A Critique of the Hybrid Model of Governance

K. R. S. Murthy

Existing model of governance of State Owned Enterprises (SOEs) is a

combination of two basic governance models—one developed for public governance
and the other for private sector corporations. The objective of the hybrid model is to get
the SOEs to perform efficiently and entrepreneurially as in private corporate governance
while being fully accountable to the government, as in public governance. Typical SOE is
a public limited liability company, owned and managed by the government, and
functioning through a Board of Directors.

Many post-colonial independent countries, including India, saw in the hybrid

model a convenient way to leap frog on rapid industrialization with government
ownership and control—a view that was also supported by economic thinking of the
post Second World War period.

The expectation that the hybrid model would enable SOEs to reap the benefits of
both the public governance and private corporate governance models has not generally
been borne out during many decades of its implementation. This has been articulated by
both those directly involved in governance, and by serious researchers, though it does not
mean that SOEs have not contributed to industrial development. The experience of
consistent under performance appears to hold across different types of governments,
especially in democratic countries. This is in spite of many corrections such as annual
performance contracts or MOUs and management contracts as well as public-private
partnerships. The hybrid model of SOE is not seen as an efficient alternative to private
enterprise subject to competition and well-enforced regulation.

Why has this been so? Does the hybrid model combine incompatible features? If
so, what are the implications? These questions are discussed below.

Some Basic Differences and Incompatibilities

Governance is a legal framework for legitimize the power to take decisions by

individuals or institutions and to hold them accountable (1). Higher the position of the
individual in a system, higher is the level of autonomy and accountability. Due care and
loyalty are expected to be taken in taking a decision. Whether such care was taken is hard
to judge, because the context and information available for decision making have to be
taken into account.

Public and private governance models approach governance differently, although

both emphasize attributes of good governance--explicit methods for legitimizing
autonomy, transparency in decision making, prompt and full disclosure of conflicts of

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interest and a well-articulated methodology for ensuring accountability. Combining the
two in a hybrid model creates incompatibilities for decision making in the SOE. Some of
the differences between the two models and the incompatibilities in the hybrid model are
outlined below.

Differences in Objectives: The two basic models are designed for different objectives.
The private corporate governance model is designed to give autonomy to the
enterprise, subject to regulatory compliance. Competition is expected to give choice, exit
and voice options to stakeholders--consumers, investors and lenders. Regulators, such as
Competition Commission of India, Securities and Exchange Board of India and the
Ministry of Corporate Affairs, are empowered to punish the corporation for any market
distortions and for failures or violations in compliance. The corporation has to focus on
results, without which it cannot survive.

The objective of the public governance model is to prevent the abuse of power.
This is sought to be achieved by structuring different institutions of governance with
defined boundaries, roles, statutory autonomy and authority. Excesses or abuse of power
by one institution is designed to be held in check by the role and statutory powers granted
to the other institutions within a political and legal process. Actual outcomes and results
of each are subject to the constraints imposed by the other institutions. Rule-based
resolution of differences and procedural compliance have premium over outcomes and
results.

Subordination of SOE Objectives: When the public and private governance models are
combined giving a corporate form to the SOE and the government acts on behalf of the
public as owners, the SOE becomes an instrument in the public governance model for the
political party in power to achieve its objectives. SOE’s own corporate type objectives
are subordinated to the government’s objectives. The government’s objectives can arise
from the needs and expectations of society, political party in power and the personal
interests of those in positions of authority.

Coal India provides an example of why and how this subordination takes place.
Former Secretary, Ministry of Coal, Shri P C Parakh, writes (2):

“Despite a large resource base, India always suffered from a shortage of coal.
This shortage generated a thriving black market and a powerful coal mafia, patronized by
the political system. A large number of bogus industries were registered only for
allotment of coal that could be sold in the black market. A number of genuine industries
and brick kilns that had no coal linkage had no option but to procure their requirement of
coal from black market. There were several mafia dons operating in concert with the
officers of Coal India. They purchased coal release orders from the bogus industries and
sold them at high premium to the actual users. This racket has continued for decades and
was accepted in the industry as fait accompli. …

“The best quality of coal was available with Eastern Coalfields Limited (ECL)
and Bharat Coking Coal Limited (BCCL), the two eastern subsidiaries of Coal India

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Limited. While coal mafia earned a hefty premium these companies were making huge
losses and were referred as sick companies to the Board of Industrial and Financial
Reconstruction (BIFR).”

The Secretary had obtained from the earlier minister in charge of coal, who was
also the Prime Minister, approval for the first test of e-auction of 1.5 lakh tons in
November 2004. BCCL sold 1.32 lakh tons to coal consumers through e-auction earning
an additional revenue of about Rs. 1.5 crore. The success of the e-auction had rattled the
coal mafia. Parakh states that the subsequent Minister of Coal kept the concerned file on
extension of e-auction for a month and then ordered that no further e-auction should be
conducted. No opportunity was also given for a presentation on the issue, which was
requested by the Minister of State. Parakh adds that ‘unfortunately, e-auction did not
move beyond the first stage …’

Notwithstanding the SOE sickness in a market that was willing to pay

considerably higher prices, the top decision maker’s overruling of the Secretary’s
proposal ended the SOE’s initiative on e-auction up to about 25 per cent of coal
production. This experience is not unique to Coal India. Air India was also in the news
recently with senior executives alleging that decisions taken by the Minister in charge
were arbitrary and imposed unbearable burdens and hurt the SOE. Despite huge losses,
Air India continues with financial support from the government.

