Making the SOEs better

By

Kashif Mateen Ansari

State Owned EntitiesMany developing countries have used state-owned entities to address a number of developmental issues. The developed world has also used commercial state-owned entities for further economic development of their respective countries.

There is a long held view, within the private sector that state-owned entities are inherently inefficient and should be privatised.

Can there be efficient State Owned Entities ???

despite of the popular belief it appears that there are many who believe so.

In his article, “State owned Enterprise Reforms”, Ha Joon Chang observes that state-owned entities can be efficient and well-run.

Successful SOEs Indeed, there have been very successful state-owned enterprises, as observed by Chang as follows:The Singapore Airlines, often voted the best airline in the world, is a state-owned entity, 57 per cent owned by the government holding company, Temasek Holdings, whose sole shareholder is the Singapore Ministry of Finance. The highly respected Bombay Transport Authority of India is also a state-owned entity.World-class companies like the Brazilian regional jet manufacturer Empresa Brasileira de Aeronáutica (EMBRAER), the French carmaker Renault, and the Korean steel-maker Pohang Steel Company (POSCO), all initially succeeded as state-owned entities, with the state still exercising critical influence in many of them.

The Power of the SOEsFrom the analysis of major global companies, The Economist observed the following companies in the world that are either state owned or state backed:Thirteen biggest oil firms, which between them they have a grip on more than three quarters of the world’s oil reserves;The world’s biggest natural gas company, Russia’s Gazprom;China Mobile is a mobile phone company with six hundred million customers;Saudi Basic Industries Corporation is one of the world’s most profitable chemical companies;Russia’s Sberbank is Europe’s third largest bank by market capitalisation;Dubai Ports is the world’s third largest port operator; and The Airline Emirates is growing at 20% annually.

The Economist report “The visible hand”

These are some of the many examples of state-owned or backed entities that have done phenomenally well and the number seems to be increasing. This is contrary to the popular belief that state owned entities are inherently inefficient.

Role of SOEsThe role of state-owned enterprises in Singapore is outlined in the Temasek’s general investment strategy and centres on the following five themes:

Transforming economies;

Growing middle class;

Pioneering innovative products and/or businesses;

Deepening comparative advantage; and

Focus on emerging champions.

IrelandProvision of essential infrastructure and services that are critical to the country’s economic development Early SOEs played a key role in enhancing skillsSOEs are used to address broader national economic and social well-being objectives of government;They have traditionally played a key role in setting salary levels for certain professionals across the economy;The commercial SOEs are key investors in infrastructure provision and are responsible for delivering a significant part of Ireland’s National Development Plan;The establishment of SOEs was driven by a desire to initiate strategically important economic activities which private enterprise had either failed to initiate or to operate on a sufficiently extensive scale;More recently, State ownership in the financial sector has increased as the State has taken large equity positions in a range of distressed banks. This is a direct response to market failure.

Indiathe SOEs in India have also played a role of developing small and medium enterprises by ensuring, among other things, funding of entrepreneurship. Recently the role has focused on internationalisation of SOEs by granting autonomy to them to make investments abroad and form joint ventures, for example Bharat HeaveyElectricals Limited (BEHL) expanded its international operation through entering new markets and building up on existing ones. Another example is Oil and Natural Gas Corporation Limited (ONGC) which is currently engaged in overseas exploration and production in countries like China, Columbia, Brazil, Nigeria, Cuba and Vietnam.

The Economist

JustificationNatural Monopoly: In industries where technological conditions dictate that there can be only one supplier, the monopoly supplier may produce at less than socially optimal level and appropriate monopoly rents. Examples: railways, water, and electricity. Under such circumstances, there is a strong case for an SOE to be set up and regulated to prevent abuse of such a natural monopoly; Capital Market Failure: Private sector investors may refuse to invest in industries that have high risk and/or long gestation period. Examples: capital-intensive, high technology industries in developing countries, such as aircraft in Brazil or steel in the Republic of Korea;Externalities: Private sector investors do not have the incentive to invest in industries which benefit other industries without being paid for the service. Examples: basic inputs industries such as steel and chemicals;Equity: Profit-seeking firms in industries that provide basic goods and services may refuse to serve less profitable customers, such as poor people or people living in remote areas. Examples: water, postal services, public transport, and basic education;Security of Supply: Ensuring constant and reliable supply of commodities that are critical to the functioning of the country and its people; and Infrastructure: The need to build and maintain infrastructure that promotes economic activities.

