Privatisation of Utilities and the Asset Value Problem

Transcription

1 CMPO Working Paper Series No. 01/41 Privaisaion of Uiliies and he Asse Value Proble Paul A Grou 1 Andrew Jenkins 1 Ania Zalewska 2 1 CMPO, Universiy of Brisol 2 Universiy of Maasrich and CMPO, Universiy of Brisol Augus 2001 (Revised Deceber 2001) Absrac Privaised uiliies are ypically characerised by boh undervaluaion and underpricing. When faced wih his proble, regulaors have ended o eploy a arke value approach o deerine he regulaory asse base. This paper analyses his approach and shows ha any error a privaisaion is agnified and ha relaive errors reain enrenched forever. We sugges an alernaive, i.e., he regulaory agency's own esiae of he copany's value and show ha errors ade a he ie of privaisaion do no have he sae ipac on fuure prices and hence far less effec on he poenial sale price. JEL Classificaion: L33, L51 Keywords: Privaisaion, uiliies, regulaion Acknowledgeens We hank he Leverhule Trus for funding his research. Address for Correspondence Deparen of Econoics Universiy of Brisol 8 Woodland Road Brisol BS8 1TN Tel: +44 (0) P.A.Grou@brisol.ac.uk CMPO is funded by he Leverhule Trus.

2 1. Inroducion Percepions of he appropriae size of he radiional public secor, and he naural boundary beween he public and privae secors, have oved draaically in he las wo decades. The scale of his change is abundanly clear fro he acceleraing inernaional rend o privaise sae asses. Europe has been a he vanguard of his oveen, paricularly linked wih he creaion of privae regulaed uiliies. For exaple, Dewener and Malaesa (1997) in heir recen inernaional coparison of public offerings of sae owned and privaely owned enerprises repor ha he UK alone accouned for 33 of he 55 privaisaions of firs in regulaed indusries wihin heir saple. Even wihin well developed European econoies regulaed privaised copanies (osly elecounicaions) accoun for a significan fracion of he sock arke (e.g., a leas 13.1% in Gerany, 11.7% in Ialy and 7.7% in France (see Megginson and Neer (2001)). Privaisaion of uiliies has ypically been characerised by boh undervaluaion and underpricing. 1 Undervaluaion occurs when he arke-value of he copany (equiy plus deb) a privaisaion is less han he replaceen cos of he asses. Underpricing occurs when he shareholders pay less han he arke value for hese asses, i.e., shares are sold a a discoun o he pos privaisaion arke price. To prooe efficien invesen i is sandard o allow asses o earn a risk-adjused cos of capial on he replaceen cos of he asses. This is generally acceped policy for invesens ha are ade pos privaisaion and indeed essenial in he long run if regulaed copanies are o have he correc incenive srucure. However, i is ofen argued ha shareholders ay derive a windfall gain if asses ha are ransferred a privaisaion are undervalued a privaisaion bu valued a replaceen cos for fuure regulaory purposes. Generally, when faced wih his proble, shareholders have been reuneraed on he basis of he arke value of he copany a or around he ie of privaisaion. This is usually referred o as he arke value approach o he valuaion of privaised asses for regulaory purposes. This paper assesses his arke value approach and shows ha i has inheren probles. We hen address he quesion wheher here is an alernaive echanis ha can accoodae he 1 Telecounicaions end o be an excepion o undervaluaion. 1

3 undervaluaion proble bu does no fall foul of he difficulies inheren in he arke value approach. We ouline an alernaive and show ha i is pracical and superior o he arke-value approach. Final uiliy prices are deerined by he produc of he cos of capial and he approved asse base so i is no surprising ha hey have received a grea deal of aenion boh in he regulaory and he acadeic arena. Kahn (1989), referring o he regulaed reurn on invesed capial, poins ou ha since i is his eleen in he cos of service ha deerines he size of he copany s profi i is no surprising ha is deerinaion has been by far he os holy conesed aspec of regulaion, consuing by far he greaes aoun of ie. In he US conex, boh cos of capial and asse base issues have received considerable acadeic aenion. Ineresingly, Kahn noes ha in he US i is he asse base ha has been he focus of os liigaion. In conras, in he conex of privaised uiliies he cos of capial has been he subjec of considerable heoreical and econoeric analysis, bu here is alos none as o he choice of asse base despie he fac ha i is he ransfer of asses ha is paricularly roublesoe. Arsrong, Cowan and Vickers (1994) provide soe analysis of he appropriae asse base in he face of undervaluaion bu conclude, when referring o price cap regulaion of privaised uiliies, ha capial valuaion is a crucial inpu ino seing prices, as i is wih rae of reurn regulaion, bu here is a heavy burden on he regulaor and here are few operaional principles. We believe ha his paper is he firs o provide a rigorous consideraion of he proble and provide a viable soluion. Differences in he choice of asse base have ajor ipac on econoies because of is iporance in he deerinaion of oupu prices of regulaed uiliies, because such copanies are frequenly criical coponens of he econoy (boh as final goods and inerediae inpus ino os indusries) and because of he sheer scale of he indusries in his posiion. 2 Therefore, i is iporan o undersand he consequences of paricular approaches and o esablish operaional principles where possible. This is likely o becoe a cenral proble for Europe in he coing decade. Wih he excepion of he UK, he bigges privaisaions of regulaed uiliies in Europe have been in he 2 By 1999 he proceeds raised by privaising governens exceed $1rillion dollars alhough, of course, any of hese, probably he ajoriy, are no consequenly regulaed. 2

