Markets in everything - internalizing expenses due to misconduct as the cost of doing business

Since the disastrous oil spill from its Deepwater Horizon oil rig in April 2010, British Petroleum (BP) has apparently spent nearly $30 bn in clean up costs, civil damage claims, and restitution to businesses and residents along the Gulf of Mexico. The incident, which involved a spillage of 200 million gallons of oil, resulted in the death of 11 workers and a massive environmental disaster. However, despite the huge price tag of the oil spill, $30 bn and climbing, BP's commercials appear unaffected. It collected more than $375 billion in 2011, pocketing $26 billion in profits.

While criminal prosecution charges were framed against the executives of BP and its contractors, nobody has been prosecuted till date for these damages. This has important moral hazard implications. Though BP has been involved in similar safety failures earlier, when they paid huge fines, they have moved on without addressing the underlying safety related issues. In fact, as Times writes, "without personal accountability, the fines become just another cost of doing business".

Much the same story can be said about the several cases of financial market irregularities, bordering on criminal misconduct, that played a major role in blowing the sub-prime mortgage securitization bubble. Several financial institutions, including its leading lights, have been found guilty of practices that involved making money by betting against their own clients. These firms peddled unsuspecting clients securities that they themselves were betting against (say, shorting). They made money from fees as well as being the counterparty in the trade.

In most of these cases, the financial institutions have settled the malpractice suits and even the criminal prosecution by making huge compensation and fine payments. However, not one top executive has been convicted on criminal misconduct. Most of these institutions have weathered the worst of the sub-prime meltdown, paid their fines, and are back to making profits by indulging in the same practices. They have come to see the fines as another "cost of doing the business".

In his best selling book, Predictably Irrational, Dan Ariely has written about the changed behaviour of parents when a kindergarten moved from a regime of mandatory pick-up as soon as school closes to a regime that charged for additional hour spent beyond the school hours. They found that in the former regime parents generally came to pick-up their children within time, whereas parents preferred to pay and pick up their children at their convenience. He argued that in the first regime, social norms kept parents from tardiness in pick-ups. However, in the second regime, introduction of a penalty increased tardiness. A fine becomes the price (pdf here) of the violation or deviation. The same motivations lie beneath the moral hazard described in the first two examples.

Such trends are not confined to high-finance and business, but pervasive in modern-day lives. Old-fashioned virtues of equality (of people standing in a que to access a service) have given way to opportunity-cost driven conventions (rich people pay to access the service out of turn). The implications of this gradual shift have been far-reaching and is surely a major contributor to the widespread widening of inequality across societies. It is obvious that there is a slippery slope associated with these trends. Traditional mores slowly get replaced with market-based morality, with all its attendant consequences.

In this context, Michael Sandel's new book, What Money Can't Buy: The Moral Limits of Markets, provides an excellent perspective on how pricing human behaviour and responses runs the risk of crowding out other values. Jonathan Last has an excellent review of the book, where he writes,

Today you can purchase your way out of waiting in line for rides at many amusement parks. There are express lanes that allow us to buy our way out of traffic. Many schools now "incentivize" performance, paying students if they read books or do well in school; some schools now sell ads on children's report cards. Cities routinely sell advertising space on public property, ranging from parks and municipal buildings to police cars. In each of these cases, long-held ideas about inherent worth and common ownership have been displaced by the simple morality of the market. 

He quotes Sandel's assessment of market driven morality,

Markets don't only allocate goods, they also express and promote certain attitudes toward the goods being exchanged... When we decide that certain goods may be bought and sold, we decide, at least implicitly, that it is appropriate to treat them as commodities. 

Prof Sandel raises questions about the effect of such marketization on democracy itself,  

At a time of rising inequality, the marketization of everything means that people of affluence and people of modest means lead increasingly separate lives. We live and work and shop and play in different places. Our children go to different schools. You might call it the skyboxification of American life. It's not good for democracy, nor is it a satisfying way to live. Democracy does not require perfect equality, but it does require that citizens share in a common life. What matters is that people of different backgrounds and social positions encounter one another, and bump up against one another, in the course of everyday life. For this is how we learn to negotiate and abide our differences, and how we come to care for the common good.

The issues raised by Prof Sandel have enromous significance for our society today. If the creeping influence of markets and its touchstone of utility maximization crowds-out individual values and social norms, then we are not far from an age where man would move from being a "social" to a "monetary" animal. Its aggregate consequences would be far from benign.

Votes would be bought and sold, criminals would purchase their way out of jails, college seats would be auctioned off, policy decisions would be purchased based on donations made to parliamentarians and ministers, and so on. Further, it would be no longer anathema to let the poor suffer or even die for lack of access to medical care, or keep lowering taxes on the rich, or provide tax concessions to businesses while loathing welfare subsidies to the indigent, and so on. 

Assualt on incentives - the case of farm loan waivers

Talking of assault on incentives and the moral hazard concerns arising from loan waivers, Mint writes,

The loan waiver announced in February 2008 had a cut-off date of December 2007. The general elections were held about 18 months later. It seems likely that farmers are now anticipating that the next election will be held sometime in the middle of 2014; so it is a good time to begin defaulting.

The Mint report points to a working paper by Martin Kanz (see presentation here) which examined the impact of the 2008 farm loan waiver and found that "debt relief does little to improve the fi nancial position of benefi ciary households" but has strong eff ects on expectations of the beneficiaries. About the material impact of debt relief, he writes,

"Debt relief does not lead to a measurable increase in investment, an improvement in the productivity or a reduction in the variance of realized returns to agricultural investment among households that had their debt cleared under the program."

