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State-Owned Enterprises: Dealing with Special Obligations

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Practice Advice on Strategy and Structure

State-Owned Enterprises: Dealing with Special Obligations (OECD)

Summary Advice: The OCED reccomends that state-owned enterprises (SOEs) clearly identify public services and other special obligations as they usually have a significant impact on SOEs’ performance.

Main Points: The cost of these “special obligations” might be high and they are often hidden or at least not easily identifiable. Disclosing “special obligations” should also increase transparency concerning various risk factors that the SOE may face. Clearly identifying “special obligations”, costing them adequately and disclosing relevant information allows an informed public debate about their relevance, budgetary implications as well as distributional consequences.

Dealing with special obligations

Agree on a definition of “special obligations”

  • Usually three main characteristics are required to qualify as a “special obligation”:
    • To be specifically required by the government.
    • Not to be undertaken on the basis of a purely commercial decision.
    • To achieve effectively a social or policy benefit.
  • This still leaves a number of issues open and there is usually scope for interpretation when these criteria are applied to a practical case. Ambiguities will need to be solved, sometimes on a case-by-case basis. They relate for example to the following questions:
    • Which directives from the government are to be considered? These directives have to be specific, explicit and public. They do not include general directives given to all companies in an industry or to all SOEs, or general regulatory directives. But they might include directives concerning inputs, including labour.
    • What would be the decision of the SOE based on purely commercial grounds or, more appropriately, a commercial decision of a good corporate citizen? The answer is not necessarily clear-cut. For example, “special obligations” will not necessarily include all loss-making products or services, nor would it generally include corporate sponsorships or philanthropy. All can result from appropriate commercial decisions, based for example on marketing considerations or capacity utilization rationales.
    • What constitutes an effective social or policy objective? This could include requirements aimed at fulfilling vertical equity objectives (such as targeting specific disadvantaged groups) or horizontal equity objectives (such as universal provision of services).
  • “Special obligations” will thus typically include the requirement to provide a product or a service at an affordable or unified price below their effective cost, to grant specific price concessions to targeted groups for redistribution purposes, or to use specific inputs with constraints or conditions not applying to private sector firms.

Mapping existing “special obligations”

  • Based on the agreed upon definition, the ownership entity should, in co-operation with SOEs, map existing “special obligations”. Agreement between the ownership entity and SOEs on what constitutes their “special obligations” is the first step towards ensuring an effective discussion on their objectives and performance.
  • This is not a straightforward exercise and will in many cases require discussion, including with stakeholders. Some activities undertaken by SOEs might be considered as “special obligations” whereas they just result from traditions or established practices. The ownership entity might announce a timetable to complete the identification and review of “special obligations”, providing an incentive for all concerned parties to complete the review process.
  • A first step is for SOEs to submit to the ownership entity and related portfolio ministries a list of what they consider as “special obligations”.
  • The ownership entity then reviews the submissions and assesses which proposal will be accepted, i.e. fulfil all required criteria to qualify as a “special obligation”. This review includes discussion with other concerned portfolio ministers. These latter might take the opportunity to evaluate the existing arrangements and review the specification and scope of these “special obligations”. The government might also consider the extent to which these “special obligations” are still priorities within its policy and might decide in cases to discontinue some “special obligations”.
  • Appropriate consultation with stakeholders in this regard should take place, while avoiding giving rise to political bargaining. This is why a clear definition will need to be provided ahead of the process to provide a clear basis for the mapping exercise.

Evaluate costs of “special obligations”

  • Measuring the cost of “special obligations” is another complex but necessary exercise. It is trying to evaluate the opportunity cost of the resources used to fulfil these “special obligations”. A commonly recommended method is “avoidable cost”, as an approximation of marginal cost and a “practically achievable benchmark”.
  • The ownership entity should ask each SOE to estimate the cost of its “special obligations”, indicating which method has been used and providing enough information to justify the estimations. Alternatively, the ownership entity could mandate a costing methodology.
  • In most cases, complexities arise and the method will have to be adapted on a case-by-case basis. Difficulties are linked especially to capacity levels with estimations being in principle based on peak-load capacity. Specific issues are also raised in industries characterised by long-run decreasing costs, which is often the case for SOEs in infrastructure industries.
  • In practice, trade-offs will have to be made between precision and the time and resources used to evaluate these costs. The capacity of the accounting systems to disaggregate cost information has an impact on the precision and reliability of estimations. The difficulty of the exercise also depends on the clarity and precision of the directive received from the government, i.e. to which point they give rise to interpretation. Compromises will probably vary from one industry to another and criteria including administrative simplicity and efficiency implications will have to be considered. Therefore, an industry-by-industry approach to measuring the cost of “special obligations” could be developed.
  • Where there are significant difficulties involved, such an exercise need not be undertaken every year, but could rather be undertaken every four or five years, with a simpler methodology adopted to roll forward the cost estimates in the intervening years.

Review existing obligations

  • Once existing special obligations and related costs have been identified, it is necessary to assess their relevance and effectiveness, in order to make an explicit political decision regarding these “special obligations”.
  • Such review would first aim at discussing whether the objectives are still relevant.
  • It should also be assessed if the “special obligations” could be replaced by other mechanisms that would achieve the same objectives at a lesser cost, more effectively and/or without the same impact on market distortion and SOE efficiency. It could be the case that social objectives, for example, would be achieved more efficiently through a direct subsidy to the targeted population, procurement processes or other regulatory provisions.
  • “Special obligations” must become the result of a rigorous process and explicit political and economic assessment, rather than a historic liability or “fait accompli”.