4 elecounicaions secor. This secor has no suffered grealy fro he undervaluaion proble in he pas alhough his ay be less so in he fuure. As counries begin o broaden he uiliies ha are privaised, i is difficul o see how he sae probles ha he UK has faced will no eerge hroughou he coninen. Clearly, i is iporan o ge o grips wih he probles before raher han afer he even. As background and oivaion, Secion 2 of he paper provides a brief suary of he experience of asse valuaion in he US and he UK. In he US, wih no hisory of privaisaion, he discussion of asse base (afer soe iniial confusion) has focussed on he choice beween hisorical and replaceen cos. However, in he UK, wih he excepion of he elecounicaions secor, all privaisaions of regulaed uiliies have faced significan undervaluaion. Shareholders have frequenly paid less han 50% of he replaceen cos of he asses a privaisaion. Indeed, in he waer secor his figure is as low as 3.6%. We show ha he reaen of he undervaluaion proble has converged on he arke value approach o deerine he regulaory asse base. Tha is, asses ransferred a privaisaion are enered ino he regulaory accouns a he arke value a or near o privaisaion. This ay be greaer han he price shareholders paid if here is underpricing as well as undervaluaion. Secion 3 of he paper provides a siple analysis of he privaisaion and regulaory proble. A he cenre of he proble is a ension beween wo forces. On he one hand, regulaors do no wish o provide shareholders wih an abnoral reurn. Tha is, if here is undervaluaion hey wish o see his refleced in reurns. On he oher hand, if he arke value is used o fix fuure prices, any eporary blip in value, say arising fro shorlived low oupu prices a privaisaion, can be exaggeraed. I is shown ha an error a privaisaion causes prices o be lower or higher han opial prices in perpeuiy and ha relaive errors reain enrenched forever. Furherore, and criically, because of he feedback echanis (i.e., shor lived changes ener he arke value which hen affec all fuure prices) sall changes can have big ipacs on he arke price of he uiliy a privaisaion. This is really he core proble. Given he poliical sensiiviy ha ends o surround privaisaion prograes, i is no ideal o adop a odel ha agnifies he ipac ha sall changes in expecaions have on he poenial sale price. Valuaion procedures becoe far ore difficul. I leaves he governen wih far ore uncerainy 3

5 abou he poenial revenues ha can be achieved fro a privaisaion and generally exacerbaes undervaluaion, reducing general proceeds. Secion 4 presens an alernaive echanis. The approach we sugges is o use he regulaory agency s own esiae of he copany s value a privaisaion as he asse base for fuure regulaory purposes. We call his he odel-based approach o disinguish i fro he arke-value approach. A purely pracical aracion of requiring he regulaory agency o esiae he value, and presen his prior o privaisaion as he base for fuure reviews, is ha i gives full ransparency and hence fairness in he process. However, we show ha here is a ore iporan benefi. This is ha errors ade a he ie of privaisaion do no have anyhing like he sae ipac on fuure prices and hence far less effec on he poenial sale price. A firs his ay see counerinuiive. Given ha he regulaory agency is esiaing he value of he business a privaisaion and allowing wihin he odelling process for he fac ha his value will be used as he basis for fuure regulaory reviews, he process ay see prone o he sae errors and volailiy as he arke base alernaive. There is, however, an inheren correcion echanis buil ino he odel-based approach. I is rue ha if he regulaory agency akes an error and underesiaes he cos of capial he error will lead he regulaory agency o se oupu prices for he firs price cap ha are oo low wheher he regulaory process uses a arke based or odel based approach. However, in he odel-based approach he regulaory agency uses his incorrec cos of capial boh o se prices and o conduc he discouned presen value. If he cos of capial is oo low hen he presen value will be overesiaed. Tha is, he endency o se low prices is offse by a siilar endency o overvalue he cash flow. This is syeric since any endency o se prices oo high will be offse by a endency o undervalue he consequen cash flow. In conras, wih a arke based approach i is he arke s cos of capial ha dicaes he presen value and hence he share price a privaisaion. In his case, here is no offseing effec hence he iniial error becoes agnified. We herefore sugges ha he odelbased approach is boh fairer and ore pracical han he approach currenly in use. Finally, we inroduce he disincion beween undervaluaion and underpricing. Our ain resuls (Proposiion 2) relae o he use of he arke value or regulaory agency s 4

6 indicaion of arke value. However, i is heoreically possible for he regulaory agency o incorporae underpricing as well as undervaluaion in he regulaory asse base. The siuaion is hen ore coplex bu we show in his case (Proposiion 3 and nuerical exaples) ha he arke-based approach is sill inferior The Unied Saes 2. Treaen of he Asse Base In he Unied Saes, he ehod of selecing he appropriae asse base for regulaed uiliies was debaed in a series of iporan Supree Cour cases aking place beween he 1890s and he 1940s. The seinal case was Syh v. Aes (1898), which concerned a dispue abou railroad raes in Nebraska. The verdic in his case had a powerful and daaging influence on regulaion for he following fify years. The Supree Cour s judgeen in he case saed ha a regulaed copany was eniled o a fair reurn on fair value. 4 This judgeen gave six differen crieria for assessing he value of capial: he original cos of consrucion and he aoun spen on peranen iproveens; he aoun of bonds and sock; he arke value of bonds and sock; he presen as copared wih he original cos of consrucion; he probable earning capaciy of he propery; and operaing expenses. These crieria are boh confusing and soewha circular, and os of hese were rejeced as inappropriae in subsequen cases. 5 3 The paper is concerned wih valuaions se in sock arkes bu in principle, since he odel is driven by he presen value of cash flows, he general resuls should carry over o any coon value aucion arkes bu no o he broad caegory of aucions (e.g., Kleperer (1998, 2002). 4 Syh v. Aes 169 U.S. 466 (1898). 5 See Grou and Zalewska (2001) for a discussion of he probles of circulariy in asse valuaion. 5