About its impact on shaping expectations, he writes,

"Households in the treatment group state that they would be much more likely to default on cooperative bank loans in the future, and this propensity is increasing in the amount of debt relief they received. Similarly, recipients of full debt relief are signi cantly less concerned about the reputational consequences of defaulting on bank debt, which suggests that debt relief removes much of the social stigma associated with nancial distress...

the finding that households that had a higher total amount of debt cleared report that they would be more likely to default on cooperative bank debt in the future appears to con firm fears that debt relief is detrimental to the culture of prudent borrowing."

Market failure in the US Banking sector

NYT has an excellent graphic that illustrates the enormity of the huge concentration of market power in the US banking industry. Of the more than 8000 banks in the US, the top 3 have 44% of market share while the top 20 take 92%.



The Times article is spot on its assessment of the US banking sector in the aftermath of the sub-prime mortgage crisis,

Failure is as important to healthy capitalism as success. The nation’s handful of huge banks, however, are spared the indignity of failure... It’s extremely likely that all of the nation’s largest banks would have collapsed over the past three years without enormous help from the Federal Reserve. In any normally functioning market, they would have subsequently had trouble making huge profits. Instead, they’ve gotten bigger and richer.

In this context, more often than not, regulatory expansion will favor the existing entrenched big firms. In fact, even the current credit squeeze, by hurting the smaller firms disproportionately and also subsidizing the bigger firms, will only amplify the market power of the latter. This is a classic market failure, with potentially catastrophic systemic risk consequences (the TBTF moral hazard), crying out for policy intervention. The only way out of this systemic risk gridlock is to break-up the larger firms and disaggregate the concentration of market power and thereby risk.

In light of both the obvious danger of systemic risk caused by a few large firms and the fresh memory of the banking sector trends in the aftermath of the sub-prime crisis, one can only assume that policy makers are being deliberately obtuse if they can't get round to pulling the plug on the banking behemoths.

The Kingfisher bailout request - saving capitalism from capitalists!

In the past four years, bailouts have been at the center stage in many developed economies. Financial institutions, companies, and even countries have been bailed out in the aftermath of the bursting of the sub-prime mortgage bubble.

It should therefore come as no surprise that the B-word should find favor among struggling Indian companies. Sample this request from Kingfisher Airlines

"Facing serious financial turbulence, Kingfisher Airlines has sought government help for a bailout... The seriousness of the crisis was underlined by the urgent request Kingfisher owner Vijay Mallya made to finance minister Pranab Mukherjee and civil aviation minister Vayalar Ravi to help Kingfisher in infusion of funds through banks at low interest rates, besides other concessions in line with what Air India was getting."

And there are indications that this may be just the beginning. It is certain that all the other similarly struggling airlines will express their solidarity with Kingfisher and come forward with their own bailout requests. In fact, request for government help has already started,

"India’s private airlines have asked the government to cut taxes on jet fuel and force state-controlled Air India​ Ltd to raise fares, as losses mounted at private carriers that control at least 83% of the local passenger market. The airline firms have lost Rs. 3,500 crore in the six months ended September, more than the Rs. 2,900 crore they had lost in the last fiscal, according to an airline lobby group."

And what has been the government's preliminary response to this request,

"Union civil aviation minister Vayalar Ravi on Friday said he would talk to finance minister Pranab Mukherjee​ to get financially-troubled Kingfisher Airlines​ assistance from banks. The minister is also talking to state governments to reduce sales tax on aviation fuel."

The government does not need to be defensive on this. It is a great opportunity for the embattled government to atleast begin the process of its redemption. The sheer audacity and hypocrisy of the request is staggering. Kingfisher, the flag-bearer of hedonistic capitalism in India, wants equivalent treatment with a public sector entity. It wants the dregs of its orgy to be cleaned up with tax payer money. In simple terms, it is a request for socialization of private losses.

The fundamental tenet of Capitalism 101 is that market competition creates and destroys companies. In this case, a badly mismanaged Kingfisher and some other larger airlines, are reaping the sins of their earlier excesses (see this earlier blog post). Capitalism 101 tells us that when faced with such circumstances in a competitive market, we should let the market dynamics prevail. This would mean letting Kingfisher go bankrupt. Its equity holders and promoters should lose their shirts to repay the company's liabilities.

The details of the bankruptcy proceedings and resultant restructuring will vary and are debatable. There are real dangers of crony capitalism rearing its head. If the government intervenes to assist Kingfisher, there is the possibility of sweetheart debt restructuring deals, wherein portions of its debt owed to public sector banks will be foisted on them as equity without forcing the existing shareholders to take losses. In fact, there are already signs of something unpleasant brewing,

"A group of 13 lenders, including State Bank of India​ and ICICI Bank Ltd, bought a 23.21% stake in Kingfisher Airlines in April this year. SBI picked up a 5.67% stake and ICICI Bank 5.3%. The airline converted Rs. 750 crore of its total debt of Rs. 7,000 crore into equity at a 61.6% premium over its share price in what many considered a sweetheart deal. It allotted shares to lenders on 31 March at Rs. 64.48 apiece."

Kingfisher shares closed at Rs 19.65 on Friday, less than one-third the price at which the banks purchased their stakes. It was clear in April (when the stakes were purchased) that Kingfisher was on terminal decline. So why were the share purchased at such a premium? It would also be worth investigating the share transactions of the original promoters and largest equity holders in the aftermath of these deals and in recent months. It could turn out to be an excellent case study for corporate governance (or malfeasance) standards in India.