InefficiencyDespite the theoretical justifications for establishment of SOEs and the many examples of well performing SOEs, many SOEs are not well run and are inefficient.The Principal-Agent Problem: This principle recognises that SOEs are not run by their owners like in private companies. Given the self-seeking nature of humans, the argument goes; no SOE manager will run the firm as efficiently as an owner-manager would run his own firm. The Free-Rider Problem: SOEs have numerous owners (all citizens). No individual owner (citizen) has the incentive to monitor the SOE managers as the benefits from monitoring will accrue to all owners while the costs are borne by the individuals who do the monitoring.The Soft Budget Constraint: Being part of the government, SOEs are able to secure additional financial assistance if their performance lags. This leeway makes the SOE managers lax in their management.

Chang, 2007

Why SOEs fail (particular reference to Power Sector):

Ownership structure

Exercise of authority

Role of regulators

Tariff

Expense

Technical standards

Quality of service

Inefficiencies

Over staffing

Political interference

Misplaced/ No Incentive systems

Transparency issues

Customer Orientation

Management ability

Performance orientation

Low profitability

Limited innovation

Broader Strategies for improvement

Vital importance of electricity in any economy

Reliable electricity is vital for economic growth and poverty reduction

Owner’s driven performance

improving the service

standards

serving the un-served areas

Strengthening competition

Corporate GovernanceA crow was sitting on a tree, doing nothing all day. A small rabbit saw the crow and asked him: "Can I also sit like you and do nothing all day long?" The crow answered: "Sure, why not." So, the rabbit sat on the ground below the crow, and rested. All of a sudden, a fox appeared, jumped on the rabbit and ate it.

Q: What can we learn from this?A: To be sitting and doing nothing, you must be sitting very high up.

First and the Foremost

Privatization

Short of privatization

Subjecting the SOE to Companies law and other corporate regulations like private companies

Additional public reporting for more transparency

Introducing commercial culture

Countries with SOEs under CompanyLegislationCorporatized SOEs operate under normal company legislation in many countries and sometimes under both company law and SOE law:

• Bhutan, where SOEs operate under the company law and must also abide by the SOE ownership policy that is in place.

• Chile, where company law applies to all SOEs except for nine large SOEs that have their own separate laws.

• Ghana and Kenya, where SOEs are governed mainly by company law.

• India, where SOEs fall under company law but must also follow the many different guidelines established for SOEs as well as a corporate governance code for SOEs.

• Malaysia, where government-linked corporations (GLCs) are governed by company law with the GLC Transformation Program and the GLC Transformation Manual in place.

Pakistan, where SOEs are regulated by the Companies’ Ordinance and by recently issued Rules on Corporate Governance for SOEs.Peru, where SOEs fall under both company law and an SOE law that creates the state ownership entity FONAFE, with a corporate governance code in place for SOEs.Serbia, where corporatized SOEs fall under the new company law.South Africa, where SOEs operate under company law with the Protocol for Corporate Governance in place.Zambia, where most SOEs are legally founded under the Company law

World bank Tool Kit on CG for SOEs

Bringing independent directors

Partial/ Limited privatization of minority stake

Involvement of debt market

Reducing conflict of interest between government and SOEs

Arm’s length relationship

The OECD principles of

corporate governance

Ensure the Equitable

treatment of all shareholders

Recognize the rights of

stakeholders as established by

law

Timely and accuratedisclosure

Ensure the strategic

guidance , the effective

monitoring

The OECD principles of corporate governanceThe principles are that the corporate governance framework should Protect shareholders’ rights.

• Ensure the equitable treatment of all shareholders, including minority and foreign shareholders. All shareholders should have the opportunity to obtain effective redress for violation of their rights.• Recognize the rights of stakeholders as established by law and encourage active cooperation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises.• Ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the financial situation, performance, ownership, and governance of the company.• Ensure the strategic guidance of the company, the effective monitoring of management by the board, and the board’s accountability to the company and the shareholders.

