Utility privatization in UK bites back?

Britain, which pioneered large-scale utility privatizations in the eighties as part of the Thatcherite neo-liberal ideological push, is currently witnessing an interesting turn of events that questions the underlying belief behind that ideology. In recent days, British regulators have stepped in aggressively to reject filings by utility operators to raise prices. Both the water and airports regulators have rejected claims by service providers to raise fees, while the gas and electricity providers are going ahead with price increases. These decisions have sparked public outrage and invited strong reaction from political parties.

The water regulator, Ofwat, has rejected a proposal by Thames Water to raise water and sewerage tariffs by 8% or by £29 from the existing rate of £354. This is over and above the inflation indexed and additional 1.4% annual rise in tariffs over the next five years. Thames Water, which is the monopoly supplier to 14 million consumers along the Thames Valley and in London, claims it needs the increase to offset bad customer debts, finance the construction of the £4.1 bn Tideway Tunnel to prevent overflows into the Thames (the 'super sewer'), and repairs to 40000 km of private sewers. Ofwat, which regulates Thames and 18 other water and sewerage utilities across England and Wales, rejected the claim arguing that the firm was not doing enough to control costs as well as pursue delinquent consumers. Tariffs are regulated by the Ofwat based on a five-year pricing settlement with the providers. The next settlement is due for the 2015-20 period.

The Civil Aviation Authority (CAA), the airports regulator, rejected a proposal by Heathrow Airport Holdings (HAA), which operates the airport, to raise airline landing fees. The CAA ruled that the landing fees should rise only in line with inflation, as originally agreed, over the next five years. HAA argues that since 2003 it has invested £11 bn to improve facilities, including building two terminals, and the recession has meant that it has not been able to recover its investments under the prevailing regulatory regime. The CAA rejects this and has proposed that the weighted average cost of capital (WACC) should be cut from 6.2% to 5.6% in view of the lower interest rates and reduction in corporate tax. It also argues that Heathrow has one of the highest landing fees in the world, which gets passed on to the airline ticket prices. The high prices is also a reflection of the generous regulatory regime that had been followed till now. 

Incidentally, Chinese Investment Corporation (CIC) and Abu Dhabi Investment Authority hold 8.68% and 9.9% stakes in Thames Water. Chinese, Qatari, and Singapore sovereign wealth funds have investments in HAA. 

The gas and electricity markets too have been in turmoil. There are more than 20 gas and electricity suppliers in Britain, though the market is dominated by British Gas, EDF Energy, Eon, SSE, NPower, and ScottishPower. Ofgem, which oversees the energy market, does not have any tariff setting powers. Its primary responsibility is to ensure that consumer choice is not impeded by misinformation or dirty tricks. Though energy consumers have supplier choice, the benefits of competition have not been in much evidence. While energy bills respond immediately to higher input costs, it has been found to be sticky downwards. In fact, energy prices have been rising steadily in recent years and the decision by most major energy providers to increase gas and electricity prices, by 8-10%, has raised political hackles. The Labor leader Ed Milibland has even announced a freeze on gas and electricity prices for 20 months if Labor comes to power. Providers have been blaming the increases on higher cost of procuring energy. 

The similarity of problems faced by the regulated and unregulated water and energy sectors respectively highlights the complexity of managing utility infrastructure markets. The experience of the electricity market in UK questions the conventional wisdom that the market mechanism, even with adequate competition, is superior to the government in effectively managing utility projects and protecting the interests of both consumers and operators.  

Historically, the British regulators have been extremely liberal, allowing operators to regularly pass on tariff and fee revisions to the consumers. It is now well documented that the rail privatization has resulted in large private profiteering without the promised capital investments and reduction in subsidy burden. Regulatory failings are to blame for many of these problems. For example, the relationship between wholesale and retail energy prices have been opaque in British energy markets.    

The average annual water (Thames Water) and energy (British Gas) bills are £383 and £1444, or a total of  £1527, or around 11% of the annual income of a family at poverty line. In UK, gas and electricity prices have risen in real terms by 41% and 20% since 2007. This was fine when the economy was doing good. 

However, the recession, where real wages have fallen 9% over the past four years, and several high profile examples of profiteering by the operators have raised the political pressure on more effective regulation of utilities. It is in this context that we have to see the aggressive actions of regulators in recent times to reject proposals for tariff and fee increases. But there is the fear that such aggression will militate against the British government's plans to mobilize £300 bn in new infrastructure investments. In any case, the latest evidence from Britain is yet another reminder about the need for a more nuanced approach towards private participation in utility services. 

The coal blocks allotment scam and bureaucratic decision paralysis

The latest twist in the CBI's investigation of India's coal block allotment scandal is a an excellent example of how decision paralysis threatens to grip the Indian bureaucracy.