However, a note of caution is that the government should not be tempted into taking it over and merging with Air India. This would be letting the promoters of Kingfisher get away too lightly. It would be unfair on Air India. It will also generate long-term moral hazard concerns. More than anything else, it would reek of crony capitalism.

Fortunately, Kingfisher is neither too-big-to-fail nor does its bankruptcy pose any systemic risk within the industry or the financial markets. There were enough indications of this coming for some time now. It is widely known that the company is neck-deep in troubles and owes money to banks, oil companies, other airlines, DGCA, and the government (by way of taxes).

In fact, a Kingfisher bankruptcy will have several positive externalities. For a start, this outcome would be an acid test for India's bankruptcy laws. It would send out a strong signal to corporate India that private losses have to remain private and will not be borne by tax payers. The resultant disincentivization of bailout moral hazard will strengthen the institutional foundations of India's emerging capitalism. Furthermore, it will provide a much-needed boost to the beleaguered government in New Delhi. It will be a rare triple win for the government - political populism converging with sound economics and equally sound public policy.

An important dimension to this development is the role of the Director General of Civil Aviation (DGCA). What was the aviation regulatory authority doing when Kingfisher was merrily running up its Rs 7000 Cr debt? Why did it not pull the plug early? Should it not have raised the alarms much early than the belated attempts now? What powers should it be vested to ensure that such failures do not recur? Answers to these and the public policy response to the post-mortems will be a test of the government and corporate India's commitment to uphold high standards in corporate governance.

In conclusion, the Government of India is faced with the dilemma of saving capitalism from capitalists. Unfortunately, when faced with this dilemma governments have traditionally failed the test. Will this time be different?

Postscript - The fear of failure and the possibility of losing your equity through a bankruptcy is the "invisible hand" that disciplines risk-taking in any market. If this deterrent is removed, excessive risk-taking and other undesirable business practices - whose catastrophic effects have been made amply clear by the events across the world over the past few years - will be left with no institutional restraints.

Update 1 (17/11/2011)

After so many days, finally one piece of meaningful analysis of the KF crisis from Businessline.

Kingfisher's interest costs as a proportion of sales were as high as 22 per cent in the latest September quarter, compared to 6.9 per cent for Jet Airways and a negligible 1.2 per cent for low cost carrier SpiceJet. Costs other than interest payouts and fuel also seem to have had a role in Kingfisher's poor performance.

The airlines' cost per available seat kilometre (CASK), a key metric used to assess how competitive an airline is, was Rs 4.31 in the September quarter. This was much higher than the Rs 3.31 reported by Jet Airways. Of this number, Kingfisher incurred as much as Rs 2.46/SKM on costs other than fuel, 45 per cent higher than the Rs 1.69 for Jet Airways.

Incidentally, fuel cost, which is often painted as the biggest villain of the piece accounted for 54 per cent of sales for Kingfisher, compared with the 48 per cent for Jet Airways and 63 per cent for SpiceJet.

The case for health insurance and government's role

What should be the role of government and the private sector in India's secondary and tertiary health care system, especially in taking care of those who cannot afford private health care?

Traditionalists see no or limited role for private sector and advocate that government hospitals should meet the requirements. Extreme liberals on the other hand advocate a dominant role for private sector. However, reality demands a much more nuanced appreciation of the health care market and the incentives and challenges facing its participants. This post will attempt to put these issues in some perspective. I will also attempt to outline a model health insurance market, applicable to legacy-free countries like India.

1. Fundamentally, government institutions, even if they expand exponentially, are in no position cover even a majority of those in need of such services. On all primary parameters - doctor to population, beds to population, diagnostic facilities to population, and so on - we lag way behind the requirements. This deficiency will persist well into the future.

It is therefore inevitable that if the government is committed to ensuring atleast access to secondary and tertiary care facilities to its under-privileged population, not only does the public facilities have to grow fast but also be complemented with rapidly expanding private healthcare facilities.

2. However any role for private hospitals raises important questions about the details of this involvement. Crucially, how should private hospitals be involved in the treatment of such cases for those below the poverty line? This question is important because of three reasons.

One, unlike other markets, that for selling and buying health care is rife with market failures (information asymmetry problems like moral hazard, adverse selection, over-treatment), behavioural biases (healthier/younger people prefer to stay uninsured, people prefer more diagnostic tests and invasive procedures) etc. Two, as I had blogged earlier, health care will be among the few markets where productivity imporvements will remain marginal even as technology continuously expands the treatment frontiers. Three, there will be a huge and persistent supply-demand mismatch in developing coutnries which will ensure that health care remains a sellers market for a long time to come.

The first and second factors, along with demographics, have been responsible for the rising health care costs and resultant health care mess in many developed countries. The third factor will only exacerbate the already inherent distortions of health care markets and will be an important factor in countries like India.

In view of all these, the nature of private sector's involvement in the provision of affordable health care becomes important. Experience from across the world shows that health insurance is the most effective strategy to manage these risks optimally and deliver affordable secondary and tertiary healthcare to citizens.

3. Assuming government's commitment to deliver affordable secondary and tertiary health care to all its citizens and the inevitable need for health insurance, the question then is one of ensuring how we can get care that delivers bang for the buck. In other words, how do we achieve the desired health care outcomes at the lowest cost.