Decide on funding mechanisms

  • The Guidelines recommend a transparent funding of “special obligations” to make their costs explicit. This allows an effective monitoring of SOE performance and an informed debate about their relevance. They also require that they be funded from the state budget, using mechanisms avoiding market distortions.
  • Among different funding options, direct funding from the state budget provides the most transparency, makes the costs explicit and avoids distortions. It ensures that related costs be subject to public scrutiny and spreads the costs over all taxpayers.4 It also creates the possibility for introducing competition between the SOE and alternative suppliers. In this case, the funding can go to a “purchasing ministry” which purchases the additional services that the SOE would not be able to provide on fully commercial terms. From the SOE perspective it turns the service provided from a non-commercial to a commercial one, with positive incentiverelated consequences. From the ministry’s perspective, it allows making the level of subsidisation needed to obtain certain societal objectives subject to a bidding process.
  • Another common funding option, “accepting lower rates of returns”, seems equivalent to direct funding in terms of financial end-result, but basically takes the funding out of the budget process, so reduces accountability. Other funding options, such as levies on users, cash transfers or voucher systems, present different sets of pros and cons. Cross-subsidies are to be avoided as they reduce transparency and as such might significantly impair public scrutiny over the relevance and cost of “special obligations”. Moreover, they have negative efficiency effects and encourage cost-padding practices. They are only sustainable in a monopoly or non-competitive environment and so act as an impediment to competitive industry reform.
  • In order to encourage more efficient delivery of “special obligations”, consideration might be given to funding them on the basis of “best practice” instead of on real costs structures. Whenever possible, best practice cost levels should be established based on industry and/or international benchmarks.
  • In order to administer this direct funding of “special obligations”, a contractual system might be developed whereby the government specifies clearly the nature and extent of “special obligations”, the indicators to assess related performance and funding mechanisms applied in compensating SOEs for related costs.

Monitoring “special obligations”

  • It is important for the state as an owner, as long as it asks SOEs to fulfil “special obligations” and compensate them for doing so, to monitor their effective fulfilment.
  • This could be done through the overall process for setting objectives and reviewing of SOE performance (see the following sections). A specific review could also be carried out separately. Other concerned departments and stakeholders might be involved in this monitoring process.
  • In case the funding is provided through a “purchasing ministry” (as described above), it removes the monitoring of the delivery of “special obligations” from the ownership entity that would have no particular interest or expertise in such matters to the concerned ministry.

Disclose special benefits or financial assistance

  • In parallel with disclosing and funding transparently “special obligations”, it is also necessary that any financial assistance from the state to SOEs be fully disclosed. This double disclosure will allow an informed discussion on objectives. It is also necessary in order to promote a level playing field with the private sector.

Methods for measuring the cost of “social obligations”

Marginal costs - Includes costs that increase as a result of increased production or service. In principle, short-run marginal costs should be used, as they do reflect the real opportunity cost of supplying the additional product or service. But there are a series of practical difficulties in estimating marginal costs, related for example to the treatment of common and joint costs, especially when the same enterprise produces a variety of goods or services, or to the determination of the appropriate marginal unit of production. The distinction between short-run and long-term marginal costs might also be difficult concerning depreciation, for example, or in cases where capacity is not in a long-run equilibrium. In addition, these marginal costs might vary significantly according to the demand level, not even mentioning issues related to congestion in some industries. These difficulties can make the estimation of marginal costs extremely costly and complex.

Fully distributed costs - The idea is to include average variable cost plus a mark-up to cover fixed costs. A practical way to achieve this is to distribute fully the total costs of the enterprise by allocating them to all its different products or services. There again a number of allocation methods could be used. Fully distributed costs are considered as “fair” but tend to overestimate costs. This method ignores the discrepancies that often exist between average and marginal costs in the case of infrastructure industries. It is appropriate when the cost functions approach constant returns to scale.

Avoidable costs - Includes all costs associated with an additional block of output, including variable and capital costs whenever additional capacity is required. Actual costs should be considered, even if they might differ from best practice. The evaluation also takes into consideration capacity utilization, with avoidable costs calculated at peak-load capacity to include capital costs incurred by the “additional” production or services deriving from the “special obligations”. Avoidable costs increase with the size of the incremental level of output to be considered, as more capital costs might thus be considered as “avoidable”. A distinction has thus to be made between short-run and long-run avoidable costs, the latter allowing incorporating additional capital costs. A related question arises with the estimation of capital costs and the appropriate rate of return to use for measuring the opportunity cost of capital. In some cases, a mark-up might also be added to avoidable costs to reflect a contribution to common costs.

Stand-alone costs - Costs incurred for producing an output in isolation. They by definition ignore economies of scale and scope. They result in significant over-estimation of the real cost of “special obligations”.

Source: OECD (2010). OECD, “Accountability and Transparency: A Guide for State Ownership” Corporate Governance, OECD Publishing at (accessed 17 February 2013).

Page Created By: Matthew Seddon. The content presented on this page is drawn directly from the source(s) cited above, and consists of direct quotations or close paraphrases. This material does not necessarily reflect the official view of the publishing organization.

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