7 Wih he price level ending o fall in he lae nineeenh cenury, copanies in he Syh v. Aes case had preferred a hisoric cos asse base. However, around he urn of he cenury he general price level began o rise and copanies involved in subsequen rae base cases cae o favour he use of replaceen cos o deerine he asse base. In Willcox v. Consolidaed Gas Co. (1909), he Supree Cour endorsed he view ha he value of he propery was o be deerined a he ie of he inquiry, no when i had firs been acquired. This was ofen o be cied as a preceden in laer cases, and in a nuber of oher cases decided before he Firs World War, os noably he Minnesoa rae cases, he Supree Cour delivered verdics in suppor of a replaceen cos asse base. 6 During he Firs World War he price level rose uch furher and he arguens by copanies for reproducion cos becae ore veheen, while he regulaory coissions consisenly preferred a hisoric cos rae base. In 1923 he Supree Cour creaed confusion when, in hree cases wihin a few weeks of each oher, he Cour decided ha a reproducion cos rae base should be chosen in wo cases while in he hird case i found in favour of hisoric cos. 7 Alongside he changing case law in he firs half of he wenieh cenury here was considerable debae in law journals and econoics journals abou he appropriae ehod of valuing he asse base. While hisoric cos versus reproducion cos was he ain baleground in public uiliy econoics in he iner-war period, oher valuaion odels were also analysed. For exaple, acadeic econoiss were consisenly criical of he use of eleens of arke value in he Supree Cour judgeens. The arke value of he uiliy s socks and bonds, despie is appearance in Syh v. Aes, had been ruled ou a an early sage in he developen of case law. Marke value was rejeced in 1923 in Souhwesern Bell Telephone Co. v. Missouri Public Service Coission on he grounds ha uiliies were no coonly bough and sold. Bu an eleen of arke value had coninued o be incorporaed in legal cases by he inclusion of allowances for various inangibles, such as good will and going concern, in he asse base valuaion. 6 Willcox v. Consolidaed Gas Co, 212 US 19 (1909); Minnesoa rae cases (Sipson v Shepard), 230 US 352 (1913). 7 The Supree Cour upheld replaceen cos in Souhwesern Bell Telephone Co v Public Service Coission, 262 US 276 (1923), and in Bluefield Waerworks v. Public Service Coission, 262 US 679 6

8 The lae 1920s were he high waer ark of cases deerined in favour of reproducion cos. For exaple, in McCardle v. Indianapolis Waer Co. (1926), he Supree Cour found agains a regulaory coission ha had esiaed he asse base using replaceen cos averaged over he previous en years, assering ha he coission should have used curren values only. 8 Siilarly, in he O Fallon case of 1929 he Supree Cour rejeced he valuaion ehods of he Inersae Coerce Coission, which were based predoinanly on hisoric cos because hey gave insufficien weigh o replaceen cos. 9 Thereafer, he ide began o urn. During he 1930s he Supree Cour gradually swung owards allowing he use of hisoric cos by coissions. In Los Angeles Gas & Elecric Corp. v. Railroad Coission (1933) i found ha he copany s use of replaceen cos based on average prices beween 1926 and 1929 was no valid in he 1930s when he prevailing price level was uch lower. 10 And in California Railroad Coission v. Pacific Gas & Elecric Co. (1938) i rejeced he copany s esiaes of reproducion cos on he grounds ha hey were plainly erroneous. 11 I was he Hope case of 1944 ha finally pu an end o he confusion begun by Syh v Aes. 12 Bonbrigh described he case as one of he os iporan econoic pronounceens in he hisory of Aerican law. This case brough o a close he involveen of he Supree Cour in seling dispues beween regulaed and regulaors, by is ephasis on pragais and a presupion in favour of he Coissions: Under he sauory sandard of jus and reasonable i is he resul reached no he ehod eployed which is conrolling... I is no heory bu he ipac of he rae order which couns. If he oal effec of he rae order canno be said o be unjus and unreasonable, judicial enquiry under he Ac is a an end. The fac ha he ehod eployed o reach ha resul ay conain infiriies is no hen iporan. Moreover, he Coission s order does no becoe suspec by reason of he fac ha i is challenged. I is he produc of exper judgeen which carries a presupion of validiy. And he who would upse he rae order (1923); i suppored hisoric cos in Georgia Railway and Power Co v. Railway Coission, 262 US 625 (1923). 8 McCardle v. Indianapolis Waer Co, 272 US 400 (1926). 9 S Louis & O Fallon Railway Co. v. Unied Saes, 279 US 461 (1929). 10 Los Angeles Gas & Elecric Corp v. Railroad Coission, 289 US 287 (1933). 11 Railroad Coission v. Pacific Gas & Elecric Co., 302 US 388 (1938). 12 Federal Power Coission v. Hope Naural Gas Co. 320 U.S. 591 (1944). 7