This would obviously require leveraging both the government and private health care facilities. The most critical factor would be the design of the insurance model. How do we structure incentives such that the doctors and hospitals confine treatment to only the necessary diagnostic tests and procedures/medications, patients do not demand more than what is required, government hospitals and private hospitals complement each other, and the insurer's administration charges are kept at a minimum?

Here is a simple model of how this insurance can be structured. The real-world model could be some variant or other of this.

Bring all citizens of the country/state into a single risk pool. All those below the poverty line and all government employees, including their families, should be part of this risk pool. In an ideal world, it would be appropriate to include all citizens and usher in a mandatory health insurance model. Further, all the schemes offered in this market should be community rated - same insurance premiums for everyone in the same age group or no differentiation based on pre-existing medical conditions.

Finalize a basic bouquet of treatments that are covered in a universal and basic insurance package and is available to all citizens at a competitively arrived premium. There can be a single or preferably multiple insurers prioviding these schemes. Then there should be a variety of top-ups available on this basic package. Government departments can offer a menu of top-ups to their employees depending on their different levels. Similarly, private employers and individuals too can purchase insurance from this market.

The government could subsidize the premiums at varying levels depending on people's incomes. For example, the poorest could have their entire premiums subsidized. Similarly, for employees, a share of their salaries could be leveraged to complement the government's share of the premium. Employees would have the option to privately top-up on their government package.

The administration of the insurance model itself could be made more transparent and protocols based, so as to minimize excesses and distortions. The entire pre-authorization process can be done transparently and rigorously audited, so as to ensure that insurers/TPAs and service providers do not over- or under-treat patients. To a great extent, as competition increases, the presence of professional insurance agencies and TPAs should contribute towards minimizing these distortions.

A protocols-based referral system can be put in place so that atleast certain categories of those covered in the government financed health insurance model are treated only in government hospitals if facilities are available. The government could, to the extent of the packages fully or partially financed by it, control the empanelment process and negotiate bulk rates with drugs manufacturers and service providers, so as encourage the insurers to quote lower premiums. The presence of a large and vibrant set of government hopspitals will provided the much needed competition to keep private service providers honest.

An additional reason for large network of government health care facilities to exist is because for much of the foreseeable future government hospitals will be necessary to service the vast interiors of the country. Private sector will find such locations commercially unviable. Insurers could deliver their services by leveraging these public facilities in remote areas.

These schemes could be sold in newly established customer-friendly insurance exchanges. Such exchanges could helps customers easily compare across similar kinds of policies, besides making clear the fine-print of these policies. The regular private insurers, who would exist and sell their respective insurance schemes, would all be eligible to bid for offering these set of insurance services. Once the insurers are designated and premiums for the basic package for both poor and different categories of government employees defined, the top-ups may be left to the markets to decide. This will ensure that in the process of rectifying market failures, governments do not end up distorting incentives wholesale and affecting market efficiency.

If required, it may even be desirable to have a risk-equalization pool, like that in Germany and a few other European countries, which would help mitigate the actuarial risks for insurers. This will contribute towards keeping premiums down and reduce the incentive for insurers to turn away patients because of their claim ratios over-shooting. All the actual claims processed each year by all insurers can be consolidated, risk incidence measured, and some pay-outs made so as to normalize risk incidence among all insurers.

Countries like the US, which already have a legacy insurance model, will invariably find it difficult to embrace many elements of this model. But countries like India, which do not have any existing insurance model, will find it easier to embrace elements that are appropriate to its requirements. Furthermore, the favorable age profile of our population too should go a long way towards keeping premiums down if the entire population is covered.

Moral hazard, systemic risk, and financial markets

It is increasingly evident that the regulators and policymakers have learnt little from the bitter lessons of the sub-prime mortgages meltdown induced global financial market crisis.

As Simon Johnson points out in an excellent post, the numbers of too-big-to-fail banks looks set to grow as more mergers are in the pipeline, despite growing signs of risk build-up. He points to the recent decision of beleaguered Bank of America (BofA) to court and accept $5 bn from America's most credible investor, Warren Buffet, as sure sign of serious troubles at the bank.

The bank is the largest bank-holding company in the United States, with assets at the end of June of more than $2.26 trillion. It services one in five home loans, and with 5,700 branches assembled through decades of mergers, it counts 58 million customers. Investors are worried at BofA's long-term health, despite the roughly $20 billion set aside to atone for its mortgage misdeeds at the height of the housing bubble, in light of the $ 9bn in losses suffered by the bank over the past 18 months.

He also points to an interesting NBER working paper by Bryan T. Kelly, Hanno Lustig and Stijn Van Nieuwerburgh who highlight the distortions in the price of put options for the financial sector stock index relative to put options on individual banks' stocks. Put options, which are effectively an insurance against price collapses, are cheaper if investors percieve less risk of such eventualities. They write,

"Investors in option markets price in a substantial collective government bailout guarantee in the financial sector, which puts a floor on the equity value of the financial sector as a whole, but not on the value of the individual firms. The guarantee makes put options on the financial sector index cheap relative to put options on its member banks... The government’s collective guarantee partially absorbs financial sector-wide tail risk, which lowers index put prices but not individual put prices, and hence can explain the basket-index spread. A structural model with financial disasters quantitatively matches these facts and attributes as much as half of the value of the financial sector to the bailout guarantee during the crisis."

The authors find that index puts were a lot cheaper than the appropriately weighted sum of put options on individual bank stocks, especially during the recent financial crisis. They argue that because "investors price in substantial government bailout guarantees for the financial sector as a whole", they find little need to insure privately against overall collapse. This disproportionately benefits the TBTF institutions (over smaller institutions), since any problems individually affecting each of them will translate into a risk for the financial sector as a whole.

