Akiva Ilan
State Comptroller’s Office,
Jerusalem, Israel
30 April, 2001
1. The purpose of this paper is to share some thoughts with my fellows at the Working Group on Privatisation regarding the possible use of some concepts from the area of privatisation in managing regulation. It does sound like a contradiction. Privatisation deals with reducing the role of the State in managing business affairs. The idea is to increase the exposure to market forces. Regulation, on the other hand, is about imposing rules of behavior, by the State, which limits the free choice of business firms in conducting their affairs, under certain circumstances.
In the discussions of our group it was pointed out that that privatisation could increase the need for regulation. It was mentioned that the privatisation of some State Owned Enterprises (SOEs), those who have a certain degree of control over the markets in which they operate, creates a need for regulation. That applies if such market power was not eliminated during the process of privatisation.
That attitude implies that:
(a) That public ownership compensates for the flaws of a monopoly. Since a SOE does not abuse market power, as a private firm may. (Some may differ because a monopoly may attempt to protect a higher level of costs, mostly salaries, and not just profits.)
(b) That regulation may be effective and offset the possible abuses by a monopoly or other flaws resulting from market failures.
A recent article in the Israeli press reminds us that these assertions are not necessarily so. The Ministry of Transport decided to auction the right to operate some bus lines which were formerly part of the national bus company, owned by a cooperative and under strict rate control for many years. The national bus company is paid a subsidy to enable it to reduce fares. When several lines were auctioned the fare proposed by new entrants to the market was 25% to 40% lower, without any subsidies.
One can suggest several explanations:
(a) Ineffective regulation;
(b) A political leverage applied by a large cooperative.
(c) A regulator who gave priority to provision of stable service and good working relations with the regulated firm.
Those findings should not be deemed as a surprise. We are aware that in many cases regulation protects a certain way of doing things, a certain level of costs and methods of management more than it does protect the general public.
2. We are also aware that in many cases de-regulation has been beneficial to the general public. But is not always feasible to de-regulate. The need for regulation is still there. I want to point out two possible methods, which may eliminate some of the drawbacks of regulation. Both reduce the discretionary powers of the State as a regulator and transfer such power to independent organizations, the forces of the market, and the judicial system.
I wish to qualify myself at the outset that such methods may not be applicable in all cases, but they may help in attaining some of the goals of regulation more effectively and at a lower social cost.
3. Let me use some very simple examples. Regulation is used to enhance public safety. Thus there are rules of safety for cars, and for construction of public and private buildings. Who should enforce such rules and how?
(a) In many countries the testing of cars for safety is done by private firms, which offer their service to car owners. The car owners must put their cars for test at certain intervals. If the firms who perform such tests have to carry liability insurance for any possible damage caused by improper testing, it will be in the interest of the Insurance companies to make sure that such tests are thorough.
One has to be aware of the second type of risk that such firms may tend to cover themselves by making the tests too strict and uneconomic, but this risk is taken care of by competition.
Thus the self interest and profit seeking of insurers and testing firms provides for a market oriented system to the safety of cars at a reasonable cost
(b) There are several means to provide for safety of buildings. First, to make sure that construction plans conform to safety rules imposed by the State. Second, to inspect the actual construction. The authorities may also regulate the construction industry by licensing contractors.
Here, again, once the appropriate construction standards have been imposed, all the enforcement and inspection could be privatised. Private engineering firms may assume the inspection of construction plans; other firms may inspect the process of construction. Licensing may be dispensed with. Again, the use of insurance can play an important role:
(b-1) The engineering firms who inspect the plans have to approve that such plans do conform to the relevant building codes. They ought to carry professional liability insurance and they have their reputation at stake.
(b-2) The engineering inspection firms must carry a similar insurance.
(b-3) Building contractors do not have to be licensed by the State. If insurance coverage is a pre-condition to engage in the contracting business, the insurance companies are the ones who issue, in effect, such licenses. The insurance companies assume also the risk of wrong screening of applicants.
