There are basically four (sometimes interrelated) mechanisms for “corrupt” privatisations, besides the obvious ones – just giving the resource to one’s cronies, or, having a first-come system in which those already in the field are in a better position to grab the resources. First, reduce competition; second (particularly relevant in economies in transition such as Guyana when capital markets are not well developed), channel funds to favourites; third, provide favourites with inside information about the value of what is being sold; and fourth, enforce terms asymmetrically.
When competition for the resources is limited – and especially when it is known that it is limited – then the prices that prevail will be lower. There are three ways of limiting competition.
- The first is suddenly to put up for lease a large number of tracts – increase the supply so that the bidding on each tract is limited. The government may get a fraction of what it would have earned had the tracts been put up in a more orderly process, and the extra profits will go into the coffers of the oil companies (Leitzinger 1984).
There are several things the government can do to increase competition and to mitigate the magnitude of the asymmetries of information and their consequences. One approach is to require all companies to disclose their geological information concerning the tract and provide all bidders with information from that pre-bidding exploration, which is publicly funded, which should be undertaken more extensively. Clearly, oil companies will resist this initiative, saying that if they are forced to disclose the information, they will reduce their bid. In equilibrium, one would expect, however, the increase in the amounts bid in the follow-on auction to more than offset the losses in the amount bid in the original auction. There may, however, be problems in enforcement. Checkerboard leasing (such as undertaken by Alberta, Canada) may allow more relevant information to become available prior to bidding, again resulting in government receiving more for its tracts.
- Another way is to design the auction in ways that reduce the consequences of information asymmetries and thus increase the magnitude of competition. For instance, royalty bidding (where bidding is over the percentage of the value of production to be given to the government) may produce significantly greater competition than bonus bidding.
- First, under royalty bidding, information asymmetries about the quantity of oil matter less (more important are information asymmetries about the magnitude of the costs of extraction).
- Second, bonus bidding favours large companies that can afford to make large up-front payments. Up-front bonuses constitute, in effect, a loan from the oil company to the government – the government gets money upfront, which the oil company recovers later through sales of oil. While the current government benefits from money that otherwise would accrue to successor governments, the interest rate implicit in the loan is typically higher, sometimes much higher, than that at which the government can borrow abroad.
- Third, bonus bidding favours larger, more diversified firms that are better able to bear risk, since, under bonus bidding, the risk (concerning the price of oil, the amount of oil, and the costs of extraction) is imposed on the bidder. Note that beyond the effects on competition, by imposing the risk on the company, bonus bidding also lowers prices as private sector participants demand compensation for bearing this risk (a risk premium is taken out of the price).
- Royalty bidding has one major disadvantage: a larger royalty rate reduces the incentive for companies to invest ex-post, and may result in a premature shutdown of wells as extraction costs rise; in contrast, the signature bonus is a sunk cost and does not distort subsequent investments. There is a second disadvantage: With no bonus payment, a firm may bid aggressively on the royalty, viewing the contract as an option. If it discovers that the cost of extraction is low, it develops the field; otherwise, it abandons it. It has little to lose. In one sense, the government too has little to lose: The oil is not a wasting asset; it will still be there. With a performance commitment, the tract may be put up for re-bidding. If the government is concerned with getting cash flow quickly, it can mitigate this problem by increasing the (fixed) upfront bonus that has to be paid, discouraging firms from simply viewing the bid as a low-cost option.
The problem of a premature shutdown has especially become a source of concern; but contractual arrangements, entailing reducing royalty rates at later stages of production, have been devised which have mitigated, if not eliminated, the problem. That is, a contract can provide that when the production from the field falls below a critical level, the royalty rate is reduced. The problem arises even in the standard bonus bidding contracts, which typically include a fixed (limited) royalty rate. Of course, if there were little uncertainty over the value of the resource, and capital markets were perfect (so there would be no discrepancy between the government and corporate borrowing rates), then this advantage of bonus bidding would predominate over the disadvantages noted earlier. However realistically, there appears to be a strong presumption in favour of royalty bidding. There is another non-distorting contract – royalty on net profit. The problem is that it is difficult to observe “true” net profits, and with net profit contracts, the agency problems noted before become overwhelming.
The processes for limiting competition through the design and scale of the auction and the disclosure of information, are far more subtle than that often employed in developing and transition economies. When corrupt officials wish to limit competition, they may simply design qualifying conditions that allow only preferred bidders to compete.
Not surprisingly, large multinationals have opposed reforms that would increase competition and lead to higher overall payment, and they have by and large prevailed. The bonus bidding system still prevails, and there is limited pre-bidding disclosure of information.
In the economies in transition, another approach can often be used in corrupt privatisations. The government may not allow foreign bidders, and at the early stages of transition, few domestic bidders have large resources of their own. The ostensible solution for firms then is to borrow from a bank. However, in some countries where the government still controls the banks – and so it could determine who gets the money to bid and how much money they have, then one pocket of the government could be giving money to another pocket through an intermediary.
There will be no net transfer of cash to the government; the situation then will only be slightly different from what would have happened if the government could buy the mine or oil field from itself. That slight difference has enormous consequences, however. By going through the private intermediary, the government’s equity position can be converted into a creditor position. If the government has received fair market value, it would simply have entailed a transfer of risk. Yet, the government cannot receive fair market value. Moreover, because it may be easy for the buyer to default, there may not even be any transfer of risk. It is simply a transfer of the up-side potential to the private party (Stiglitz 2006).
Matters differ little if the government controls the licensing of private banks. The granting of a license, with lax regulation, is granting the right to print money – or in this case, to determine who is able to bid for the government’s resources. Even with some regulation, the government can affect who wins it can determine at whose bank deposits are put, and therefore who has the potential for making loans (Freeland 2000).
There is a clear implication: If privatisation is to occur in countries in which there are limited numbers of private parties capable of bidding for the resources in a bonus bid, then: (a) bidding should be converted to royalty bidding – augmenting the argument for royalty bidding given in the previous section; and/or (b) foreign bidders must be allowed. Alternatively, the privatisation should be postponed until there are enough viable bidders within the country to give rise to a competitive auction.