Puerto Rico has taken an important step toward modernization with the decision to privatize its bankrupt and failing power utility. Governor Ricardo Rossello has announced that the sale of the Puerto Rico Electric Power Authority (PREPA) will take place in the next eighteen months. The widely-anticipated privatization will ease the territory’s crippling debt burden, and, if properly managed, deliver Puerto Ricans a safer and more reliable power system.
The Puerto Rico Electric Power Authority (PREPA) is the largest utility in Puerto Rico in terms of revenue and clients, serving 1.5 million customers. Vertically integrated across generation, transmission, distribution and retail, it defines Puerto Rico’s electricity sector. Politicized and dysfunctional management of the utility has added $9 billion to Puerto Rico’s crippling $74 billion in debt and hamstrung economic growth on the island.
After the recent hurricane, PREPA has taken months to get back into service, far slower than other damaged utilities. Large parts of the island still do not have service.
International evidence shows that privatized energy companies are more efficient than their publicly-owned counterparts. Reasons for outperformance are relatively straightforward, and center on the different incentives of government versus private-sector owners. Management is considerably more disciplined in achieving efficient operation when facing oversight from shareholders that seek to maximize the value of the enterprise rather than achieving diffuse and potentially conflicting social goals.
It is important to emphasize that privatization does not necessarily mean deregulation. The transmission and distribution elements of the electricity system are natural monopoly assets and should be subject to cost of service regulation to ensure the efficient use of these network assets. Indeed, establishing a credible and stable regulatory regime for PREPA is a necessary precondition for privatization in order to attract investors. Progress has been made in recent years.
PREPA provides an excellent case study in just how badly government mismanagement of an energy business can adversely affect consumers and the taxpayers that ultimately own the business. The Puerto Rico Energy Commission (PREC), the latest entity to regulate PREPA, was established in 2014. PREC seeks to ensure that PREPA’s costs are reasonable. A recent independent expert report for PREC demonstrates the dysfunctional management of the utility and illustrates the detrimental effects of a lack of commercial incentives.
At the outset, the consultants find that political pressure to sustain low rates has forced the utility to operate subject to considerable cost constraints. In turn this has led to the introduction of practices that have compromised system reliability and spending on maintenance. Political interference by government owners delivered lower prices in the short-run at the expense of vital programs of operating and capital expenditure necessary to ensure the long-term safety and reliability of the system. A commercially-run utility subject to economic regulation, by contrast, would have priced its services more efficiently.
The consultants identified irregular spending in the business’s administrative area which had experienced unexplained growth in recent years. Of the $165 million in administrative expenses in the 2016 financial year, $135 million was allocated to a “discretionary fund,” with no detail on how funds were spent. These discretionary expenses were considerable, equivalent to one-third of the utility’s entire capital budget. Privately-run utilities do not have an incentive to lay out money on unnecessary expenses for which they cannot account. Costs are cut in order to prioritize returns to shareholders.
Another reason why private sector ownership would deliver a more efficiently-run utility is that commercial owners can bring with them superior technical and managerial prowess. The privatization process sees those companies best placed to operate the utility able to deliver the highest bid and secure ownership. The market for corporate control then maintains a constant discipline on management to meet industry best practices, through the threat of takeover and displacement of under-performing management.
A state-owned business faces no threat of takeover and sub-optimal performance can continue indefinitely. In the case of PREPA, the consultants found that it was not clear it had the “infrastructure to manage a strategic budget allocation process.” Explanations for “multi‐million dollar capital projects were often limited to two to three sentences, and in no case did PREPA provide an explanation of the basis of its cost estimates”. On the whole, there was little in the comprehensive examination of the business that engendered much confidence that the utility was close to meeting industry benchmarks for managerial competence.
The experts’ report detailed the utility’s inadequacies at length and would demoralize even the most committed central planner. Privatization of PREPA offers a once in a generation opportunity for wholesale structural reform of the energy sector in Puerto Rico. As currently operated, PREPA is a dead weight on the Puerto Rican economy, delivering high cost and unreliable electricity. Private sector ownership of an appropriately regulated energy sector has the capacity to revitalize growth in the island, and Governor Rossello should be commended for proceeding with an overdue and much-needed economic reform.
Burchell Wilson is a contributor to E21.
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