The latest issue concerns the decision to allot Talabira II and III coal blocks in Odisha to Mahanandi Coalfields Ltd (MCL), Neyveli Lignite Corporation (NLC), and Hindalco. The coal blocks were originally allotted to the two state-owned firms by the Coal Ministry's Screening Committee. However, Mr Kumar Mangalam Birla, owner of Hindalco, wrote to the Prime Minister, asking for allotment of some coal from Talabira for the captive power plants being set up for its two Aluminium plants in Odisha. On the Prime Minister request for a report, the then Coal Secretary, Mr PC Parakh, after re-examining the case, recommended for sharing of coal extracted from the two blocks in a ratio of 70:15:15 between MCL, NLC, and Hindalco. The present controversy arose when the CBI, investigating into all coal-block allotments, filed an FIR, implicating the Mr Parakh and Mr Birla for indulging in a criminal conspiracy to get the coal block allotted to Hindalco, in contravention of the earlier decision to allot the blocks to only the two public sector entities. 

The Prime Minister's Office has issued a very detailed clarification to clear the air. It has clearly asserted that the decision to change the allotment was influenced by the strong recommendation of Odisha Government, directly through its Chief Minister, that Hindalco be given preference in the coal block allotment since it sought to establish two Aluminium plants which would create a number of jobs. 

Now consider the context. The Government of India had been following a discretionary allotment policy for coal blocks. The role of Mr Parakh, was to give his remarks on the request of the Prime Minister. He did so, by making out a case to revise the allotment. The Prime Minister, being the Coal Minister too and therefore the competent authority, after examining the case and the report of the Coal Secretary, approved the change in allotment. The due process of law being followed in all the official transactions. Given this context, the CBI's FIR makes interesting reading,

Pursuant to these letters and personal meeting between Parakh and Birla, Parakh, by abusing his official position as a public servant recommended the allocation of Talabira II along with Talabira III coal block to Hindalco Industries Limited, along with other two companies without any valid basis or change in circumstances and with the sole intention to show undue favours to Hindalco Industries Limited… The inclusion of Hindalco reduced the share of Neyveli Lignite in the coal field… Due to this arrangement, the proposed power project of the NLC could not take off as planned.

Notice the insinuating reference to a “personal meeting”, which, atleast from the FIR's operative part, forms the basis a very sweeping accusation. Mere reversal of a decision, even if it meant adversely affecting the interests of a public sector entity, cannot form the basis for a “criminal conspiracy”. In this case, Mr Parakh had clearly laid out the reasons for his recommendation so that the competent authority could take a decision. One can ponder over the merits of the recommendation. However, to attribute malafide due to selective focus on three events from amongst an expansive cohort of potentially unrelated events - a “personal meeting”, loss caused to a public sector entity, and gains to a private entity - strains credulity. 

The substantive allegation in the FIR is that the decision caused loss to a public sector entity and gains to a private sector entity. This reveals the widespread proclivity, even among well-intentioned people, to view national interest as equivalent to the interest of any government agency, especially so when it is pitted against a private agency. It is of course true that, more often than not, governments and corporates have colluded in a manner as to defraud public entities. However, in the instant case, even leaving aside the state government's preference, economic considerations alone would have been enough to prioritize allotment of the blocks to a firm which sought to establish two Aluminium plants. Further, as the PMO statement shows, NLC could establish its power plant by partnering with MCL. It is another matter, and not surprising given its track record, that the NLC never got round to building the power plant.     

  

A decision, by definition involves an exercise of judgment! In a ‘rule-based’ regime and especially so in a ‘discretion-based’ regime (as was the case with the extant coal-allotment policy), this would invariably benefit one party at the cost of another. It is fallacious to presume that “following the rules” amount to an algorithmic application of those rules. The FIR betrays a failure to appreciate the complex dynamics of public resource allotment decisions - after all, the specifications of even an open-competitive bid document involves considerable subjectivity, which often benefits one party at the cost of another. If this line of argument takes hold, then every decision is liable to be questioned and officials will shy away from taking decisions.

In the entire case, I leave aside any reference to Mr Parakh's personal and professional integrity, impeccable as they are. Indeed, in this case, it was Mr Parakh’s correspondences that formed the basis of the CAG’s reports that exposed the coal-scam. Apart from several steps to introduce transparency into the allotment mechanism, he played the critical role in dispensing with the discretionary allotment regime. All this incontrovertible evidences appear to have been overlooked in favor of a subjective and questionable appreciation of the events leading to the decision. 

In simple terms, a Secretary to Government of India gives his considered opinion, following the due process, on a formal request from the Prime Minister, who as competent authority agrees with the opinion and takes the decision. All the transactions and decisions are in consonance with the prevailing rules and within the powers of the respective individuals. However, the premier investigating agency of India sees red and finds the Secretary culpable of "criminal conspiracy". Given such precedents, who can blame officials in Delhi and elsewhere, of sitting on decisions.   

Such hair-trigger investigations will only demoralize the bureaucracy, at all levels, and amplify the trend towards a potentially complete paralysis of decision-making within the government. Or is there something more than incompetence that influenced the FIR? Or is it further evidence of our descent into a banana republic?

The challenge with private development of mineral and energy resources

What is the most effective contractual framework for governments to appropriate "fair returns" from the allotment of natural resource exploitation rights to private parties? I think this is a question that deserves much more attention than it has got.