Source: OECD

Important highlights on Board’s Role in SOEs from Companies Act, 2013, India Disclosures in the Directors’ Responsibility Statement by all companies The boards would now have to articulate their policy on directors’ appointment and

remuneration The boards would have to explain if there are any qualifications in the secretarial audit

report The boards would have to lay down its policies for regulatory compliance and risk

management and ensure these are operating effectively The boards would have to devise proper systems to ensure compliance with the

provisions of all applicable laws and that such systems were adequate and operating effectively

The boards have to make annual assessment of the internal financial controls and may consider getting an independent expert assurance on such systems

The boards would have to lay down the manner of formal evaluation of performance of the board, its committees and individual directors for listed and public companies.

Source: Companies Act 2013, Ministry of Corporate Affairs, Government of India

Separating the SOEs and Regulators

The GOP is committed to pursue a far reaching reform programme for the power sector and to help meet the country's future power needs.

Implementation of the envisaged programme will bring about a gradual transition of the power system from integrated, state-owned utilities to a decentralized system with separate generation, transmission and distribution entities,

Having substantial private ownership and management, reflecting and encouraging a commercial and competitive operating environment.

Importance of hydropower SOEs and their Financial Management

The predominance of the hydropower sector in the national economy is expected to increase during the next 10 years.

Commissioning of Tala HPP (1,020 MW) in 2007 had a major impact on both GDP and exports. The power export in 2008–2009 was 45% of total exports and the power sector contributed over 40% of fiscal revenues.

Power sector-related debt consisted of 55% of external debt as of 2009.

The addition of debt from Tala HPP and the expected addition of further debt from new hydropower projects to be commissioned during 2014–2019 will see a substantial buildup in external debt. Hydropower-related debt will amount to about 80% of GDP by 2017 and the debt service will increase to about 50% of total exports by 2020.

Evaluation Study By ADB on “Bhutan Energy Sector”

The increased debt burden will be accompanied by an rise in fiscal revenues from hydropower exports. After meeting debt service obligations, the net cash surplus of the power export sector in 2017 will be 22.5% of the projected GDP in 2017 and this will increase to 31% of projected GDP in 2020.

Instituting prudent and transparent financial management practices to utilize the substantial financial surplus from power exports to promote the overall economic growth and socioeconomic well-being of Bhutan in a sustainable manner will be a challenge for the government.

Training of Management As per IFAC Financial managers in the public sector need to be competent and proficient in the following areas to discharge their responsibilities effectively:

• Strategic management • Information systems• Performance measurement • Economy• Management Accounting • Presentation• Financial Accounting • Analysis• Operational Planning and Design • Negotiating• Budgeting Writing• Internal Control • Counseling• Audit • Facilitation• Governance • Conflict management

Study by IFAC public sector committee tilted “governance in the public sector”

The critical areas for financial management performance are:• strategic planning;• formulation of output objectives, performance measures and operational plans;• organization (people and structure, operational processes and technology);• performance measurement, financial and performance reporting;• management of funds, working capital and other assets;• reliable and relevant accounting and information systems; and• procurement and contracting for goods and services.

Study by IFAC public sector committee tilted “governance in the public sector”

Other measuresOther than improving the Corporate Governance other measures can be undertaken:

Facilitate competition in the electricity industry

Improve regulation of functions that cannot be competitive.

Improving the business environment for all firms , which may include

Enforcement of Contracts,

Improving Employment Law,

Simplifying Tax Administration

CreditsRole of state-owned entities in the developmental state , South Africa courtesy Presidency Office ,

The Economist, Special Report ; “The Visible Hand”

The World Bank Toolkit on Corporate Governance of SOEs

Some Options for Improving the Governance of State-Owned Electricity Utilities, energy and mining sector board discussion paper, the World Bank

SRO_180_PublicSectorCompanies_CGRules_2013 pakistan

Evaluation Study, by ADB, “Bhutan : Energy Sector”

Tackling Investment Challenges in Energy Sector by IEA

Thank you

Bhutan energy sector- ADB

Key Issues,

Way forward

Key findings

recommendations

Institutional reforms and corporatization. Prior to the establishment of BPC as a corporate entity in 2002, the power sector in Bhutan was managed as part of the government under civil service rules and regulations. Issues were:

lack of flexibility,managerial autonomy, andfinancial independence.

flexibility introduced under the new corporate structure resulted in a more enterprising corporate culture. Use of private contractorsdecentralization of project implementation, and

This has resulted into timely provision of counterpart funds would have been difficult under the previous organizational structure.

