance was portrayed as evidence that multilateral development banks were becoming irrelevant. Between 1988 and 1999, service sector foreign direct investment (FDI) increased at an annual rate of 28 percent and accounted for 37 percent of total FDI stocks in developing countries in 1999. The share of infrastructure in total FDI flows nearly doubled during 1990-98. Hence, it is significant that net FDI inflows to developing countries fell sharply in 2002 to an estimated $143 billion compared to $171 billion in 2001. FDI has dropped to Latin America, since the region has sold most of its assets, many to foreign buyers.20

While FDI is often touted as the critical resource for the entire developing world, FDI flows to developing countries remain highly concentrated. Today about three quarters of FDI to developing countries goes to just 10 countries, and most of this amount goes to China, Brazil and Mexico. All low-income countries combined received only $11 billion in FDI in 2002. Economist David Woodward divided developing countries by per capita equity inflows. He found that the 71 countries receiving less than $1 per capita received a combined total of just 0.1 percent of total equity flows, despite having 22.3 percent of the population of the developing world.21

Moreover, not all FDI has the same developmental potential. Increasing foreign investors are spending on mergers and acquisition (M&A), rather than new “greenfield” investment in new assets and production capacity. Private provision of essential services by foreign investors, especially infrastructure, usually takes the form of sale – or long term lease – of existing assets. According to a study by UNCTAD, the share of M&A in total FDI among developing countries – not including China, the largest recipient of greenfield investment – grew from 22 percent in 1988 to 72 percent in 1997. According to Cambridge University economist Ajit Singh, “When FDI takes the form of green field investment, it represents a net addition to the host country’s capital stock. However, FDI entry via an acquisition may not represent any addition at all to the capital stock, output or employment.”22
 
 

Part 4. Lessons Learnt, Common Mistakes.

Moreover, the benefits of private provision are often most doubtful precisely where public services are performing the worst. Governments that already have strong institutions and accountability mechanisms are likely to be able to implement privatization policies quite effectively. However, they are also more likely to have effective service providers and low levels of corruption to begin with. On the other hand, rent-seeking public institution and governments driven by special interests typically deliver poor quality services, or limit access to the privileged few. While there may be much room for improvement, such governments offer little hope for properly regulating private firms that deliver services. 

Proponents of private provision often assume a “counter-factual of inaction.” They compare best-case private provision scenario with continuation of failing public service. The implication in much privatization literature is that government is simply beyond hope. Yet there are often viable options for reforming public services, especially by increasing accountability to citizens, and making budgets more progressive. In many cases, the constraints on these options are starkly political, while in others the need is for greater technical capacity or better organizational incentives. Before committing to private provision, especially with weak regulatory capacity, governments should assess the constraints to “doing privatization right,” the costs of doing it wrong, and options for reforming existing public sector services. Toward that end, citizens and policy-makers are encouraged to: 

• Determine which kinds of institutions are needed for different provision options.
• Assess the feasibility and time horizon for strengthening or creating those institutions, 
• Evaluate the risks associated with different reforms and ask whether they are acceptable
• Estimate the potential social and economic costs of service provision while appropriate institutions are being built.
• Consider a range of roles that the private sector might play in essential service

Don’t assume the problem. Privatization advocates often start from the assumption that public services are failing because of public sector weaknesses: apathy, incompetence, political patronage or outright corruption. Moreover, they often imply that these problems are so entrenched that they are essentially unreformable, leaving no choice other than replacing the government provider with a private one. As noted in Part 3, this position creates a paradox: the same weak state must now regulate profit-seeking private interests with severe disadvantages in information and monitoring capabilities. Citizens and policy-makers should begin with the simple question: What’s the problem? Is it really an organizational “pathology?” All too often, the root problem is simply insufficient resources. Public sector critics often assume that insufficient resources is the result of improper pricing that doesn’t produce enough revenue to invest in expansion, or sometimes even to maintain existing infrastructure. Is this really the case? Or does the problem lie elsewhere: fiscal austerity measures eroding investment over many years, profits being sent back to the general budget instead of re-investment, non-payment by major users, including the government itself, or rapid growth of poor users who cannot afford to pay commercial prices?

Don’t assume the solution. When the nature of the problem has been determined, deliberations over the right reform can begin. A comparison of costs and risks is essential. For each proposal, citizens should demand that proponents justify it as the most feasible or least costly option for reform. For example, when organizational mismanagement is found to be a problem, is it really unreformable? A great deal of public management literature focuses on the use of incentives and accountability mechanisms to improve performance. Can the organization be restructured or given better incentives to deliver services? When insufficient resources are the problem, is privatization the best way to procure adequate resources? If large numbers of poor people still require subsidies, is private provision the most efficient way to deliver those subsidies? If better off users are paying much less than they are able (e.g., middle class, industry, government), can a more progressive cross-subsidy mechanism be created to produce enough revenue for serving the poor? 

Take regulation seriously. Without proper governance and monitoring, privatization of natural monopolies is a house of cards. This means that there needs to be an ex ante analysis of regulatory capacity, autonomy and authority, as well as the legislative framework which gives regulators their mandate. [An EPEP module focusing on regulatory regime is to be produced in the near future.] Where regulation is found to be weak, promises to improve regulation, technical assistance and “capacity building” programs should not be accepted as sufficient for moving ahead with privatization. The damage to public welfare while a private provider operates without regulation can be extensive, or even irreversible. 

