IMPLEMENTING SOE REFORM IN THE PACIFIC: CHALLENGES, PROGRESS AND LESSONS LEARNED

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1 PACIFIC ISLANDS FORUM SECRETARIAT PIFS(13) FEMT.OOS.01 FORUM ECONOMIC MINISTERS MEETING AND FORUM ECONOMIC OFFICIALS MEETING Fa'onelua Convention Centre Nuku alofa, Tonga 3-5 July, 2013 OUT OF SESSION PAPER IMPLEMENTING SOE REFORM IN THE PACIFIC: CHALLENGES, PROGRESS AND LESSONS LEARNED This information paper, prepared by the Asian Development Bank, highlights the progress made in implementing State Owned Enterprise reforms in recent years, in particular since the 2012 FEMM, and broadly links to the issues for discussion in Sessions 2 on Promoting Sustainable Development in Large Ocean States.

2 Purpose Out of Session Paper Implementing SOE Reform in the Pacific: Challenges, Progress and Lessons Learned [PIFS(13)FEMT.OOS.01] The purpose of this paper is to highlight progress made in implementing State Owned Enterprise (SOE) reforms in recent years, in particular since the 2012 FEMM, and the required Ministerial direction and support to achieve SOE reforms. Background 2. In July 2012, the Forum Economic Ministers resolved to take steps to further improve public service delivery, resource allocation and efficiency through ongoing SOE reforms. These reforms were to focus on commercialising the SOEs through strengthened governance arrangements, clear mandates, transparency and accountability. In the ensuing 12 months, however, only a few countries have made tangible progress towards these goals. Others struggle to find the political support necessary to push through reforms, or the technical capacity to implement them. In some cases the reforms are being questioned, while in others, new ways of supporting inefficient SOEs are being devised; putting additional strain on already stretched public resources. In this context, the Economic Ministers in 2013 could develop more concrete action plans to underpin their longstanding commitment to SOE reforms, and in particular look at the employment and productivity-enhancing benefits of privatisation, increased contracting out of services to the private sector and public-private partnerships (PPPs). The experience of Forum Island Countries (FICs) has shown that privatisation, contracting out and PPPs can result in rapid employment creation, service improvements and increased productivity, all of which positively contribute to economic growth. Issues 3. Economic Ministers have long recognised that improving the performance of SOEs is not only essential for efficient public resource allocation, but is also necessary for economic competitiveness and sustained growth. Since the seven principles 1 for SOE reform were adopted by the FEMM in 2005, successive Action Plans have underscored the Ministers commitment to improving SOE performance. 4. This paper highlights the progress made in implementing reform in recent years, in particular since the FEMM meeting in 2012, and demonstrates that while there is no immutable sequence of reforms that should be applied in all countries, there are common characteristics of successful SOE sectors which include: i. robust legal and regulatory frameworks for SOEs; 1 The seven principles are: (1) A coherent and holistic public enterprises policy, (2) Strengthen adherence to principles of good corporate governance, (3) A transparent approach to identifying and funding community service obligations, (4) A clear separation of the ownership role of Government from its regulatory role, (5) Increase the contestability of the market, (6) Maintain competitive neutrality between state-owned companies and the private sector, (7) Wherever possible, monitor both financial performance and service quality against appropriate national and international benchmarks. 2