In simple terms, the moral hazard created by the sub-prime bailouts and the the resultant market expectations have had the effect of lowering the price of risk for the TBTF institutions. The cause of this risk reduction being the effective bailout guarantee for TBTF institutions that governments provide. The handful of TBTF institutions are so large that they have become proxies for the financial market itself. As Simon Johnson writes, "No other sector in the United States economy gets anything like this kind of insurance". I would call it subsidy.

The populist assualt on incentives - MFI loan defaults

I had blogged earlier about a study by Citigroup economists Willem H. Buiter and Ebrahim Rahbari where they identified factors that could affect future global economic growth. One of the more interesting factors pointed out was the dangers to growth genereated by "the populist assaults on the incentives to work, save and invest". Here is one such example.

Mint quotes Vijay Mahajan of Basix who claims that, thanks to the state-wide default on Microfinance Institution (MFI) loans by self-help groups (SHGs) in Andhra Pradesh, there could be "92 lakh households in Andhra Pradesh who are appearing on the defaulters list of the National Credit Bureau".

Even assuming an element of exaggeration in the figure, it is an extraordinary situation. As far as I can remember, this is the first truly big example of a full-scale debt default by a large section of population. Unlike the loan waivers, where governments decree to write-off loans, here is an example of borrowers deciding to collectively and unilaterally extinguish their debt obligations, without abrogating their loan contract with the MFIs.

First, there is the legal-technical issue of these defaulters, forming a major share of SHGs and women in Andhra Pradesh, losing their credit-worthiness in a single stroke. How would the banks classify or risk-weight future loans to this massive category of borrowers?

More importantly, the larger message that would have been internalized by these women and their communities is that their contractual obligations to their lenders is no longer sacrosanct. The hitherto entrenched belief among borrowers that their private debt will always have to be re-paid is now shaken (the loan waivers have long since shaken this belief on government debts).

Similarly, lenders, of all kinds (who lend to these people), will now be aware that the credit risk of their borrowers have suddenly spurted. Markets will price it accordingly, with higher rates and stronger conditions, which in turn will adversely affect access and hurt borrowers. Unfortunately, this moral hazard is not limited to just borrowers and lenders. It covers all forms of contracts, and this is an even bigger concern.

As standard economic theories have taught us, a market economy is underpinned by bonds of loyalty and trust which facilitates contracts that form the basis of most market-driven transactions. There are a number of studies which have shown that developing countries have weaker contract obligation and enforcement capital and they are binding constraints on economic growth in these economies. The MFI default would surely have diminished the already limited contract capital available in such societies.

In this context, governments need to ensure that their policy decisions do not distort incentives. In the instant case of MFI loan defaults in Andhra Pradesh, even if the government wanted to punish the MFIs, it would have been appropriate if it was done without distorting incentives.

One approach would have been to, in some form, recover the loans through the regular government SHG institutions, with or without interest. The recovered amounts could then have been returned back to the banks that financed the MFIs. This would have punished the MFIs, who would have been deprived off their profits and would suffer credibility loss, without distorting borrower incentives nor causing loss to the financial institutions that funded the MFIs.

Moral Hazard in Power Sector

I have blogged earlier here and here about how the possibility of contract renegotiations on competitively bid tender conditions has generated a moral hazard among infrastructure developers. Secure in the belief that the re-negotiation window is always open, they bid aggressively to win the bid.

The latest evidence of this moral hazard comes from Reliance's Coastal Andhra Power Ltd. (CAPL) stopping work at its Krishnapatnam Ultra Mega Power Project due to increase in the cost of its Indonesian coal. The developer claims that the new Indonesian Coal Price Regulation would push up the coal price and therefore cost of generation, imperil its cash flow and its ability to repay lenders.

As the Businessline writes, this development is surprising since the UMPP PPAs exclude fuel from the force majeure provisions, being specifically mentioned under Clause (a) of Article 12.4 of the PPA that lists out the 'Force Majeure Exclusions'. Further, even the 'Non-natural Force Majeure events' specified in the PPA does not include actions by a foreign government.

In other words, when the tender was called and agreement negotiated, it was clearly known to all parties that the fuel risk was solely vested with the developer. CAPL had bid aggressively in the tariff-based competitive bidding process, quoting a levelised tariff of Rs 2.33 per unit. Reliance Power has won three UMPPs so far. It is therefore, on every measure of reasonableness and contractual obligations, unacceptable for CAPL to stop work citing fuel price risks. Given precedents elsewhere by the same firm and others, this is the predictable path towards a request for re-negotiations on the terms of the contract.

It reflects a lack of professionalism, even questionable intent, on the part of the developer to have entered into the PPA without having hedged for fuel price risks. In the circumstances, the government should issue notice and get the developer to comply with its contractual commitments failing which the PPA should be terminated and the firm black-listed. It is the least that can be done to mitigate the moral hazard that has been unlreashed by frequent requests for re-negotiations.

Most importantly, the final outcome from the CAPL example could well determine the fate of tariff-based competitive bidding in India. The critical parameter in all the Case I bids are the tariffs discovered in the competitive bidding process. All bidders offer their quotes based on clearly known assumptions, of which fuel price risk being borne by bidder is the most fundamental. It is outright dishonest for any successful bidder to backtrack from the project citing fuel price increases.