It is critical to effectively address the governance issues in natural resource exploitation contracts. This assumes great relevance for mineral resource rich countries, especially in Africa, whose relationships with mining and energy firms have been mired in allegations of corruption and exploitation. It is equally important for many developing countries seeking to enter development contracts with private firms to exploit their natural resources. 

This is not to say that things will be fine once we have effectively addressed contract governance issues. The effective management of the money generated from the contract would still remain a formidable challenge.

Evidently, the most relevant contract will vary based on context as well as sector. However, there are basically two broad questions. One, what should be the contractual form for sharing of profits between the private developer and the government? Two, should the price of the resource extracted be regulated or determined by a market-based (domestic or international) process of price discovery? If regulated, what should be the principles for the regulated price discovery?

Unfortunately, there exists considerable ambiguity, certainly no consensus, on any of these questions. The commonest form of development contract is different models of production sharing contracts (PSCs). There are broadly two types of PSCs - one where the entire capital investment made by the developer is recovered before revenues or profits are shared and another where the revenue/profit sharing (or royalties) starts as soon as production begins. In the former, the investment risks are borne entirely by the government whereas in the later those risks lie with the developer. In practice, most development contracts reside somewhere between the two extremes. Further, many of these PSCs also have an upfront signing bonus which is transferred by the developer to the government alongside the signing of the agreement.

In case of the least developed resource-rich countries, where developers often hold the upper hand in negotiations, the PSC is more likely to be skewed towards back-loaded sharing of returns. However, governments in larger developing countries prefer to front-load the extraction of their benefits, which in turn often ends up putting off the larger multinational firms.

Both these PSC's suffer from operational problems. The back-loaded revenues sharing PSC raises the question of valuation of the capital investment. Since the firm knows more about its investment decisions and governments have limited expertise to reliably assess investments made, the incentives are aligned towards the private firm gold-plating its investments so as to extend the investment recovery period. The front-loaded revenues sharing PSC often runs into problems of accurate estimation of the production output or its value, as firms try to under-invoice its production either directly or through abusive transfer pricing (under-invoice or charge lower prices in selling the output to its subsidiary) along the upstream of the production chain. Again, a mix of incompetence and corruption enables firms to game the process to its benefit.

Interestingly, in case of the energy sector, the development of oil and gas fields is mostly done or led by state-owned entities. Private participation is through strategic partnerships with the state-owned entity. This eliminates the need to enter into production sharing agreements. Indeed there are just a handful of cases where governments have invited private firms to exclusively develop oil or gas fields. The Government of India's allotment of the KG Basin to Reliance is a very rare example of such PSC with a private developer. It is no surprise that the contract has been mired in controversies.

In the US, where competitive market exists and regulatory and political uncertainty is minimal, most PSC's are front-loaded with a pre-defined revenue/royalty sharing and with a signing bonus as the bid/auction parameter. Much the same is true of other developed market. However, private developers would be reluctant to invest in many developing countries with such a PSC design given the large political and regulatory uncertainties with these countries. But any back-loaded PSC runs the risk of private profiteering and large-scale corruption, with attendant controversies and regulatory and political uncertainties.

This leaves us with the question of pricing. In this there is greater consensus that the price discovery should be left to the market mechanism. However, there are sectors like natural gas, which does not have a globally integrated market. In such cases, a market-based price discovery may not be possible nor be the most efficient option. Once price regulation becomes the most effective option, it begs the question of how the price should be calculated. Again the case of Reliance in India is instructive.

In any case, as the aforementioned challenges highlight, the issue of contracting private firms for the development of natural resources remains a minefield. And it is surprising how little attention is paid to the critical last mile issue of structuring the development contract. 

On Cyclone Phailin and India's state capability

Cyclone Phailin has come and gone. Thanks to a massive evacuation effort, nearly a million people, and good preparedness, loss of human lives have been minimal. Given the limited personnel and material resources and logistics available, it is a truly remarkable achievement by district governments in Odisha and Andhra Pradesh. 

It begs the question as to what is it about India's weak state machinery that enables it to do certain things, like massive emergency relief operations or organizing large events or managing large short duration campaigns, with a great degree of accomplishment, arguably better (and yes, I am sticking out my neck and confidently making that claim!) than what more developed bureaucracies with much greater resources could have done when faced with similar challenges? 

Amidst the plethora of governance failures, governments in India do remarkably well with certain activities like disaster relief, elections, census, pulse-polio campaigns, or even Kumbh Mela and the like. Just recently, the Tamil Nadu government successfully delivered on its campaign promise to distribute televisions and mixer-grinders. A defining feature of all these activities is that they have clearly defined goals and deadlines. A testament to the effectiveness of this strategy is that several state and local governments often embrace such one-off mission-mode campaigns to deliver certain prioritized public services. It is of course a different matter that the programs so implemented too fail, but for different reasons.

In stark contrast, once the program is open-ended, as those like statutory services and certain welfare services are, the problems start to arise and rot sets in quickly. What explains the contrasting fortunes of the two types of programs? Here are a few conjectures.