9 under he Ac carries he heavy burden of aking a convincing showing ha i is invalid because i is unjus and unreasonable in is consequences. The Hope judgeen did no specify a uniquely valid approach o he asse base, bu lef he aer in he hands of regulaory coissions. I laid he ground for he oveen o hisoric cos since os coissions chose o use hisoric cos valuaion of he asse base. 13 A survey of 43 saes in 1954 found ha 19 had explicily swiched o hisoric cos as a resul of Hope; a furher 8 had adoped hisoric cos in pracice, hough hey had no forally disavowed fair value; 4 had used hisoric cos prior o Hope and coninued o do so; while 9 were sill using fair value, leaving 3 saes in he survey as indeerinae. A 1991 sudy of 53 regulaory coissions revealed ha 44 were using hisoric cos, while 7 sill adhered o fair value, and wo coissions considered all he evidence, wihou a predeerined choice of rae base. 14 The ineresing feaure is ha he US experience rejeced arke-based approaches and focused afer 1944 on he hisorical cos approach. This is in arked conras o he UK experience. 2.2 Privaisaion and he Asse Base in he UK As indicaed, a coon feaure of public secor uiliies is ha when privaised hey end o have arke values below he replaceen cos of he asses. In he UK all priary uiliies had arke valuaions a he end of he firs rading day ha were below he CCA replaceen cos of heir asses. This difference beween replaceen cos and arke value, however, varies significanly fro indusry o indusry. In he case of he waer indusry, arke value was less han 4% of CCA book value a he ie of privaisaion; for he gas indusry he figure was around 42%; 60% for regional elecriciy copanies; while he discrepancy was very sall in he case of elecounicaions wih Briish Teleco s arke value a privaisaion soe 97% of he CCA valuaion. (Carey e al, 1994). 13 See Grou and Jenkins (2001) for evidence of opporunis on he par of regulaors in he US a his ie. 14 See Phillips (1993). 8

10 Despie he hisorical experience on his opic in he US, here was alos no discussion of he proble before or a he ie when he indusries were firs privaised. Under he syse of regulaion pracised in he UK, he privaised copanies have price caps se for a period of four o five years. I was generally in he period leading up o he seing of a new price cap, soe hree o four years afer he ransfer of ownership, ha he issue of he appropriae regulaory asse base was ackled. The firs ajor privaised uiliy in he UK was Briish Telecounicaions in The debae concerning he fuure price in elecos followed he US radiion and focused on hisoric cos versus curren cos asse valuaion, wih he forer being chosen in he firs wo regulaory price reviews (1988, 1992) and a swich o a curren cos approach since he hird review (1996). In he run-up o he firs price review in he gas indusry, Briish Gas and he indusry regulaor, Ofgas, were unable o reach agreeen on he rae of reurn which Briish Gas should be allowed o earn, and he aer was referred o he Monopolies and Mergers Coission (MMC). In is deliberaions on he quesion of he appropriae asse base, he MMC suggesed ha he rae of reurn for Briish Gas should be se a jus over 60% of a risk adjused cos of capial. The reducion was o reflec he difference beween he arke value (deb plus equiy) and CCA book values a he end of 1991, a ie chosen on he assupion ha i was jus before he uncerainy of he MMC case ay have ipaced on share values. The reducion was jusified as a coproise which in par refleced wha shareholders had paid for he asses a he ie of privaisaion (Monopolies and Mergers Coission (1993)). Thus he MMC chose wha was essenially an iplici arke value approach o he asse base. In he waer indusry an explici arke value approach was chosen. When he indusry was privaised, in 1989, he governen ade an assessen of he value of he exising asses which i ered indicaive value. Prior o privaisaion, he waer and sewerage copanies had been earning abou 2% on he replaceen cos of heir asses. I was assued ha hey would coninue o do so afer privaisaion, and hese hypoheical cash 9

11 flows were discouned by he cos of capial o deerine he iniial value of he asses, i.e., he indicaive value. 15 However, he waer regulaor, Ofwa, rejeced hese indicaive values on he grounds ha hey involved a nuber of iporan assupions, and he resuling value was subjec o a wide degree of uncerainy. CCA valuaions, which were very large relaive o arke value, were also rejeced and he waer regulaor seleced insead an explici arke value asse valuaion based on share prices averaged over he firs 200 rading days fro he dae of privaisaion. To his figure he value of deb less cash balances was added o deerine he oal iniial valuaion of he asse base, which has been used since hen for all regulaory reviews. Explici arke values have also been used by he Office of Elecriciy Regulaion, Offer. When he regulaory asse base for he Regional Elecriciy Copanies (RECs) was considered, Offer rejeced he CCA approach in favour of a arke value asse base. Offer decided o scale up he value a floaion and so an uplif of 50% was added o he floaion value. The resuling valuaions varied fro copany o copany bu, on average, were equivalen o abou 90% of CCA asse value. However, before hese values could be ipleened, a conesed bid for one of he RECs indicaed ha he oucoe of he periodic review ay have been overly generous and so his paricular asse valuaion was never used. Offer concluded ha an uprae of 50% was oo large, and seled insead on a figure of 15 per cen, i.e., an increase of 15% on he floaion value of he RECs a he close of he firs day of rading. The arke value approach has also subsequenly been adhered o by Offer in assessing he regulaory asse base in oher pars of he elecriciy indusry (such as he Naional Grid Copany and Norhern Ireland Elecriciy). As he os recen of he ajor privaisaions, he railways were also he las o consider he quesion of valuing he regulaory asse base. The Rail Regulaor followed precedens se in he oher regulaed indusries quie closely, and chose a arke valuaion. For 15 See, for exaple, Arsrong e al (1994). 10