3 ii. iii. strong governance and monitoring arrangements; and an unambiguous commercial orientation. 5. In recent years, as the FEMM has become more aware of the cost of poorly-performing SOEs, there has been an increased focus on SOE reforms. However, this has not always translated into meaningful actions, including in the past year. The small size of most FICs, the close linkages between SOEs and policy-making bodies in government, and the absence of a strong political commitment to fully commercialise the SOEs has meant that the seven principles remain highly challenging to implement. 6. Because the benefits of SOE reform are often realised only after the restructuring costs have been incurred, SOE reforms can be politically unpopular. In many countries, political opposition to SOE reforms often stems from: (i) the potential loss of patronage; (ii) the loss of direct control over the SOEs, which are perceived to be important policy implementation tools; (iii) potential job losses as SOEs are restructured and made more efficient; and (iv) foregone revenue streams from privatising SOEs that generate a cash surplus. SOE reform therefore often comes at a short-term political cost, in particular if the rationale and future benefits of the reform are not effectively communicated to the general public. It is therefore not surprising that in most cases reforms have been progressed in an opportunistic way, whenever the needed political support exists. Notable progress in recent years in each key area of SOE reform is outlined below. Legal/Regulatory Reform 7. New or amended SOE legislation has been enacted in six Pacific countries since 2007, and a draft SOE bill was submitted to Parliament in the Republic of Marshall Islands (RMI) in October Following elections in 2012, Vanuatu restarted its SOE reform programme with the development of a new SOE policy, which is now awaiting Cabinet endorsement. Once endorsed, the SOE policy will serve as a blueprint for a new SOE Act. Also in 2012, the Cook Islands adopted an SOE reform policy very much in line with the FEMM s seven principles and commenced an extensive review of its SOE legislation to bring it in line with the approved policy. However, it appears that decisions taken in February 2013 will move the policy further away from the seven principles. With the exception of Papua New Guinea (PNG), Kiribati and Cook Islands, all of the SOE Acts share some key characteristics that are compatible with the FEMM SOE principles: i. a primary objective for SOEs to operate as successful (profitable) businesses; ii. iii. iv. a process for selecting and appointing professional directors; robust corporate planning and disclosure requirements; and a process for contracting community service obligations on a commercial basis. 8. While the quality of SOE legislation in the Pacific is generally very high, implementation remains patchy. A number of countries continue to act extra-legally and while in some cases this is due to capacity constraints within the SOEs or their respective monitoring agencies, in many cases it is due to a lack of political commitment to implement the full letter and intent of the law. It should therefore be of no surprise that in every country in the Pacific, SOE performance continues to fall short of the mandated primary objective. 3

4 Governance 9. In the 12 months leading up to the 2012 FEMM, more than 200 new directors were appointed to SOE boards in Samoa, Solomon Islands, PNG and Tonga. These directors replaced politicians and civil servants who had a fundamental conflict of interest in serving as directors on SOE boards. The professionalisation of SOE boards means that appointed directors possess the right set of skills, knowledge and experience to assist the SOE to achieve its primary objective. Professional directors can focus on their duties and obligations towards the SOE and towards the shareholder, and be more effectively held accountable for results. 10. Notwithstanding these achievements, the restructuring of SOE boards remains highly challenging, as the practice of appointing political allies to SOE boards has been widespread. Changing these practices requires a change in culture. In Samoa, the board composition and appointment provisions of its Public Bodies Act were ignored for 10 years due to an absence of political support for their implementation. Once this was overcome, however, Samoa became the first Pacific country to use an independent selection committee for the appointment of its SOE directors. 11. In the Solomon Islands, it took three years to develop the implementing regulations to the 2007 SOE Act, but these regulations (which focus on director selection and appointment and community service obligations) are now being implemented thanks to the strong political support of the Minister of Finance and Prime Minister (who sponsored the development of the legislation when he was Minister of Finance in ). The benefits of this reform program are clearly demonstrated in the dramatic improvement in the Solomon Island SOE portfolio return on equity, which has improved by 3 percentage points since The director selection and appointment processes now being implemented in Solomon Islands and Samoa represents regional best practice. In Tonga, position descriptions have been prepared for all SOE directors, which is the first step in introducing a director performance review system, which should be fully implemented by July This will be the first formal director performance review system in the Pacific. As governments become more committed to implementing their SOE legislation, including the director appointment process and the duties and liabilities of SOE directors, qualified private sector directors come forward to take up these roles as they are more confident in securing the independence required to act as effective directors. 13. The FEMM also made a commitment in 2012 to support women s economic empowerment, and in particular to increase the proportion of women on SOE boards 2. In 2012, only 15% of the SOE board positions in 6 of the larger Pacific economies were held by women. Statistics for the broader formal private sector can now be tracked thanks to the implementation of electronic business registries, and numbers are more encouraging. In the Solomon Islands and Samoa, for example, women hold 22% and 32% of the total directorships among formal private companies, respectively. These numbers are relatively high compared to OECD countries, and are certainly higher than the proportion of women on SOE boards, which is 16% in Solomon Islands and 20% in Samoa. As women are given further access to board appointments, director training programmes are made available and the pool of women qualified to serve as directors expands. These numbers will continue to grow. ADB, through its Private Sector Development Initiative (PSDI), is working with Forum countries to achieve this goal. 2 The 2012 FEMM Action Plan called for the Forum Islands Countries to implement affirmative action/equal opportunity employment practices in public sector employment practices, including State Owned Enterprises and statutory boards, to increase the proportion of women in senior positions, and advocate for a similar approach in private sector agencies 4