Primarily, these mission mode programs have clearly defined goals, both in terms of the activity to be done as well as the time line to be adhered to. Second, they involve mobilization of sufficient manpower and logistics, required to complete them within the required time and without compromising on its rigor. Third, all such programs involve unambiguous delineation of work responsibilities, well-documented processes and protocols, and well-defined and pre-announced functional targets for officials. Fourth, it has clear and rigorously enforced reporting mechanism that enables appropriate monitoring and supervision. Fifth, the officials are adequately trained in their functional responsibilities. 

But the most important reason may be its exclusive focus. This addresses the bandwidth scarcity problem associated with public systems. It is commonplace to have overburdened bureaucracies being entrusted with a variety of disparate responsibilities. This is a recipe for failure to deliver effectively on anything. 

In any case, it is surely a pointer to how we can set about reforming our program implementation environment, in a manner that helps get stuff done.  

China's economic re-balancing challenge

From an excellent article by Yu Yongding,

Currently, the most severe problem confronting Chinese authorities is over-capacity. For example, China's annual production capacity for crude steel is one billion tons, but its total output in 2012 was 720 million tons - a capacity utilization rate of 72%. More strikingly, the steel industry's profitability was just 0.04% in 2012. Indeed, the profit on two tons of steel was just about enough to buy a lollipop. So far this year, the average profitability of China's top 500 companies is 4.34%, down 33 basis points from 2012...

Despite China's lack of a comparative advantage for steel production, it has built approximately one thousand mills, with output accounting for roughly half of the global total. As early as 2004, China's government tried to clamp down on over-investment; and yet output increased dramatically, from 300 million tons that year to a billion tons in 2012, owing to strong demand generated by investment in infrastructure and real-estate development...

With per capita income at less than $6000, home ownership in China is roughly 90%, compared to less than 70% in the US... China has 696 five-star hotels, with another 500 on the way. Five of the ten tallest skyscrapers under construction worldwide are in China... China's economy is being held hostage by real-estate investment... currently running at 10-13% of GDP, is already far too high.

Going forward, China's biggest problem is in re-balancing its unsustainably high investment rate...


... which has underpinned its physical capital accumulation based economic growth model.

There are lot of things going on here. The rulers in Beijing realize that their investment-driven model is critical to sustain the high growth rate, which is the glue that maintains economic, political, and social stability in the country. It keeps creating the jobs required to employ a large and growing workforce rapidly transitioning out of agriculture. The high property prices gives the provinces and local governments the required resources to sustain their grand infrastructure and real-estate projects. In turn these projects provide the demand to keep manufacturers with their high capacity factories working full-time. Besides, it also helps cover-up the strains on heavily exposed (to construction-intensive sectors) bank and debt-laden corporate balance sheets. A rapidly expanding economic pie provides the officials and leaders with ample to nibble at the margins and thereby keep the ruling establishment satisfied. Finally, the high growth rates provides the Communist Party with the credibility to continue the political status quo.

Any talk of re-balancing invariably involves unsettling this tenuous equilibrium. But given the complexity of the situation, any prospects of calibrated government policy maneuvers to re-balance the economy by shifting consumption and investment trends, does not look promising. 

Lessons from Britain's utilities privatization

Britain has privatized its last remaining large public utility. The decision to privatize the Royal Mail has attracted considerable investor interest as well as triggering a reassessment of the outcomes of the massive privatizations of the eighties. For the record, the privatization involved selling 52.2% of Royal Mail, valued at £3.3bn.

The floatation was over-subscribed seven times, attracting 700,000 retail applications, encouraged by the low 330 p share price. In fact, the low listing price was immediately borne out when the share debuted at 450 p, before easing down to 441 p, or 36% higher than the listing price. This does naturally raise questions about whether the utility was sold too cheap. However, emboldened by the over-subscription and to pre-empt "stagging" (selling immediately after the debut), the government had announced that investors who had applied for more than £10,000 worth shares would return empty handed.

But an assessment of the utilities privatization of the eighties raises many questions about the value addition that has accompanied ownership transfers. The FT draws attention to a study of the privatization of railways which finds large private profiteering without capital investments and large subsidy outflows from the government. The report finds that the franchising policy has artificially boosted the profits of the privately owned train operating companies (TOCs) while loading debt into the publicly guaranteed Network Rail,

Network Rail has been inflating the profits of the TOCs by lowering track access charges from £3.19 billion in 1994 to £1.59bn in 2012... This hidden sum is nearly twice as large as direct government subsidies to the TOCs and the cost of servicing this growing debt is now larger than the cost of annual railway maintenance. Now, half of the new debt currently being issued by Network Rail covers the cost of servicing existing debt. Direct public expenditure on rail has more than doubled since privatisation and is currently running at £4 billion a year... despite fares rising which are now higher than in other major European countries.

In the context of British government decision to cap rail commuter fares and calls to do the same with energy prices, an FT commentator argues that

If the regulatory balance is wrong or the competitive structure ineffective, the public ends up paying too much, corporate profits become too high and private sector shareholders get a free ride from tax payers... mysterious pricing, hidden state subsidies, consumer confusion and inbuilt advantages to established operators appear systemic in the privatized utilities... Failure to construct an effective market mechanism risks creating faux competition, characterized by cosy rivalry rather than head-to-head battles that drive down prices and transform public service. In turn, this facilitates low-risk profit opportunities for the private sector on the back of officially condoned oligopolies and hidden state subsidies.