Therefore, if the CERC buckles on this, it will inevitably open the floodgates for similar requests and destroy the market for tariff-based competitive bidding in the country.

Update 1 (28/7/2011)

Another example of contract renegotiations is the decision by Reliance Power Transmission's Talcher-II Transmission Company to issue the force majeure notice to electricity distribution utilities in Andhra Pradesh, Karnataka, Kerala, Tamil Nadu and Orissa. The Businessline reports that the company has cited unforeseen delays in clearances for a key transmission link being executed by it as one of the reasons for serving the notice. It has not started work on the Talcher-II transmission system that was to evacuate electricity from generation stations in the eastern region to mainly the southern States. The link was to be up by October 2012.

Overcoming the moral hazard from contract renegotiations

I had blogged earlier about the increasing trend of contract renegotiations in infrastructure concessions and the moral hazard generated by it. Such re-negotiations generate inefficiencies in multiple dimensions.

Assured of the possibility of re-negotiations, bidders offer excessive bids to win the tender. This often screens out the best developers or operators who lose out to those with the political muscle to wring out favorable terms during re-negotiations. More importantly, it results in considerable cost escalation, as the re-negotiated terms are certain to be in favor of the bidder. In simple terms, re-negotiations fritter away the efficiency and cost-effectiveness gains that come from a competitive bidding process.

This assumes significance in view of the decision of National Highways Authority of India (NHAI) to focus more on BOT Toll contracts instead of annuity concessions. BOT Toll concessions carries the risk of over/under-estimation of traffic, which in turn often opens up contract re-negotiations. Experience from such re-negotiations show that they are neither transparent nor conclusive. The controversy surrounding the re-negotiations of the Delhi-Noida Toll Bridge is a case in point.

In this context, a recent report on infrastructure public private partnerships (PPP) in the US advocates the use of present value of revenues (PVR) contracts as a means to mitigate the risk of contract renegotiations. Such renegotiations are common in infrastructure contracts which are financed with service fees, like tolls and user charges. The demand (or traffic) risk associated with such contracts is generally borne by the bidders, who cite the shortfalls to re-negotiatee contracts.

It is in this context that flexible-term contracts like PVR contracts assume relevance. In a PVR contract, the regulator sets the discount rate and the user-fee schedule, and bidders bid the present value of the user fee revenue they desire. The firm that makes the lowest bid wins and the contract term lasts until the winning firm collects the user fee revenue it demanded in its bid.

If the demand is lower than expected, the concession period is longer, and vice-versa. The resultant elimination of demand-side risks reduces the risk-premiums demanded by the concessionaires and would attract investors at lower interest rates. The UK was the first to use such variable term contracts, for the Queen Elizabeth II Bridge over the Thames River and the Second Severn bridges on the Severn estuary. Both contracts will continue till the toll collections pay off the debt issued to finance the bridges and are predicted to do so several years before the maximum franchise period.

Chile used a PVR auction to contract out the improvement of the Santiago-Valparaíso-Viña del Mar highway in 1998. It has since adopted PVR auctions as the standard to auction highway PPPs.

The report points to two other important advantages with PVR. One, it provides for a natural fair compensation payable, if the government decides to terminate the contract early. It can buy out the franchise by paying the difference between the winning bid and the discounted value of collected toll revenue at the point of repurchase (minus a simple estimate of savings in maintenance and operations expenditures due to early termination).

Second, unlike fixed term contracts, variable term contracts are especially useful in urban highways, where ex-ante fixation of tolls carries considerable risks - either too high (which causes under-utilization and reduces revenues) or too low (which results in over-use and congestion, generates a windfall for the concessionaire, and distorts his incentive to make investments in improvements). In a PVR contract, the regulator could set the toll rate efficiently to alleviate congestion (by raising or lowering it), without causing any harm to the concessionaire.

Apart from highways, port infrastructure, water reservoirs, and airport landing fields are natural candidates for a PVR. However, the real world risk with PVR contracts is the possibility that regulators will be forced into keeping user fees or toll rates low for political considerations (to not alientate the voters). This would generate sub-optimal outcomes, with the concessionaire having a longer than optimal concession period.

Winner's curse and market failures in resource allotments

One of the most controversial areas of public policy in recent years has been that involving allotment of public resources to private interests. As the role of the private participation in the economy expands, many hitherto public assets - land, mines, telecom spectrum, municipal infrastructure, etc - are increasingly being operated by private participants.

In light of the numerous resource allocation scandals in recent months, a debate has been generated about what is the most effective strategy to allot public resources. Though competitive allocation of resources appear to be the best strategy for such allotments, there are very valid enough reasons to be sceptical. Critics point to the need for governments to be flexible and retain discretion in such allotments in the larger public interest. Let us examine both sides and see how the balance sheet squares up.

Conventional wisdom would have it that competitive markets always result in efficient allocation of scarce resources. However, real world experience reveals that competition also has the potential to generate market failures that create inefficient outcomes. In particular, all sides in the bargain are vulnerable to the winner's curse - over-paying for your purchases. This happens irrespective of whether the allotments are done in a transparent and competitive manner or by discretionary allotments. So what is the most efficient method to allot public resources to private interests?

The most famous recent example of winner's curse is the 3G spectrum auctions in Europe at the turn of the century. Telecom operators who bid fantastic sums to claim 3G licenses soon realized the folly of their excessive commitments. It had a devastating impact on their balance sheets and adversely affected the sector itself. Subsequently, the subject has generated considerable research and analysis and many prescriptions have been offered on efficient auction designs (see Paul Klemperer here).

