Is privatising power a real turn-off?

Privatisations involve transferring ownership and control of assets, resources, means of production and services, from the state to the private sector. Methods, timing, and valuation are critical.

Privatisations can involve full public floats, issuance of shares at a discount to customers, suppliers, managers, and/or an employee share ownership trusts, issuance to the general public using vouchers, sale to private sector groups domestic or foreign using a tender system, subsidisation of sale with assisted loans and so on.

There are a myriad of methods of privatisation, which should be linked theoretically to the stage of economic and social development of an economy. The issue of valuation often influences the method but this in turn is influenced by two factors. These are: government goals as to proprietorship and property rights; and the stage of development of human capital. The latter refers to human capital both within the institutions subject to change in ownership, which affects its efficiency, and externally in the larger financial system, in terms of analytical capacity.

Valuation techniques

Privatisation can give rise to two difficult problems - allocation of property rights and the skills necessary to conduct a valuation. The former involves political value judgments, so only the latter is considered here. In an advanced economy the usual method of valuation of government corporations operating commercially, is to offer shares in a public float where the price is predetermined for retail shareholders within a range of bidding set by institutional shareholders.

In Australia, this was the valuation method used to assess the Commonwealth Bank of Australia, Telstra, and Qantas in the 90s. This open bidding system, although backed by a pre-bid valuation phase by the government as vendor, ensures that the final valuation is a true market value as rival bidders set the final price. However, the method relies on companies being profitable at the time of the float as the result of efficiency audits conducted during a corporatisation phase.

If an organisation is a loss-making venture, despite being corporatised, privatisation may result in a sale, which eventually transfers wealth to the private sector with zero compensation to the government. This occurred in the case of an Australian state owned bank where a government guarantee of 70 per cent of the loan portfolio and a low valuation resulted in the government not receiving any of the final sale proceeds of A$9 billion (Currie, 2001).

Several methods of valuation are used. The Discounted Cash flow (DCF) method calculates the value of the firm as the present value of after-tax net cash flow. In this case, value depends on three variables - an estimate of the net cash flow over the useful life of the firm (as an asset), an estimated discount rate, which is normally the weighted average cost of capital, and an estimate of the residual value of the firm at the end of the period. Although the method is ideal theoretically, some commentators consider that its built-in problems limit its usefulness for the purpose of privatisation (Abdel-Magid, 1999, p.8).

These problems are the subjectivity inherent in making estimates of future net cash flows and in estimating the weighted average cost of capital. In addition, the question of how to account for future inflation and high uncertainty, and incorporation of management expectations in the resulting present value, can result in over or under pricing, or inability to price individual assets.

Other valuation problems are the capitalisation of earnings using rates implicit in the price/earnings ratios for the industry. This method is difficult to apply to entities where no comparable publicly listed institutions exist.

Another approach is to use modern management techniques to forecast the future income of the enterprise, and replacement cost and value engineering to value the assets. This approach provides an opportunity for introducing market-oriented, modern management techniques to the SOE. It uses techniques such as target pricing; value engineering and activity based costing in order to generate information for decisions crucial to the technical problems associated with privatisations. Examples of such decisions are the redesign of products, the evaluation of future service potential of existing assets, retooling of factories, generating information about future capital outlays, and rationalising the downsizing and retraining of the existing labor force (Haggis, 1997, pp. 14 -15).

The claimed advantages of new ownership structures involve four dimensions, which can isolate reasons for success and failure of reform policies dependent on such changes. These dimensions are political, economic and financial, legal and managerial/organisational structure and process (Culpin, 1999, pp. 10-12).

This framework not only provides a basis for choice of ownership structure, timing and valuation, but how to judge success. At times ownership structures have been chosen to maximise returns to the government as the vendor. At other times the reason was to remove an economic burden by the creation of a privately owned entity that allocates resources in a more efficient and productive manner.