The British rail privatization had unbundled the system into three parts. An infrastructure company, Network Rail (earlier Railtrack) owns the track, rolling stock operating companies (ROSCOs) own the trains, and TOC's run the trains. There are currently 17 TOC franchises (down from the original 25), operating both long distance inter-city routes as well as urbanized commuter lines. The ownership of the franchises have changed hands many times. 

Solar Power - Lessons for Gujarat from Spain

In the second half of last decade, Spain witnessed massive investments in renewable energy. This was underpinned by a policy of  feed-in-tariffs (FIT) which assured very generous (44 euro cents per KWh) tariffs for 25 years or the project life. This led to a massive spurt in investments, raising the share of non-hydel renewables in the country's electricity supply from 13% to 27% in the 2007-12 period. This predictably led to the emergence of a large tariff deficit, or the difference between the cost of purchase (or the assured FIT) and the price consumers pay. The cumulative subsidy burden from this tariff deficit is now about 26 billion euros (or $35 bn), with the deficit this year estimated to be 2.5-3 bn euros.

In July this year, the Spanish government issued a decree aimed at bridging the tariff deficit. The decree mandates that instead of an assured FIT, solar generators have to sell their electricity on the open market like other generators and receive additional "fair" compensation based on their investment. That compensation will be linked to 10 year sovereign bonds, plus 300 basis points, implying an annual return currently of about 7.5%. This will apply to even existing generators who have been guaranteed very profitable 25 year FIT subsidies.

The Spanish experience assumes great relevance for countries like India which has aggressively sought to promote investments in renewables. The Gujarat Solar Policy is the one which bears the greatest resemblance to the Spanish story. In 2009, the Gujarat state government announced attractive FIT's, Rs 13 (for those commissioned before 31.12.2010) and Rs 12 per KWh (commissioned before 31.03.2014) of solar PV power supplied for the first 12 years.

It met with immediate success as generators rushed in to set up solar plants. The state now accounts for more than half the solar installed capacity in India as a wave of solar power plants have been commissioned in recent years. In fact, the Gujarat Urja Vikas Nigam Ltd (GUVNL), which buys the solar power, has so far signed power purchase agreement under the Policy with 88 developers for about 971.5 MW. These agreements, worth Rs 15000 Cr of investments, were signed without any competitive bidding and on a direct nomination route under the Policy. Commentators have rushed in to advocate the Gujarat model as an example worthy of emulation.

In fact the aggressive policy of Gujarat government has been in stark contrast to the more measured approach of the central government. Instead of a head-long plunge, it has preferred a phased expansion. Interestingly, in the first two auctions held under the National Solar Mission, developers have quoted far lower prices than the FIT's assured by the Gujarat state government. The steep drop in solar panel prices has enabled a much faster convergence between solar and thermal prices, thereby leaving the Gujarat government to saddle a very high tariff deficit and subsidy burden.

Now, in an acknowledgement of the mis-judgement with its Solar Policy, the Gujarat state government is exploring ways to restrict the period of the FIT. The GUVNL recently petitioned the state electricity regulator to lower the FIT under the Solar Policy to about Rs 9 per unit ($0.15), comparable to the prices received by the Government of India in its auctions. Clearly Gujarat ignored the lessons from Spain, which were already widely known by 2009, and choose to go ahead with aggressive tariff subsidies. Even with the lower tariffs, given the pace of solar-thermal convergence, the Gujarati tax payers will end up subsidizing the solar generators. 

My problem with randomistas

Prof Ricardo Hausman made a very interesting point in class today about the use of randomized control trials  (RCTs) in social policy and medicine. He makes the distinction between exploring general questions of economic growth or of medical research, and examination of growth in a particular country or treatment of a patient. He argues that while RCTs may be useful instrument in the former (RCTs in clinical trials of drugs or to isolate the effect of a particular social policy intervention) it is likely to be less useful in the second quest. I agree and I particularly like the analogy with medicine.

I feel that just as clinical judgement should form the starting point for any treatment of a medical condition in a patient, a diagnostic approach should do the same with social policy design and implementation. This diagnostic approach can be either a consultant's deep-dive problem solving one or Hausman and Co's growth diagnostics or any other similar process which essentially starts with the problem. Further, such diagnosis rests on a very strong foundation of priors, whose strength and reliability depends on judgement skills that have been honed by a rich experience of diagnosis.

However, once the clinical judgement is done, the doctor may still resort to some diagnostic tests to validate his initial clinical judgement. This is done when he/she is uncertain about certain symptoms. By the same analogy, a field test, including an RCT, can be effective in identifying the still uncertain elements that remain after the initial diagnosis is done. I have written about this earlier here.

But it needs to be borne in mind that field tests and the like come after the priors have been established through a non-experimental process of problem diagnosis. In other words, tests like RCTs are secondary to the primary process of problem diagnosis. Unfortunately, I believe that the randomistas refuse to allow for many priors and see their process as being primary to everything else in their quest for the ideal policy design.