12 exaple, for he price review in Deceber 1998, he value of Railrack s asses were se a heir value a he close of he firs day of share rading. 16 In suary, wih he excepion of elecounicaions where a CCA asse value is now in use, i is clear ha he regulaory fraework for ajor UK privaised uiliies has converged on a arke value approach o deerine he regulaory asse base. Regulaors have ended o conclude ha invesors should be reuneraed on he basis of wha was acually paid a or around he ie of privaisaion, raher han on he generally larger CCA valuaions. The deails are suarised in Table 1. Table 1. The Asse Base in Major Privaised UK Uiliy Indusries Copanies and Regulaory Bodies Briish Teleco/Ofel Briish Gas/Ofgas Waer Copanies/Ofwa Oucoe of Periodic Reviews/MMC Enquiries Hisoric cos a he firs wo regulaory reviews (1988 and 1992), CCA fro hird regulaory review (1996) Iplici Marke Value a he end of 1991 adoped afer MMC enquiry Marke Value averaged over firs 200 days RECs/Offer Marke Value a close firs day rading plus 15% NGC/Offer Norhern Ireland Elecriciy/ Offer Railrack/Office of Rail Regulaor Marke value a close firs day rading Marke Value a close of firs day s rading plus 7.5% Marke Value a close of firs day s rading 3. Marke Value The previous secion has shown ha regulaors faced wih he proble of underpricing and undervaluaion in privaised indusries have chosen o adop a arke value approach o asse valuaion. In his secion we foralise his approach and discuss is weaknesses. The copany has in place, a privaisaion, a se of asses wih replaceen cos k. We assue here is no growh in deand, no inflaion and ha he regulaory regie requires 16 Railrack has recenly gone ino adinisraion as a resul of financial failure. 11

13 he copany o replace asses. Therefore, physical capial and is replaceen cos are consan. Le S denoe he arke value of he copany a privaisaion, i.e., S is he presen value of he cash flow of he privaised copany a he ie of privaisaion. A privaisaion he regulaory agency values asses for regulaory purposes a heir replaceen cos and iniial prices for he copany are based on he asse base k. However, if S differs fro k hen a he firs review and for all subsequen reviews he regulaory agency places a arke-based value on he asses ransferred a privaisaion. 17 This ay be less or greaer han k. 18 Asses replaced afer privaisaion are always valued in he regulaory asse base a purchase/replaceen cos. The regulaory agency reviews he copany s prices every T periods. To deerine prices he regulaory agency us ake an esiae of he appropriae risk adjused cos of capial for he uiliy. We assue ha he agency akes an independen assessen a each review. A review he agency allows he copany o se prices o cover he agency s esiae a ha ie of he cos of capial and o cover he depreciaion charge for he coing T periods. Asses depreciae a an insananeous rae of γ. For he firs and all subsequen reviews, he allowed depreciaion charge is based on regulaory asse value for asses acquired a privaisaion and he allowed depreciaion charge for new asses is based on heir rue value. The rue cos of capial is r >0. This does no change over ie. The regulaory agency s esiae of he cos of capial a ie is equal o r + ϕ(). The error generaing process has a syeric disribuion funcion wih zero ean and a suppor conained in an inerval (-r, r). ϕ(0) is known and announced before privaisaion. Noe, i is no he cos of capial iself ha is rando bu he regulaory agency s esiae of i. I is iporan o draw he disincion beween undervaluaion and underpricing. Undervaluaion occurs when S is less han k. This arises when he presen value of expeced fuure cash flows is less han he replaceen cos of he asses. In addiion he 17 Noe ha he arke value is used o deerine prices fro he firs review onwards, no fro he oen of privaisaion. 18 In pracice a regulaor is unlikely o approve an asse value greaer han k siply because he shareholders paid ore han k a he ie of privaisaion. However, we include he possibiliy for copleeness. 12

14 price ha shareholders pay ay no be he equilibriu arke price, i.e., shareholders ay pay (1-µ)S, a privaisaion. Underpricing occurs when µ > 0. The privaisaion of uiliies has been characerised by boh undervaluaion and underpricing. Underpricing has been well-docuened (see, e.g., Dewener and Malaesa (1997), Jenkinson and Mayer (1988) and Peroi (1995)) bu undervaluaion raher less. In pracice he arke-based regulaory asse approach has ignored he offer price, (1-µ)S, and focused on arke price, S, i.e., undervaluaion bu no underpricing has enered he asse base. However, i is useful o look a wha igh happen if underpricing is allowed o ener he asse base and so we allow for he possibiliy ha regulaion is affeced by underpricing. We denoe he regulaory value of asses acquired a privaisaion by α S where α is equal o (1-µ) if he regulaory asse base reflecs underpricing and uniy if i does no. Finally, we define a relaionship beween he privaised uiliy s price and he asse base. Clearly, he uiliy s aggregae oupu price is deerined by inpu cos oher han capial and he regulaory rule ha enables he copany o cover he allowable cos of capial and depreciaion of he asse base. Since inpus oher han capial play no role in his analysis, hey are se equal o zero for convenience. For all > T we denoe he expeced (oupu) price ha exacly covers he expeced cos of capial plus depreciaion rae ies he replaceen cos of capial by p*, i.e., p* = (r + γ) k. Given ha replaceen cos is, under reasonable regulaory rules, he deprival value of he asses, we refer o p* as he opial price, i.e., opial in he sense ha i is a reflecion of opporuniy cos. 19 For any fro T onwards, he exac price charged by he uiliy will depend on wo separae errors by he regulaory agency, ϕ(0) and ϕ(t i ), where T i is he ie of he os 19 Noe, in addiion o being a reflecion of opporuniy cos, here is an addiional eleen of opialiy in p* since if he regulaory agency never akes an error hen p = p* for all. However, we canno say if p* is or is no opial in any broader sense since we provide no analysis of how his aggregae price aps ono price per uni, ec. 13