Cost recovery. A cost-reflective tariff structure is essential, with due consideration for the residential consumers consuming less than the lifeline block (i.e., less than 80 kWh per month).

Financial sustainability. Rural electrification to be financially sustainable. Hence, the power sector in Bhutan can continue to absorb the high cost of rural electrification provided the government continues to provide electricity for domestic supply at a discount to export price.

Grid extension and off-grid renewable energy. There is scope for judicious use of grid extension and off-grid renewable energy applications for achieving 100% electrification. Bhutan has achieved an electrification rate of around 60%, mostly with grid extensions, at an average cost of connection per household of $1,500.

High voltage transmission network. Ensuring the development of the high voltage (400 kV/220 kV) transmission network in parallel with implementation of the 10,000 MW hydropower program remains a challenging task. Tala HPP and Chukka HPP had dedicated transmission lines to evacuate power to India. However, with the development of over 10,000 MW of hydropower capacity consisting of over 10 separate projects during the next 10–15 years, a holistic approach must be taken to development of the transmission network. This would enable Bhutan to minimize the investment requirement in the transmission network while providing adequate redundancy in the network to ensure network reliability while providing connectivity to domestic load centers and collecting substations across the border in India. The adverse impacts on biodiversity corridors can also be reduced by minimizing the transmission corridors through protected areas.

Seasonal variations. The availability of hydropower is seasonal and Bhutan isexperiencing difficulties in meeting its domestic power demand during winter. Hence, anadequate level of firm power capacity must be developed through several hydropower projects,with storage to minimize power shortages during winter. Another option is to develop non-hydro forms of renewable energy (such as wind power) to complement hydropower and diversify the country’s energy mix to reduce over-dependency on hydropower and mitigate the hydrology risk.However, development of the renewable energy in Bhutan is limited by lack of data andfeasibility studies on potential renewable energy projects, including small hydropower projects (i.e., below 25 MW), transmission network connectivity constraints, and financial constraints. It is expected that some of the policy barriers to renewable energy development will be addressed in the renewable energy policy under preparation with ADB assistance.

. Key IssuesEnvironmental and social issues. Environmental and social issues associated with thelarge-scale development of hydropower must be addressed in the context of possible changesto hydrology in the Himalayas as a result of climate change. The NEC, which has the primaryresponsibility for monitoring and enforcing mitigating measures for the adverse environmentimpacts of large hydropower projects, lacks the institutional capacity to discharge itsresponsibilities effectively given the scale of proposed hydropower development in Bhutan.There is also an absence of basin-wide studies to assess the cumulative impacts of thedevelopment of hydropower projects in cascade along the same river basin, and a need forenvironmental flows to ensure the ecological integrity of river basins. ADB has provided severalTA projects, including the ongoing TA 38 for institutional capacity building of the NEC, toinstitutionalize mechanisms for climate change adaptation and developing CDM projects. TheNEC needs more focused capacity building on river basin management and monitoring, andenforcement of environmental management of large-scale hydropower projects as Bhutan isembarking on a large-scale hydropower development program.

Lessons Learned Bhutan

Continuity. Long-term continuity in supporting institutional building and sectorinvestments, such as rural electrification, has been highly effective. ADB has maintainedcontinuity in its support for institutional building and financial assistance for rural electrification.This has built up a high degree of trust and confidence in ADB by government counterparts.ADB’s record of financing a major share of the rural electrification target under each five yearplan since 1995 has enabled the government to plan ahead with certainty over the availability offinancing. The presence of ADB as the anchor financier for the rural electrification program alsoprovided comfort to bilateral development partners to provide funding to complement ADBfinancing, and share project preparation and implementation arrangements with ADB-financedlarger rural electrification projects.