In this context, the current state of medical treatment in the US, where clinical judgement has taken a backseat to diagnostic tests, is instructive. As a result of the threat of litigation suits and the moral hazard problems unleashed by a lightly regulated insurance based model, "defensive medicine" has gripped the US health care practitioners. This has resulted in the emergence of more time consuming and expensive treatment protocols. The use of RCTs in design and implementation of social policy for a particular context is remarkably similar to this, a resort to "defensive" policy making. Its dominance is just a reflection of the weakness of problem diagnosis. And like with medical treatment, it is both time consuming and expensive.

We need to be cautious in stretching this analogy with medicine. First, the number of combinations (of solutions) that populate a design space is much smaller with medical research than with social policy. After all, the number of ways in which a molecule can combine with another or affect an organ (or the body) is likely to be just a handful. Second, unlike social policy, external validity is a much smaller problem with medical research. Once the drug is tested with the few broad genetic or other physiological types, the external validity as well as functional effectiveness can be reliably established. Unlike medicine, social policy is not science! 

Libra Auctions - Maximizing Fiscal Revenues Vs Ensuring Commercial Viability

Last week the Brazilian government opened the much awaited auction of the pre-salt Libra off-shore oil field in the South Atlantic to lukewarm response from global oil majors. Its 8-12 bn barrels of recoverable oil lie under a 2 km thick layer of salt beneath the seabed and is estimated to eventually produce 1 million barrel per day, or nearly 50% of Brazil's current production. It is the first of a series of proposed auctions to develop large off-shore oil discoveries made in recent years.

The US oil majors were not among the 11 firms which registered, far lower than the 40 bids expected by the Brazilian government. State owned oil firms, from China, India, and Malaysia, dominated the list of registrants. The demanding terms of the auction is said to have put off competition. The FT writes,

The government was charging a signing bonus of R$15bn ($6.6bn) for the winning group. Petrobras, which is required to take a minimum stake of 30 per cent in all blocks in the pre-salt fields, will need to spend at least R$4.5bn on the signing bonus. The bidding groups will compete on how much of the so-called “profit oil” in the production-sharing contract they are willing to allocate to the government beyond the state’s minimum share of 40 per cent. All told, the total “government take” will be 75 per cent, including the amount from the signing bonus, income tax and the 40 per cent of profit oil. The winning bidder will be able to use up to half of the value of gross production per month to cover the cost of development of the field for the first two years of the contract, after which this will be reduced to 30 per cent.

The auctions being held under the country's new oil field development policy places further restrictions, most notably the operational control of the field,

The auction will be the first under the country’s 2010 production-sharing agreement through which the government has sought to increase its control over the country’s newly discovered reserves. Under the model, the government will award rights to explore and produce oil at Libra to whichever company or group that promises to give the largest share of its output from the field to the Brazilian government... Petrobras will also automatically take a minimum stake of 30 per cent in the winning consortium and become the sole operator of the field, controlling exploration and production.

The initial response raises questions about the strategy being pursued for the development of the pre-salt fields, discovered in 2006-07 and easily the largest oil find in South America in decades. Apart from the restrictive conditions, two other factors may have muted investor enthusiasm. One, this is part of the $237 bn five year (2013-17) investment plan being implemented by Petrobras, the largest corporate capital expenditure plan ever. The scale of its planned deep-water drilling operations have never been attempted by any oil firm before. Two, despite positive drilling results till date, the technological challenges associated with extracting oil from under the sheet of salt is likely to be formidable. Both these factors exacerbate the risks associated with the project.

Clearly the Brazilian government views the pre-salt oil fields as a cash cow to be milked to maximize the country's fiscal gain. In fact, the one-time signing fee itself is seen as too steep in comparison to similar international agreements. In addition, by making Petrobras as the sole operator for these fields, the external investors will remain "sleeping partners" of the state-owned firm. The decision has given currency to the perception that the government plans to use Petrobras as an instrument to exercise operational control. The long history of expropriation of privately held assets too would not have been lost on investors. 

The government has resorted to the production-sharing agreement, as against a concession model, since the exploration risk (possibility of finding oil) is lower in the pre-salt area. Under the production sharing contract, the government retains ownership of the resource and the operator is allowed to profit from selling a share of the oil. In a concession contract, the company owns the resource but returns a share to the state through taxes and royalties. 

Governments, like Brazil, seeking to leverage foreign capital and technology to exploit natural resources face the difficult dilemma of balancing between maximizing its windfall revenues and allowing the commercial viability of the development project. Unfortunately, immediate financial gain and populist considerations predominate in such decisions. This undermines the long-term financial viability of the project and reduces the attraction for foreign and domestic private investors. The pre-salt oil fields, where the government effectively appropriates 75% of the output and uses Petrobras to exercise operational control, is only the latest example of this trend.  

Update 1 (12/22/2013)
Mexico has amended Articles 27 and 28 of its Constitution to allow contracts between the government and private companies to share profits from the extraction (also refining, transporation, storage, and distribution) of the country's rich on-shore and off-shore (off Gulf of Mexico) oil and gas deposits. The country's oil industry was nationalized in 1938 and in 1960 a constitutional change assigned full control to Pemex, which today contributes nearly a third of the country's budgetary resources. The FT writes,

Other promising hydrocarbon deposits in Mexico, particularly in shale beds and deepwater wells, remain untouched because Pemex lacks the technology and financial capacity to profitably extract from these sites. While Mexico’s energy production remained stalled, other countries with the assistance of the private sector have learned to develop hard-to-reach resources efficiently, with less pollution and risk.