However, nothing seems to have been learnt from the European debacle by both policy makers and the industry itself. Though it is a little early to tell, there is enough evidence to suggest that most of the telecom operators in India over-bid during last year's 3G spectrum auctions. The poor latest quarterly results of these operators are an indicator of the strains imposed by their excessive bids.

All these represent classic market failures. It is astonishing that professionally competent managers who run these telecom operators could not have learnt the bitter lessons from the European auctions. Equally baffling is the failure of financial institutions that supported the respective bidders to exercise the required due diligence that would have exposed the risks inherent in such irrationally exuberant bidding. Policy makers too should take the blame for failing to take into account the inevitability of winner's curse in such auctions and their inability to design the auction so as to mitigate these risks.

However, one of the critical, albeit less-discussed, reasons for such exuberance in bidding could be attributed to the moral hazard arising from the increasing trend of contract re-negotiations. The number of recent precedents of governments permitting such re-negotiations on very specious and flimsy grounds, after the completion of a competitive price discovery process, has considerably eroded the sanctity of contracts. Bidders realize this and rationalize that they could bid on the higher side and mitigate any risk of winner's curse by lobbying to re-negotiate away the unpalatable terms and conditions. And when all bidders play the game on the same assumptions, then winner's curse becomes superfluous.

There is another side to the debate. Economies in transition, especially in a closely integrated world, face an interesting dilemma. On the one hand, they have to compete with others to attract investments and engender business confidence. This competition exists among nations and within them between regions. Governments therefore have to accommodate the requirements of this competitive environment and tailor policies that encourage investors. This often demands discretion-based decisions that appear to favor or provide preferential treatment to certain private groups or firms.

Consider this. A state government faces stiff competition from other states to provide additional incentives to lure say, an IT company, to prefer the state over competitors to set up its new development center. Apart from standard infrastructure sops (like assured quality of power, good connectivity etc), such incentives typically include fiscal concessions, exclusive infrastructure, and additional land. Over the past few years, states have wooed such investors with huge land allotments, far in excess of the specific investment requirements.

Arriving at the right type and degree of incentives is at best of times a very difficult exercise. There is a fundamental information asymmetry in this process. The private firm has clear information of what are the respective offers of individual states and can make its decision based on them. However, the state governments work in an environment of information asymmetry. Unaware of the promises and intentions of their competitors, a state government is forced into marking up its offer on the higher side so as to pre-empt its competitors. The private firm is fully aware of this game and contributes more than its fair share to exacerbating the information asymmetry and trying to bargain the best possible deal from its interlocutor states. The net result is that the successful government invariably ends up with a winner's curse by offering excessive concessions.

Since the environment in which these decisions have to be taken is bedevilled with information asymmetry, it is no surprise that preferential offers made to attract individual investments are mostly controversial and involve some form of corruption.

More worryingly, this challenge has to be managed by public institutions and a civil society that are rarely strong enough to exercise the vigilance required for ensuring fairness in such decisions. Most often, the public institutions are captured by the private firm and the terms of the bargain severely compromised against public interest.

The civil society and its opinion makers mistake the trees for the woods by falling prey to the attraction of a public media trial of a few scapegoats. The public debate gets circumscribed and rarely tries to address the problem with systemic solutions.

Given the prevalance of winner's curse with both strategies, how do we address the problem of public resource allotments? In an ideal world, the benevolent and wise ruler would negotiate with the best interests of his citizens at heart and commit just enough concessions to tip the investment in their favor. But as discussed, the real world is rife with information asymmetry, moral hazard, and winner's curse. Besides there are real-people (read officials and politicians) prone to colluding with unscrupulous investors and a public who are either powerless or distracted by media trials and the lure of instant justice.

Allotments of public resources by way of both competitive bidding and discretionary approaches face the problem of winner's curse. In the former, the private firms end up over-paying and ultimately ending up defaulting or atleast compromising on its commitments. In case of the latter, public resources get allotted on the cheap to private interests.

So the issue boils down to which approach is likely to work best, given these circumstances? Alternatively, which risk - winner's curse for bidders or governments - is less difficult to mitigate? Here, I am inclined to hold that ensuring transparency in the process of allotments of public resources on a discretionary mode, even through empowered committees of eminent people (who are the eminent people and how honest are they), is an almost impossible task in most developing countries, including India. Institutional mechanisms to minimize corruption is difficult to implement for a variety of reasons.

However, markets are versatile enough to mitigate the adverse consequences of winner's curse. After all, the fundamental ideological issue here is over whether the individual wisdom and knowledge of government (and a few of its officials) is superior to the collective wisdom of the market in both ensuring most efficient price discovery and in mitigating the effects of possible incentive distortions like winner's curse. This debate has been settled for some time now.

However, if markets are to determine the allotment process, it is important to structure its institutional design details by taking into account the specific issues related to the sector and lessons from failures across the world. Besides trying to resolve any winner's curse, the design should also address the other sector-specific problems that come in the way of success with such allotments. This not only ensures transparency and efficiency, it can also mitigate the consequences of the market failures that result from various incentive distortions.

Information over-load and health care

Standard explanations trace market failures in health care in general and health insurance in particular to information asymmetry (patients knowing more about their condition than the insurers and doctors knowing more about treatments and diagnostic procedures than patients) and its resultant adverse selection problems, and moral hazard (insured patients having no incentive to curb treatment and costs) concerns. Here are two less-discussed dimensions to this debate, both of which highlight the complexity involved in managing health care markets.