15 resen review before. ϕ(0) appears since i deerines he regulaory asse base. ϕ(t i ) appears because, a, r+ϕ(t i ), is he agency s esiae of he relevan risk adjused cos of capial. We can herefore alk of he expeced price a ie where he expecaion is aken over ϕ(t i ). This expeced price, derived using he arke value (or underpriced equivalen) in he calculaion of he regulaory asse base is denoed p. Indeed, hroughou he paper, all prices in he paper, save for p*, will be expeced prices aken over ϕ(t i ). We can now invesigae he consequences of using a arke value as he regulaory asse base. Proposiion 1 For α = 1 and ϕ(0) 0 ( p p ) ( p *) any >. 1, 2 T * 2 p 1 is independen of ϕ (0) for Proof The prices se by he regulaory agency during he firs period afer privaisaion are chosen o cover: T (1) ( r + ϕ( 0) + γ ) 0 ke r d where ϕ(0) is known. A ie T here will be a new review and prices will be se o cover: 2T γ γ (2) ( r + (1) + γ )( αse + ( 1 e ) k) T r ϕ e d. The difference beween (1) and (2) is ha he regulaory asse base fro T onwards reflecs αs whereas prices fro 0 o T are based on k. The ipac of S diinishes as ie passes, i.e., depreciaion runs down he original asses as new asses replace he. Noe also ha when viewed fro ie zero, ϕ(1) is no known. The expeced presen value of he copany fro T onwards is he expecaion of: (n+ 1)T γ γ (3) ( r + ϕ ( n) + γ ) ( α Se + ( 1 e ) k ) n= 1 nt e r d 14

16 Thus he value of he copany is (1) plus (3) inus invesen. The copany has o ake good all depreciaion so he presen value of invesen is: (4) γ ke r d. 0 Therefore he oal expeced presen value of he copany is S = T 0 ( r + ϕ (0) + γ ) ke r d (5) + E nt n= 1 (n+ 1)T γ γ ( r + ϕ ( n) + γ )( α Se + ( 1 e ) k) e r d 0 γ ke r d. (5) reduces o ϕ ( 0 ) + r (6) S = k + k ( 1 e rt ) + ( α S k) e r γ ) T or This gives: (7) k S = ( ( r )T (0 ) 1 e γ ϕ + ) + k ( 1 e rt ) r ( 1 αe r + γ )T ) (8) S ϕ = k 1 + r ( 0 )( 1 e rt ) ( 1 e r + γ )T ) if α = 1. For α = 1, given non-zero ϕ(0) and any > T we find: 15

17 p = ( r + γ ) e γ ϕ k 1+ r rt (0) ( 1 e ) r+ γ ) T ( 1 e ) + γ ( 1 e ) k = ( r + γ ) k 1+ e γ ϕ r rt (0)( 1 e ) r + γ ) T ( 1 e ). Therefore, p p* = ( r + γ ) e γ ϕ r (0 )( 1 e rt ) ( 1 e r + γ )T ) k which is non zero for all non zero ϕ(0). For all 2 > 1 > T and non zero ϕ(0) we have p 2 p* p p* 1 = γ e ( ) 2 1 which gives he required resul. Proposiion 1 says ha an error a privaisaion causes prices o be lower or higher han opial prices forever and siilarly ha he relaive price consequences of alernaive errors are also infiniely lived. Tha is, coparing he price consequences of wo possible errors, if we find a one poin in ie ha one price is n ies as far fro he opial price as he oher hen i will always reain n ies as far fro he opial price as he oher. Equaion (6) also shows ha if he regulaory asse base is equal o he arke value a he ie of sale, i.e., α = 1, hen he elasiciy of S-k wih respec o ϕ(0)/r is uniy. This indicaes ha he sall changes in he iniial error can have large changes in he arke value even hough he iniial lower prices induced by he error are in place for a very shor period. For exaple, if he rue cos of capial is 5% and he regulaory agency believes 16

18 for he firs review only ha he cos of capial is 4% hen he arke value is 20% lower han replaceen cos regardless of how rapidly he siuaion is reviewed. The laer is he ajor proble of he arke-based approach. Valuaion procedures becoe far ore difficul, leaving he governen wih far ore uncerainy abou he poenial revenues ha can be achieved fro a privaisaion. This is paricularly iporan given he poliical sensiiviy and inheren uncerainies ha end o surround privaisaion prograes. I akes lile sense o adop a odel ha agnifies he ipac ha sall changes in expecaions have on he poenial sale price. The relevan quesion is wheher here is an alernaive echanis ha can accoodae he undervaluaion proble and does no fall foul of he difficulies inheren in he arke value approach? In he nex secion we sugges an alernaive approach ha ees his objecive. 4. A odel-based asse valuaion Secion 3 has quanified he probles ha arise wih using UK-syle arke based valuaions o deerine he regulaory asse base. In conras, no surprisingly, copanies have argued for he use of replaceen cos of capial as he relevan asse base. However, here ay be a proble wih using replaceen cos if he shareholders receive a windfall gain as a resul of is ipleenaion. There has been a debae as o wheher here is a windfall gain or no. I is difficul o answer his quesion wihou knowledge of why here is undervaluaion and wha shareholders expecaions were a he ie of privaisaion as o he precise regulaory regie ha hey hough would be in place. As indicaed, we seek o find an alernaive echanis ha can accoodae he undervaluaion proble and does no fall foul of he difficulies inheren in he arke value approach. I is clear ha if here is a srong possibiliy of undervaluaion hen an obvious need is o idenify a coon, agreed valuaion ha is coon knowledge a he ie of privaisaion. If all paricipans know his value and know ha i will be eployed in fuure regulaory reviews hen one can have soe confidence ha shareholders are 17