The government estimates the reform will lower energy prices, create over 2m jobs over the next decade, strengthen Pemex by making it compete on equal grounds with private companies, and provide Mexico with needed funding to invest in long-term infrastructure projects. Under the legislation, a new Mexican sovereign fund will be created, operated by an appointed independent board, to manage royalties and make investments in the country.

The reform will allow private investment through various schemes: profit sharing, production sharing, or in the form of licences. Mexico will benefit from new technology and financial and human capital to exploit its abundant energy deposits, not to mention the royalties it will receive. Foreign and domestic private investors will benefit from entering a market with plentiful energy resources.

India gold market fact of the day!

From India Together (and Writers Block),

There are no official figures for how much Indians invest in physical gold (in the form of gold bars and jewelry). But according to estimates of the World Gold Council, the investment demand in India has grown from about 16 per cent of total imports in 2003-04 to over 35 per cent in 2012-13. The federation representing Indian jewelers (AIGJTF) estimates that 30-35 per cent of gold imports are used for meeting investment demand in the form of gold bars and coins. Of the approximately 1000 tonnes of gold being imported annually in recent years, an estimated 350 tonnes is for investment purposes with most of the rest going into jewelry.

Much of the discussion on gold imports have revolved around its impact on India's current account deficit. Who are the investors in these gold bars? What is the source of their wealth? My conjecture is that gold has become an excellent (safe and remunerative) channel to launder black money, whose volume has increased rapidly in recent years. Is it just a coincidence that in recent years we have seen a spurt of investments in jewelry retailing, including branded ones, even in second and third tier cities across India? It will be interesting to examine their balance sheets to see whether any of them are making formal profits. My guess is not!

Update 1 (31/10/2013)

Jahangir Aziz argues that restrictions on gold imports as a means to lower CAD may be a misdiagnosis of the problem, in so far as households were only fleeing to gold in the absence of good alternatives,

Gold imports rose from an average of $15 billion (1.5 per cent of the GDP) through 2005-07 to $55 billion (3 per cent of the GDP) last year, peaking at $67 billion (3.6 per cent of the GDP) in 2011-12. Some of the $40 billion-increase in gold imports is clearly due to the growth in gems and jewellery exports, but not very much. India's national income data provides a stark reminder of how much gold was used for pure investment purposes. Household investment in gold rose from an average of 1 per cent of the GDP over 2005-07 to nearly 2.5 per cent of the GDP. Using this and the pace of growth of jewellery exports, it is not unreasonable to surmise that roughly $30 billion of the rise in gold imports, that is, about 1.5 per cent of the GDP, was for investment.

The broking firm CLSA estimates that India has 20000 tonnes of gold worth $1.1 trillion. FT has more interesting points,

Indian demand jumped from 471 tonnes in 2001 to 1,017 tonnes in the year to March, worth $54bn... donations have transformed India’s temples into vast gold stores, with the country’s three largest owning a stock of 3,500 tonnes, according to a recent report from Credit Suisse... Were Indian gold demand to fall back below 1 per cent of gross domestic product, its average in the decade before the financial crisis, an extra $200bn of investment flows would be generated for the broader economy, according to research from Goldman Sachs. 

 

Update 2 (1/11/2013)

Three articles in FT here, here, and here. Also this study by RBI on gold imports and loans by NBFCs.


Update 3 (10/11/2013)

Arvind Subramanian, Devesh Kapur et al have an interesting article that raises the possibility of capital flight into Swiss banks contributing substantially to the higher gold imports. They point to the wide discrepancy between Indian gold imports from Switzerland and Swiss accounts of their gold exports and argue that it could be the case of over-invoicing gold imports from Switzerland, with the excess money finding its way into Swiss banks. Graphs here.

Update 4(1/12/2013)
From the RBI report (via Zero Hedge), this graphic of the eightfold rise in formal sector gold loans in the 2008-12 period.

The end of second wave of globalization?

In response to Gawyn Davies' lament that protectionism may be responsible for the relative decline in global trade growth, Paul Krugman points to three trends to argue that the second wave of globalization may be a thing of the past.

He claims that the rapid growth in global trade since the sixties was facilitated by lowering of tariffs, first by developed countries and then by developing countries, and the advances made in transportation logistics with containerization and the construction of large container ships. The first two trends have certainly plateaued out and the benefits of logistics improvements may already be deeply internalized. Does this mean that the second unbundling led globalization is behind us? Krugman's are compelling arguments on the plateauing of global trade.

However, there are some uncertain elements in the game. For example, there may be more traction left in global services trade. Or has the information technology revolution played out fully? Further, there is a real possibility that demographic transitions in the developed world could lead to easing of restrictions on cross-border labor mobility. What will be its effect on global services trade? More specifically, will this lead to a shrinking of the non-tradeables or a rise in the "trade in tasks" sector? Finally, there is the logic of extending the flying-Geese model to countries of Africa. Who are we to say now, with any degree of conviction, that African countries cannot benefit from the dynamics of countries movement up the production value chain?