First, Tyler Cowen makes an important distinction between information asymmetry and information overload, and feels that adverse selection is less a problem. He writes,

"When it comes to the elderly, adverse selection as a problem is overstated. The real problem is usually a high degree of information about many conditions, so often insurance is difficult per se. It’s not the asymmetry of information that is the core issue, it is the existence of lots of information, and that is one of Arrow’s subtler points. That distinction matters a good deal for mechanism design.

An old person might know better his health care condition, but not know better his expected health care costs. That is a critical distinction. You can’t reach age 60 and credibly say: "I’ve been healthy so far, I guess my lifetime health care costs will be low." It’s not even clear whether the healthy or the unhealthy will have lower health care costs in their later years; the unhealthy might die rather quickly and decisively. Adverse selection on the grounds of health care costs need not be high and arguably actuaries can estimate those as well as the individual himself."

Another manifestation of information over-load involves the problem of patients being unable to effectively discriminate between multiple treatment options. For example, a patient exposed to two different sets of diagnosis, struggles to make a choice, leave alone the correct choice. Also, though the patient can avoid subjecting his/her body to all diagnostic tests if he/she can trust the doctor's clinical skills, such trust, for various reasons, is an increasingly rare commodity.

Further, most often, in their anxiety, patients end up following the herd and over-treating themselves. Unfortunately, the incentives of the doctors and the diagnostic service providers too are aligned towards leading patients down the path of the herd. In all these cases, it is not information asymmetry, but information over-load that either paralyses decision making or leads patients to make the wrong choices.

Co-payments and deductibles, while trying to incentivize patients to optimize on their treatment, does not always, atleast among those at the top half of the income ladder, curb over-treatment. Awareness campaigns and focussed information dissemination about medical conditions and treatment options can play an important role in helping patients make informed treatment choices.

In another post, Paul Krugman makes the point that health care recipients cannot be exact substitutes for "consumers" in the general marketplace. He writes,

"Medical care is an area in which crucial decisions — life and death decisions — must be made; yet making those decisions intelligently requires a vast amount of specialized knowledge; and often those decisions must also be made under conditions in which the patient is incapacitated, under severe stress, or needs action immediately, with no time for discussion, let alone comparison shopping.

That’s why we have medical ethics. That’s why doctors have traditionally both been viewed as something special and been expected to behave according to higher standards than the average professional. There’s a reason we have TV series about heroic doctors, while we don’t have TV series about heroic middle managers or heroic economists."

The term consumer-choice becomes meaningless in case of patients fighting to save their lives. The choice is mostly a fait accompli. As Krugman argues, it is indeed surprising that even forty years after Ken Arrow wrote this seminal paper distinguishing health care from other markets, the issue still evokes confused rhetoric. See also this post on the shockingly low levels of health care literacy even in the US.

The TBTF moral hazard gets even bigger

Excellent post by Simon Johnson highlighting the too-big-to-fail moral hazard that big financial institutions like Goldman Sachs enjoy. Far from being sensitized and forced into taking action to address this problem in the aftermath of the sub-prime crisis, public policy has regressed further. The TBTF moral hazard appears to be even more deeply institutionalized into the global financial markets.

In fact, while in 1999, the five largest US banking organizations had about 38 percent of total banking assets, the top five banks today have 52 percent of all bank assets. Prof Simon Johnson, writes about the TBTF hazard posed by the $900 bn giant, Goldman Sachs,

"If a bank like Goldman were in trouble, there remain the same unappealing options that existed for Lehman in September 2008 – either to let it fail outright or to provide some form of unsavory bailout. The market knows this and most people – including everyone I’ve spoken to in the last year or so – regards Goldman and other big banks as implicitly backed by the full faith and credit of the United States Treasury.

This lowers Goldman’s cost of funds, allows it to borrow more, and encourages Goldman executives – as well as the people running JPMorgan Chase, Citigroup and other large bank-holding companies – to become even larger."

Permitting TBTF institutions to fail, an orderly winding down through a resolution authority, while theoretically appealing, is not practical,

"But the resolution authority would not helpful in the case of Goldman Sachs, a global bank that operates on a vast scale across borders. Such a case would require a cross-border resolution authority, meaning some form of commitment among governments. As this does not exist and will not exist in the foreseeable future, Goldman is, as a practical matter, essentially exempt from resolution."

In this context, given the aforementioned, there are only two options - break up the TBTF institution or raise reserve capital requirements steeply. The former, while the most appropriate policy choice, stands no chance of success given the lobbying power of the banking industry. As Simon Johnson writes,

"Given that this is the case, the only reasonable way forward is to follow the lead of Prof. Anat Admati and her colleagues in pressing hard for much higher capital requirements for Goldman and all other big banks. If they have more capital, they are more able to absorb losses – this would make both their equity and their debt safer."

But the Basel III, which look likely to raise capital requirements to no more than 10 percent of Tier 1 capital, does not go far enough on this. This is despite the bankers arguement that equity is expensive (and possibly harmful to the banking industry's innovation and growth potential) being fairly comprehensively refuted by many leading finance academicians.

The final word on TBTF moral hazard should go to Neal Barofsky, the outgoing inspector general for the Troubled Asset Relief Program (TARP), who said in his final testimony before the Senate,

"For all its help in rescuing the financial system from the brink of collapse, TARP may have left a truly frightening legacy. It has increased the potential need for future government bailouts by encouraging the 'too big to fail' financial institutions to become even bigger and more interconnected that before, therefore increasing their ultimate danger to the financial system."