19 aware of wha hey are buying. This process rules ou arke value since i canno be known before privaisaion. The approach we sugges here is o use he regulaory agency s own esiae of he copany s value. This is found by adoping a presen value process siilar o ha idenified in Secion 3. We denoe his value as I, o denoe he regulaor s indicaion of value. There will be wo ain differences beween his approach and he presen value equaion ha underlies he arke value. One is ha he regulaory asse base used on he righ hand side of he presen value calculaion fro T onwards will be I raher han he arke price. The oher is ha he regulaory agency will use heir bes esiae of he cos of capial o conduc he exercise. The laer us obviously be he case since if he agency believed ha heir esiae of he cos of capial was syseaically incorrec in soe way hey would no have been using i. We call he consequen valuaion a odelbased value since by definiion i will be calculaed using a presen value odel of he esiaed cash flows of he copany. An aracion of requiring he regulaory agency o esiae he value and presen his prior o privaisaion as he chosen base for fuure reviews is ha here is full ransparency and hence fairness in he process. However, we show in Proposiions 2 and 3 ha here are ore significan benefis. Proposiion 2 If I α = 1 and ϕ (0) 0 hen for any > T : p * p > p * p = 0. Proof Following he proof o Proposiion 1 he value of I is given by: 18

20 I = T 0 ( r + ϕ (0) + γ ) ( r + ϕ(0)) k e d (9) + n= 1 ( n+ 1) T γ ( ( )) ( (0) ) γ + 1 r ϕ n r + ϕ + γ α Ie + e k e d nt 0 γ k e r+ ϕ (0)) d. This reduces o (10) I = k + ( α I k) e r+ γ + ϕ (0)) T or r+ γ + ϕ (0) T k( e ) (11) I 1 = r+ γ + ϕ (0 T ( 1 αe ) ) This gives: (12) I = k if α = 1. I = k gives he righ hand equaliy and Proposiion 1 gives he lef-hand inequaliy. Proposiion 2 shows ha fro T onwards he expeced price under he odel-based approach is opial regardless of ϕ(0) whereas he expeced price under he arke-based approach is opial iff ϕ(0) is zero. The inuiion for his resul is he following. If he regulaory agency a privaisaion akes an error and underesiaes he cos of capial hen he regulaory prices are se oo low boh for he arke value and he odel-based approach. However, in he odel-based approach he regulaory agency is using heir own view of he cos of capial o conduc he discouned presen value in he odel as well as o se prices. Therefore, he endency o se low prices is offse wihin he odel by a siilar endency o overvalue he fuure reurns. Indeed Proposiion 2 shows ha hese wo effecs exacly offse each oher, herefore he expeced price fro T onwards is efficien. 19

21 Noe, his is a syeric arguen and any endency o se prices oo high will be offse by a endency o undervalue he consequen cash flow. Of course, unless ϕ(0) is zero, he regulaory agency will sill se incorrec prices during he firs period, i.e., up o he firs review, bu expeced prices will be opial for all fuure reviews. The siuaion becoes ore coplex if he regulaory odel incorporaes he undervalued prices raher han he arke prices, ha is, α is equal o (1-µ) in boh he arke and he odel-based odel. We should ephasise ha we believe his is an iplausible approach for wo reasons. One is ha in pracice regulaors have no aeped o apply his approach o he arke odel. Second, even if applied o he arke odel, i is no clear ha i akes any sense o ipleen he sae price reducion, i.e., use (1-µ)I in fuure reviews raher han I, in he odel-based approach. Indeed, we know of no regulaory regie ha incorporaes α = (1-µ), as opposed o α = 1. However, even in his case we are able o show ha here are benefis, albei soewha less, o he odel-based approach. We can prove he following proposiion where he expecaions operaor is across all ϕ(0). Proposiion 3 If α = ( 1 µ ) hen for any >T, 1) I p p* for any ϕ(0) 2) r 1 p * > p when ϕ(0) < 1 rt 1 e α I 3) E ( p p ) > E ( p * p ) values of µ). r 1 and p * < p when ϕ(0) > 1. rt 1 e α * when α is sufficienly close o 1 (i.e., for sall Proof To prove par 1 of he proposiion is sufficien o noice ha p * p I = ( r + γ ) k ( r + γ )( α I e = ( r + γ ) ke γ 1 α 1 αe γ r+ γ + ϕ (0)) T + k(1 e γ )) (13) 20

22 is always non-negaive as 0 α 1 and ϕ (0) < r. The proof of par 2 follows fro analogous calculaions. Tha is, p * p = ( r + γ ) k ( r + γ )( α Se = ( r + γ ) ke γ γ + k(1 e ϕ(0) 1 α(1 + (1 e r r+ γ ) T 1 αe rt γ )) )) (14) is posiive if he noinaor is posiive. The proof of Par 3 is an iediae consequence of Proposiion 2 and coninuiy of p* p and I p * p as funcions of α. Proposiion 3 proves ha for any error generaing process a ie 0 he expeced absolue difference beween p* and price under he odel-based valuaion approach a any greaer han T, is saller han he expeced absolue difference beween p* and price under he arke-based valuaion approach providing α is in soe inerval (1, α 0 ). Tha is, providing underpricing is no oo large, hen he odel-based approach gives prices ha are closer o p* han he arke-based approach. This raises he quesion as o how large hese differences are boh wihin and ouside he inerval. To consider his we provide nuerical exaples ha hrow soe ligh on he relaionship. 21

23 Figures 1 and 2 illusrae he differences beween p* and odel-based price p I, and beween p* and arke price p respecively. 20 Boh graphs are ploed under he assupion ha he review akes place every four years (T = 4), he depreciaion rae γ is 4% and he cos of capial r is 5%. Given he bounds on he error er, he laer assupion iediaely iplies ha ϕ(0) <0.05. I is clear fro he figures ha when he regulaor s error is negaive (i.e., she underesiaes he rue value of he cos of capial), p*-p I is always saller han p*-p for any α [0,1]. Hence, for all 0.5<ϕ(0)<0 he inequaliy in Proposiion 3(3) holds all α and for any disribuion of he regulaor s error. The siuaion reverses when he regulaor overesiaes he rue value of he cos of capial (i.e.0<ϕ(0)<0.5). In his case, if α [α 0, 0], he price obained fro he arke-based valuaion can be closer o p*, han he price found based on he odel-based valuaion. Figure 1. p* inus price under odel-based valuaion for r =5%, γ=4% and T = p*-p I φ (0) α In fac we only plo he differeniaing pars of forulas 13 and 14, ha is we drop off boh expressions. γ ( r + γ ) ke fro 22