This highlights the difficult of prognosticating about such complex global trends which have long time horizons. We can at best talk in probabilistic tones about these issues, which may be not much different from coffee table speculation on such universal trends.  

The framing problem with welfare programs

It is commonplace for political leaders to claim that they have increased the number of beneficiaries of Old Age Pensions (OAP) or Public Distribution System (PDS) or the National Rural Employment Guarantee Scheme (NREGS) by a certain percentage every year. In fact, the irony cannot be missed that even as we achieve significant reductions in our poverty level (while the magnitude of decline is debatable, it cannot be denied that poverty has declined, and that too significantly), the coverage of our poverty support programs have been expanding at an even faster pace.

The performance of the state Rural Development and Civil Supplies departments and its officials are judged by the magnitude of increase in the coverage of OAP or PDS or NREGS beneficiaries. Chief Ministers proudly highlight this achievement in their annual Independence Day speeches. Ministers lose no opportunity to declare them in every meeting and press conference. “Exemplary work” in these areas, recognized in the form of awards given to officials, are generally defined in terms of innovations to expand coverage. “Coverage expansion” has become the thousand pound gorilla in the room with many of our redistributive programs.  

It has distorted incentives and priorities in atleast two significant ways. One, its quantitative simplicity and ease of monitoring has edged out every other parameter, including those related to the quality of coverage or the achievement of the desired program outcomes. Therefore, inclusion and exclusion deficiencies in the coverage of these program, quality of food grains delivered, pilferage in the pension delivery chain, productivity improvements achieved by the wage guarantee program, and so on become incidental to coverage expansion.

Second, as aforementioned, this definition of program success has cognitively suppressed the logical fact that their successful implementation should translate to reduction in coverage. Consider the case of NREGS. In many state, atleast many districts, even after a very high level of coverage has been established and even local wages have risen sharply, District Collectors continue to be evaluated based on their coverage metric. We overlook that the NREGS is an unemployment insurance program and its success carries the seeds of its irrelevance.

Behavioral psychologists would define this a framing problem. Our cognitive understanding of the program has become entrenched in terms of coverage expansion, so much so that everything else has been relegated to the background. A cognitive bias arising out of a framing problem can be overcome only by breaking out of the framework and redefining it.

In the circumstances, we need to reframe the discussion and start debating such programs in terms of its objectives. More specifically, the programs should be judged on their specific and clearly defined objectives. This evaluation narrative should naturally include a measure of people exiting the program, having successfully, temporarily or permanently, graduated out of the deprivation that the program sought to address.  

India's labor market concern of the day

From Jayan Jose Thomas in Livemint,

Of the net increase of 48 million new non-agricultural jobs in India between 2004-05 and 2011-12, 24 million or half of the total increase was on account of jobs in construction, which were largely in rural areas and likely to be of poor quality. On the other hand, the manufacturing sector generated just five million new jobs during this period.

Specifically, there are three concerns. One, the construction jobs are not sustainable, especially given the cyclical nature of the sector. Now that the economy is on a trough, not only will a significant proportion of these jobs disappear but also the pace of new job creation will decline sharply. Two, manufacturing is clearly anemic, having created just 0.6 m jobs in the eight years. At a fundamental level, given the structural and demographic transitions that India is undergoing, this should be the biggest worry for the Indian economy. Three, the dominance of construction, taken together with the weakness of manufacturing, raises questions about whether there is a resource mis-allocation problem. My speculation is that crony capitalism, fueled by construction intensive infrastructure, doubtless played an important role.  

China's latest reform experiment

China has perfected the art of reform by stealth. By this I mean the strategy of initiating reforms in a small-scale and low-key manner - so as to figure out the challenges, prepare the political ground, provide adjustment cushions for businesses and citizens - before scaling them up in a big-bang.

The latest is an attempt to introduce the next generation of external market liberalization in the services sector by opening a 11 square mile Free Trade Zone (FTZ) in Shanghai. The FTZ's would have liberalize rules for financial market transactions and the services sector. Financial sector reforms in the FTZ would include liberalized norms for opening of banks, fewer restrictions on capital movements, and allowing market determined interest rates. Other reforms include easing of restrictions on foreign investments in 18 sectors, including general business, shipping, culture, and social sectors. Another important focus is on improving the ease of doing business in this area through management innovation and improvements in the regulatory environment and the legal system.

This follows the pattern of liberalization that has made China a global manufacturing powerhouse. Many of these measures would neatly fit into the basket of desired set of reforms for a country seeking to open up its financial and services sector. What is surprising is how the Chinese policy makers happen to hit the right policy buttons with such regularity. And the understated and cautious strategy to introduce those reforms is equally impressive.

Irrespective of how this will pan out, there is a compelling case that this pragmatic approach has the best likelihood of success in the implementation of such complex and generic sectoral reforms. Are policy makers on the other side of the Himalayas, who too face similar transitional compulsions, watching?