5 Samoa Broadcasting Corporation Successful Management Buyout In 2008, the Government of Samoa completed the privatization of the Samoan Broadcasting Corporation, which had historically been profitable but recorded losses in 2006 and 2007, the two years preceding the sale. The company was offered for sale via a competitive tender, which was awarded to a consortium led by the company s management. Four major shareholders, including the pre-sale chief executive officer, now own 90% of the company s equity, with the balance held by the staff. A little over 1 year after the completion of the sale, the new owners reported improvements in almost all aspects of the business. In the first year after the acquisition, the company earned sufficient profit to pay the new owners a dividend. In the second year, the directors elected to retain the profits in the business as they embarked on a reinvestment program. Radio coverage has increased from 85% of the population to 98%; TV broadcasting hours have been extended; the company has expanded its TV program offering and invested an estimated ST400,000 into broadcasting infrastructure; and staff morale and commitment have improved. This sale demonstrates the powerful performance incentives that privatization creates, and that state-owned enterprises can be sold for fair value even when they are making losses. Sasape Marina A Privatization Success Story in Solomon Islands In early 2007, the Solomon Islands government privatised Sasape Marina Ltd. Lack of investment and mismanagement had resulted in a steady deterioration of the company s financial and operating position over the years, with the value of the government s equity in Sasape Marina falling from SI$14 million in 1996 to an estimated SI$3 million in 2005 the last year in which financial statements were prepared. By 2008, the company was insolvent and its assets were in a state of disrepair, with both of the company s slipways inoperable. Without substantial investment, the company faced certain closure. The government, recognizing its limited capacity to invest in and profitably operate the slipways, turned to the private sector. With technical assistance from ADB s Private Sector Development Initiative, a competitive tender was successfully conducted in 2010, with the winning bidder putting forward a plan to substantially rehabilitate and expand the slipways. The new owners, a joint venture between a Solomon Islands company and the National Provident Fund, has invested over SI$10 million to rehabilitate the slipway and created over 70 new jobs. In addition, economic life in Tulagi, where the slipway is located, has been revived, with a local market, shops, a hotel and restaurants opening as a direct result of the slipway rehabilitation. This transaction illustrates that privatization ultimately leads to employment creation as assets are put to more productive use, and even insolvent state-owned enterprises (SOEs) can be attractive candidates for sale and rehabilitation. 14. The establishment of functioning community service obligation (CSO) frameworks has also been a major breakthrough in SOE reform in recent years, with Tonga and Solomon Islands leading the way. CSO frameworks create a process through which SOEs identify, cost and contract the provision of CSOs with the Government in exchange for direct compensation. In this way, SOEs do not violate their mandate to operate as profitable businesses and Governments are able to more effectively budget for CSO provision. With support from PSDI, Solomon Islands has developed detailed CSO contracts for 4 of its SOEs in the past 12 months, and now has a robust process in place to include CSOs in the government s annual budgeting process. PNG has been working on a similar CSO framework since 2010 and once Cabinet endorses the proposed CSO Policy it will then pave the way for legislative amendments. Commercialisation 15. Many SOEs have completed the corporatisation process and become companies (sometimes under the Companies Act) - but they have not completed the commercialisation process as they continue to operate with substantial government support. In this way there is no competitive neutrality with the private sector, in violation of FEMM SOE principle no.6, and these SOEs continue to be a burden on public finances. An example of this is in Samoa, where the Unit Trust, established in 2009, is now lending to SOEs at subsidised rates. This has the dual effect of crowding out the commercial banks and propping up inefficient SOEs. Moreover, the Government of Samoa continues to extend government guarantees on SOE borrowings, totalling WST60m in Total debt either guaranteed 5