Socioeconomic and cultural context. Poverty and gender targeting should be basedon extensive understanding of the country’s socioeconomic and cultural context. ADB-financedrural electrification projects in 1999 and 2003 attempted to target the rural electrification benefitsto poor households by providing pre-designed household wiring kits to poor households. ADBalso attempted to train female technicians to install and maintain solar panels in remote areas toincrease the gender focus of the rural electrification program. Although these initiatives weredesigned based on socioeconomic surveys, they have not been effective as expected as thecultural context and social prejudices in the case of wiring kits, and institutional and financialsustainability in the case of village-based technicians, were not fully taken into account.

Ownership. Increased ownership of TA by the executing agencies results in more effective TA implementation and sustainable TA outcomes. Executing agencies have shown ahigh degree of ownership in identifying the need for TA, defining the scope of the TA projects,and in TA implementation. Selectively increasing their role in TA management, based on theirrecord in TA implementation, could increase the effectiveness of TA as it provides an increasedsense of ownership and responsibility. The IEM has noted that several executing agencies inthe energy sector are highly competent and familiar with ADB TA administration procedures.

Corporate-governance disclosure requirements of the ASX—excerpt

The Australian stock exchange, ASX, requires listed companies to disclose whether they abide by the following“best practice recommendations” for corporate governance and, if they do not abide by them, explain whynot. For brevity, we have excluded some recommendations about providing information. Original numberinghas been retained.1.1 Formalize and disclose the functions reserved to the board and those delegated to management.2.1 A majority of the board should be independent directors.2.2 The chairperson should be an independent director.2.3 The roles of chairperson and chief executive officer should not be exercised by the same individual.2.4 The board should establish a nomination committee.3.1 Establish a code of conduct to guide the directors, the chief executive officer (or equivalent), the chieffinancial officer (or equivalent) and any other key executives as to: 3.1.1 the practices necessary tomaintain confidence in the company’s integrity and 3.1.2 the responsibility and accountability ofindividuals for reporting and investigating reports of unethical practices.3.2 Disclose the policy concerning trading in company securities by directors, officers and employees.4.1 Require the chief executive officer (or equivalent) and the chief financial officer (or equivalent) to statein writing to the board that the company’s financial reports present a true and fair view, in all materialrespects, of the company’s financial condition and operational results and are in accordance with relevantaccounting standards.4.2 The board should establish an audit committee.4.3 Structure the audit committee so that it consists of: only non-executive directors; a majority ofindependent directors; an independent chairperson, who is not chairperson of the board; at least threemembers.

4.4 The audit committee should have a formal charter.5.1 Establish written policies and procedures designed to ensure compliance with ASX Listing Rule disclosurerequirements and to ensure accountability at a senior management level for that compliance.6.1 Design and disclose a communications strategy to promote effective communication with shareholdersand encourage effective participation at general meetings.6.2 Request the external auditor to attend the annual general meeting and be available to answershareholder questions about the conduct of the audit and the preparation and content of the auditor’sreport.7.1 The board or appropriate board committee should establish policies on risk oversight and management.7.2 The chief executive officer (or equivalent) and the chief financial officer (or equivalent) should state to theboard in writing that: 7.2.1 the statement given in accordance with best practice recommendation 4.1(the integrity of financial statements) is founded on a sound system of risk management and internalcompliance and control which implements the policies adopted by the board; and 7.2.2 the company’srisk management and internal compliance and control system is operating efficiently and effectively in allmaterial respects.

8.1 Disclose the process for performance evaluation of the board, its committees and individual directors,and key executives.9.1 Provide disclosure in relation to the company’s remuneration policies to enable investors to understand(i) the costs and benefits of those policies and (ii) the link between remuneration paid to directors andkey executives and corporate performance.9.2 The board should establish a remuneration committee.9.3 Clearly distinguish the structure of non-executive directors’ remuneration from that of executives.9.4 Ensure that payment of equity-based executive remuneration is made in accordance with thresholdsset in plans approved by shareholders.10.1 Establish and disclose a code of conduct to guide compliance with legal and other obligationsto legitimate stakeholders.Source: ASX Corporate Governance Council, 2003.

Power sector

ENABLING INVESTMENT THROUGH

POLICY CLARITY AND REGULATORY

EFFICIENCY

Improving governance of State owned Utilities