Make contracts transparent. An evaluation of regulation is not possible with access to details of what is to be regulated. This means that proposed contracts with private providers must be publicly disclosed. Currently utility firms resist subjecting contractual terms to public scrutiny, claiming that the contract is private intellectual property and that the government itself adequately represents the public interest. This argument must be rejected. Governments are typically woefully unprepared to negotiate complex legal contractual provisions with sophisticated corporations. Moreover, those contracts, once signed, can last for decades, amplifying the cost of mistakes, ambiguities or omissions that firms can exploit. To the extent that civil society can support government with advice, opinions and information, the public interest will benefit. Civil society has a very strong case to insist: No transparency, no deal! 

Carve out essential services from trade agreements. The uncertainty of the legal implications of trade deals like GATS is enormous, as is the impact on public welfare. Because there is so little information or analysis available to help guide governments in negotiations – and because commitments made are essential irreversible, trade negotiators should simply make a categorical policy to exclude essential services from trade liberalization.
 
 

1) Ada Krina, “Private Infrastructure: A Review of Projects with Private Participation 1990-2001.” Public Policy for the Private Sector, Note No. 250. World Bank Group, 2002.
2) Keith Pitman, Bridging Troubled Waters: Assessing the World Bank’s Water Resources Strategy, World Bank, 2002.
3) Humberto Pena and Miguel Solanes, “Effective Water Governance in the Americas,” Presented at Third Water Forum, Kyoto, Japan, March 23. 
4) William Megginson and Jeffry Netter, “From State to Market: A Survey of Empirical Studies on Privatization,” Journal of Economic Literature, vol. 39, June 2001.
5) For an annotated bibliography of empirical evidence comparing the efficiency of public and private utilities, see Andrei Jouravlev, “Water Utility Regulation: Issues and Options for Latin America,” ECLAC LC/R.2032, October 2000.
6) Vivian Foster, “Ten Years of Water Service Reform in Latin America: Towards an Anglo-French Model,” in P. Seidenstat, D. Haarmeyer and S. Hakim (eds.) Reinventing Water and Wastewater Systems, Center for Competitive Government, Temple University, 2003.
7) Penelope Brook Cowen, “Getting the Private Sector Involved in Water – What to Do in the Poorest of Countries?” Public Policy for the Private Sector. No. 102. Private Sector Development Department, World Bank, 1997.
8) For review of cases and issues, see: Sue Hawley, “Exporting Corruption: Privatisation, Multinationals and Bribery.” The CornerHouse, Briefing No. 19, 2000; David Hall, “Privatisation, multinationals, and corruption,” Development in Practice, vol. 9, no. 5, November 1999.
9) J. Hellman, G. Jones, D. Kaufmann, “Are Foreign Investors Engaging in Corrupt Practices in Transition Economies?” Transition Newsletter (May-June 2000).
10) World Trade Organization, “Trading Into the Future,” on-line guide to the WTO Agreements, 1999. Quoted in Scott Sinclair and Jim Grieshaber-Otto, Facing the Facts, Canadian Centre for Policy Alternatives, 2002, p. 34.
11) GATS Article XIX(3) states: “For the purposes of establishing such guidelines [for new rounds of negotiations] the Council for Trade in Services shall carry out an assessment of trade in services in overall terms and on a sectoral basis with reference to the objectives of this Agreement . . .” Before the Doha Round, several developing countries called for completion of the assessment, but were ignored by the northern countries. The USTR treated the request as untimely. 
12) Navroz K Dubash, Power Politics: Equity and Environment in Electricity Reform, World Resources Institute, 2002. 
13) Arthur MacIntosh, “Privatisation of Water Supplies in Ten Asian Cities,” January 2000.
14) Judith Tendler, 2000, "Why Are Social Funds So Popular?" in Local Dynamics in the Era of Globalization (Shahid Yusuf, ed.) Oxford University Press, 2000.
15) Public Communication Programs for Privatization Projects: A Toolkit for World Bank Task Team Leaders and Clients. 
16) David Hall, “Water multinationals in retreat: Suez withdraws investment,” Public Services International Research Unit, January 2003.
17)Patrick McCully, “Avoiding Solutions, Worsening Problems: A Critique of the World Bank’s Water Resources Sector Strategy,” International Rivers Network, May 27, 2002.
18) WaterAid, “The Paradoxes of Funding and Infrastructure Development in Uganda,” 2003. See www.wateraid.org.uk.[
19) Pena and Solanes, “Effective Water Governance in the Americas,” Third Water Forum, Kyoto, Japan, March 2003.
20) “Global Development Finance 2003: Striving for Stability in Development Finance,” March 2003 draft, p. 47 and 84; Ada Krina, “Private Infrastructure: A Review of Projects with Private Participation 1990-2001.” Public Policy for the Private Sector, Note No. 250. World Bank Group, 2002.
21) David Woodward, The Next Crisis? Direct and Equity Investment in Developing Counties, Zed Press, 2001, p. 32.
22) Ajit Singh, “”Foreign Direct Investment and International Agreements: A South Perspective,” Occasional Paper No. 6, South Centre, October 2001.