24 Figure 2. p* inus price under arke odel valuaion for r =5%, γ=4% and T = p*-p φ (0) α If we assue ha ϕ(0) is uniforly disribued on inerval (-r, r) (i.e., (-0.5, 0.5) in our exaple), hen for any given α E( p * p ( r + γ ) ke ) = ( r + γ ) ke γ γ 1 α r+ 1 αe 2 α (1 e 2α (1 αe γ ) T rt ) 2 r+ γ ) + (1 α) T )(1 e 2 rt ) if if 1 α [0, 2 e 1 α ( 2 e rt rt ] ;1] and 2r+ γ ) T I γ 1 α 1 1 αe E( p * p ) = ( r + γ ) ke (2r + ln ). γt 2r T 1 αe I Figure 3 shows he resuls of he coparison of E ( p p ) E ( p * p ) * for hree values of r (i.e., r = 5%, 7% and 9%), under he assupion ha γ = 4% and T = 4. 23

25 Figure 3. E( p*-p )-E(p*-p I ) for r =5%, 7% and 9% α r=5% r=7% r=9% All hree have a siilar feaure. For os cases where prices under he odel based valuaion are closer o p* han prices under he arke-based approach he difference in proxiiy is arked. Tha is, when he figures are in he posiive doain hey are srongly posiive. In conras, when prices under he odel based valuaion are less near o p* han prices under he arke-based approach he differences beween he (and fro p*) are sall. Therefore, alhough once we allow for any possible level of underpricing we canno say for sure han he odel-based valuaion provides prices ha are always closer o p*, hese figures sill lend furher evidence in favour of he odel based approach since he scale of error is very one-sided. In he exaples here, large deviaions can occur fro p* if one adops he arke-value approach bu no if one adops he odel-based approach. 5. Conclusions The paper has addressed he quesion of how o deal wih he regulaory asse base proble caused by undervaluaion of privaised uiliies. We show ha he sandard soluion o his proble is flawed. Errors ade a privaisaion as o he appropriae risk adjused rae of reurn cause oupu prices o be lower or higher han opial prices forever. Furherore, he relaive price consequences of alernaive errors are also infiniely lived. Tha is, coparing he price consequences of wo possible errors, if we find a one poin in ie ha one price is n ies as far fro he opial price as he oher 24

26 hen i will always reain n ies as far fro he opial price as he oher. Given he poliical sensiiviy ha ends o surround privaisaion prograes, i is inappropriae ha he sandard approach o resolve he undervaluaion proble agnifies he ipac ha sall changes in expecaions have on he poenial sale price. This can exacerbae undervaluaion reducing governen proceeds. Furherore, valuaion procedures becoe far ore difficul, leaving he governen ore uncerainy han necessary abou he poenial revenues ha can be achieved fro a privaisaion. We hen address he quesion wheher here is an alernaive echanis ha can accoodae he undervaluaion proble bu does no fall foul of he difficulies inheren in he arke value approach. We ouline he alernaive of using he regulaory agency s own esiae of he copany s value a privaisaion as he asse base for fuure regulaory purposes; called he odel based approach. We show ha for a given error generaing echanis he privaisaion raises ore oney and here are saller deviaions fro opial prices wih his approach han wih he arke value approach. Finally we consider he eris of he odel based approach when he regulaor correcs he asse base for underpricing as well as undervaluaion and show ha he odel based approach is superior, albei less han when he regulaory agency deals wih undervaluaion alone. References Arsrong, Cowan and Vickers, (1994) Regulaory Refor, MIT Press. Carey A., M. Cave, R. Duncan, G. Houson and K. Langford, (1994), Accouning for Regulaion in UK Uiliies, Research Board of Insiue of Chared Accounans in England and Wales. Dewener, K.L. and P.H Malaesa, (1997), Public Offerings of Sae Owned and Privaely Owned Enerprises; An Inernaional Coparison, Journal of Finance, 52. Grou, P.A. and A. Jenkins, (2001), Regulaory Opporunis and Asse Valuaion: Evidence fro he US Supree Cour and UK Regulaion, Leverhule Cenre for Marke and Public Econoics Working Paper Series 01/38. Grou, P.A. and A. Zalewska, (2001), Circulariy and he Undervaluaion of Privaised Copanies, Leverhule Cenre for Marke and Public Econoics Working Paper Series 01/39. Jenkinson, T and C Mayer, (1988), The Privaisaion Process in France and he UK, European Econoic Review,

27 Kahn, A.E., (1988), The Econoics of Regulaion: Econoic Principles, (reprined by) MIT press. Kleperer, P.D., (1998), Aucions wih alos coon values, European Econoic Review, 42, Kleperer, P.D., (2002), How (no) o Run Aucions: he European 3G Teleco Aucions, European Econoic Review, forhcoing. Lopez-de-Silanes F., (1997), Deerinans of Privaisaion Prices, Quarerly Journal of Econoics. Meggison, W.L. and J.M. Neer, (2001) Fro Sae o Marke: A Survey of Epirical Sudies on Privaisaion, Journal of Econoic Lieraure, 39, Monopolies and Mergers Coission, (1993), Repor on Briish Gas Plc, 3 Vols, C Peroi, E.C., (1995), Credible Privaisaion, Aerican Econoic Review. Phillips, (1993), Regulaion of Public Uiliies 26