In all these cases authority and responsibility are bound together. An insurance company which approves the wrong contractor will have to bear the consequences. If the insurer turns down a deserving applicant he may lose the business to a competitor. Reputable contractors may pay a lower premium; new contractors, strong on drive and short on experience, will have to pay higher premiums until they establish their reputation, but would be able to enter the market. Such an approach may render the market more competitive and benefit the public while reducing the cost of regulation.
Sellers’ warranties and responsibility may, this way, be effective for a longer period than the "life" of the selling companies. This may be an important feature in the sale of assets in which defects, and the resulting claims, may appear a long time after the purchase, when the original sellers, or even the inspecting engineer, may no longer be in business.
4. The examples used are very simple, and most of us can add more such illustrations. They are elements of a set of cases in which regulation is required, for the good of the public, and there are ways to utilize market forces to reduce or even abolish the need for direct regulation by the State. It means that the State will still be involved in setting the "rules of the game", but not in applying them in individual cases. It is worthwhile to explore if that set is big enough and includes a sufficient number of elements, and the rules of inclusions of elements in it. If the set is large enough it may affect the way regulation is conducted.
There are more methods of getting the government out of direct regulation. Establishing independent public agencies to regulate specific industries, e.g. public utilities such as power companies or public transport, by bus or rail. Such agencies may set rates and standards of service. They may act as interpreters of the general rules set by the governments and approved, where necessary, by parliaments. The public agencies are in charge of collecting the required data on the costs of operation and using their own models to derive from the data decisions concerning rates or prices of services. They may follow a path similar to the one used by government Ministries, but they are expected to be able to better resist political pressures and to conform to professional standards. Their strength may stem from their "weakness", the result of the lack of discretion. Their authority is only to interpret the rules set by the government. Their decisions are open to review by the courts. The possible review of the agency’s decision by a court of law is certainly a restraint against arbitrary decisions, but any appeal of such a decision must rely upon the law and cannot be assisted by political leverage.
The underlying assumption here is that governments and other political institutions can find it easier to make decisions, which are more public oriented, and free of pressure by special interest groups, when dealing with a general agenda than when dealing with a specific case.
5. Thus, the success of "privatising" regulation depends upon the ability to perform its functions and achieve the desired effects without the use of discretionary power by the State in individual cases. One can suggest a decision process composed of several stages:
(a) Identifying a need for regulation. It is usually a case where a "market failure" exists. In this respect a market failure exists when the market forces, or the price mechanism, does not bring about the effects deemed desirable to the public. What is desirable to the public depends upon the social priorities at the time.
Usually we relate the need for regulation with control of the market by some dominant firms. But regulation may be used in other cases. To correct for ignorance of consumers regarding complex products like drugs or pension programs; to correct for consumers’ preferences that may be in conflict with "social norms", e.g. prescribing certain building codes; etc. Or a society may wish to impose upon certain types of business some ethical codes, like the provision of easy access to handicapped people.
(b) Designing a set of rules and regulations that, if observed, would correct such market failures. The Regulation can be "privatised" if such rules are clear and easy to interpret, and if such interpretation does not require discretionary powers by the authorities.
(c) Privatisation of the regulation depends also upon the existence of commercial or professional firms who can fulfill the functions of "regulation" in the ordinary conduct of business, e.g. insurance companies, CPAs, consulting engineers, product testing firms etc.
(d) Another condition for success in such privatisation is an effective and trusted judiciary system. A general trust in the supremacy of the law is a precondition for any successful privatisation, in all fields.
Under such circumstances it is possible to use market forces to perform, at least, a part of the tasks of regulation, with the advantage that many enforcement decisions are made by people or firms who may bear the consequences of wrong actions. Also, the elimination of discretionary powers from political appointees reduces their exposure to political leverage.
As mentioned above, the set of possible cases for "privatising regulation" may not be very large, but it is worthy of notice by both governments and SAIs.