6 or taken over by the government due to SOE default represents 36% of total SOE debt 3. While the Government makes important progress towards commercialising its SOEs by professionalising their boards, it concurrently undermines these reforms by further relaxing SOE budget constraints. 16. Fully commercialised SOEs operate with the same hard budget constraints and accountability for results as private sector companies. Two good examples of this are the National Bank of Vanuatu (NBV) and Tonga Power Ltd. In both cases, commercialisation came about after substantial restructuring; in the case of NBV, it came about after the bank became insolvent in Tonga Power was established in 2009 as a fully commercial enterprise owned by the Government, with proper controls and a professional board. NBV has continued to operate profitably in a competitive sector, returning an average of 19% on equity since It has not been directed to undertake any non-commercial activities nor lend to SOEs at below market rates. Tonga Power, on the other hand, has suffered from political interference and pressure to deliver unfunded CSOs. In its first full year of operation (2010), it established a power tariff that allowed full cost recovery, and its return on equity (ROE) was 8%. Since that time, however, the company has twice been informally directed to hold power price increases, despite rising fuel costs. These informal CSOs, for which the company received no compensation, drove down the company's ROE to 5.5% in FY2012. Recognising the adverse impact of this practice on Tonga Power's financial and operational performance and its ability to pay for imported fuel, in March 2013 the Government agreed to formalise and compensate Tonga Power for the CSO. This should allow Tonga Power to again adhere to its commercial mandate. 17. Where SOEs can be privatised, this is the most expedient way to achieve commercialisation. While there were a total of 11 privatisation transactions in the Pacific since 2005, only one has been successfully completed since the 2012 FEMM 4. Some countries are preparing SOEs for sale, such as Tonga, Solomon Islands and Samoa, but progress has been exceedingly slow. Where privatisation has occurred, productivity has increased dramatically, such as with the Samoa Broadcasting Corporation and Sasape Marina in the Solomon Islands (see text boxes on page 4). In both cases, privatisation has resulted in new investment, an expansion of services and new management teams with very strong performance incentives. Where full privatisation is not possible, the contracting out of selected SOE functions and public-private partnerships can often improve productivity. Where SOEs remain under majority public ownership, commercialisation is still attainable but requires much closer monitoring on behalf of the government. This is perhaps best illustrated by the example of New Zealand which undertook one of the world s most comprehensive SOE reform programmes in the 1980s, only to see many of the benefits of these reforms lost under subsequent governments which were less demanding in terms of SOE performance. The recent and well-publicised decline in the financial performance of Solid Energy highlights these risks 5. Conclusions 18. Important progress has been made in implementing the FEMM SOE reform principles throughout the Pacific, but we note a slowing of momentum in a number of countries over the past 12 months. With the region under continuing fiscal strain, SOE reform remains an essential tool to unlock scarce resources. Over the past decade, the level of awareness of the importance of SOE reform 3 Concluding Statement 2102 IMF Article IV Consultation, April 10 20, This is the recently announced sale of 51% of Ports Terminal Limited, a 100 per cent owned subsidiary of Fiji Ports Corporation Ltd. 5 Solid Energy, formally Coal Corporation, rode the resources boom and was valued by its directors at NZD 3bn in While it was one of the SOEs identified for partial sale by the government, it instead was allowed to continue its diversification into a range of non-core activities as coal prices fell, resulting in NZD40 million of net losses in Government now estimates its value to be less than its NZD389 million of external debt. 6

7 has very tangibly increased in the Pacific, and a body of knowledge and experience in implementing these reforms has been created. Put simply, we now know what works and what must be done to achieve improved SOE performance. While the reform path is necessarily different for each country, the end game is the same. The responsibility of each government is to create the conditions that allow reform momentum to build and ensure the sustainability of the reforms achieved to date. Asian Development Bank June