In the hybrid model, the legitimacy of a decision is more important than its
correctness given the opportunities or threats and the strengths and weaknesses of the
SOE or its likely risks and returns for the SOE. The accountability of the Minister is not
to the SOE but part of the larger and more complex process of the accountability of the
government itself to the other institutions in the model such as the Parliament, the
Judiciary and the general public.

SOE Interests: Broader objectives of the government, therefore, such as of controlling

inflation or fiscal deficit override subordinate SOE objectives. Continuing with the Coal
India example, government concern about pricing of power and of railway fares has kept
coal price below market level. Downstream consuming units--government departments
such as the Railways and other SOEs like NTPC and state power generation plants--
import large quantities of coal at a higher price and are not being allowed to pass the
increased cost to their customers. In such situations, SOE performance is part of the
performance of the government itself. SOE efficiency and effectiveness cannot be
measured by measures used in the private governance model such as growth, profits or
market valuation. This conflict in the evaluation measures came into the open recently in
another event also related to Coal India.

Children’s Investment Fund of the U.K., which had invested in Coal India, went
to the Kolkata Court alleging that government interference in the pricing of coal had hurt
it as a minority shareholder and that it had suffered an opportunity loss of $1.5 billion. It
also stated that additional electricity worth $18 billion could have been generated with
the dividends, if Coal India had priced coal at market prices. Coal India’s defence was

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that it had disclosed in its Draft Red Herring Prospectus the risk of government
interference, when GOI offered shares to the public a decade earlier.

The conflict has brought to light the in-built weakness, the dependence on the
hybrid model as an instrument for economic growth and global competitiveness. Coal
India is unable to generate surpluses to improve its technology and productivity or
expand to meet the growing demand. Government policy does not allow private
investments in coal production and many private and public thermal electric generation
units dependent on linkages with Coal India for allocations. They have suffered losses
and have defaulted on their loan and interest repayments to banks. Electricity regulatory
authorities, who are also under the control of the government, and who have to balance
the interests of consumers and producers, have not been able to ensure proper functioning
of the electricity market. In many cases, even after conceding the argument for a price
increase, the regulator has resorted to forcing a compromise on private electricity
distributors, saying that the losses to the extent of the rate rise that was disallowed, can
be converted into a ‘regulatory asset’ on which the firm can earn a rate of return!

The hybrid model’s yardsticks for measuring the performance of SOEs are
lost in the government’s ideology for the quality of life of its citizens.

SOE Culture: The SOEs when measured on conflicting objectives of the two basic
models can explain shortfalls in one as arising out of the pursuit of the other objectives.
The extent to which a given explanation is correct is difficult to measure.

SOEs have evolved in such a culture. The decision of the Supreme Court in India
that SOEs are a part of the state under Article 12 of the Constitution has further
introduced rigidities in human resource management. SOE are unable to attract qualified
and talented needed for changing technologies or in laying off of people no longer
required.

The interests of those in positions of power influence culture through what is

known as the Pygmalion effect in organizations (3). A supervisor’s expectations subtly
influence the behavior and performance of subordinates, which need not be explicitly
communicated. By keeping the e-auction file with himself for a month, the Minister of
Coal signaled his expectations. Staff members figure out and behave accordingly to shape
its culture. Leadership and organization culture are two sides of the same coin (4). Goals
such as productivity, growth, or technological excellence get displaced by the interests of
leaders in positions of power. Compliance to rules rather than SOE performance ensures
career progress. Routine matters are pushed to the top even as surpluses are spirited away
by power brokers and conniving officers. The culture of SOEs is too dependent on
leadership drawn from an election and political culture unlike in the private governance
model, where top level selection is increasingly based on proven record of success. The
public governance model, in its very design, is open to powerful extraneous and
corruptive interests, who can take advantage of an SOE.

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 Leadership influences the organizational culture in the private corporate
governance model also. Leadership in private corporate governance is increasingly being
guided by market capitalization. Corruption and interference happen in the private
corporate governance model also. Major scandals do come up to the surface periodically
all over the world. But the impact of such events is sought to be localized to the firm and
its stakeholders, especially when competition and regulation are effective. Violations are
subject to carefully calculated penalties specified under regulation. Investors, consumers,
and lenders are provided powerful exit and voice options. Bankruptcy is an option.
Regulators are increasingly being empowered to take timely action, such as the recent
search and seizure powers being given to Securities and Exchange Board of India.

Transparency: Transparency is an essential principle of good governance. It enhances

accountability. The scope and manner of its application in the two governance models
differ. For example, the Right to Information Act, which provides for citizen’s right to
obtain information from government, applies to SOEs but not to private corporations.
SOEs have to provide the information sought by citizens. Elaborate independent
commissions have been set up to ensure that the required information is provided within
prescribed time periods. Thus transparency is greater in the public governance model, one
may say, but pinpointing individuals responsible is hard.

Managing Incompatibilities: Because the public governance model emphasizes

compliance and accountability, rules are framed to limit managerial discretion,
without regard to efficiency or its impact on performance. In the private corporate
governance model, a culture of trust and fast action on developments are used to ensure
that discretion is exercised for achieving superior performance.
For example, the purchase function provides a striking contrast between the two
models. Procurement in an SOE is subject to elaborate guidelines and rules. SOEs have to
procure through open competitive tenders and are not allowed to negotiate with vendors.

An example of this is the case of Bharat Sanchar Nigam Limited. At a time when
the market was growing and competition was intensifying, the leadership in the SOE
cancelled a procurement decision that was to increase its capacity. The L1 bidder went to
the Court and the SOE was set back by years in its expansion plans affecting its market
share and profitability.

SOE relationship with vendors is transactional. SOEs cannot, as an operational

issue, enter into flexible, open-ended multi-year contracts with vendors or undertake joint
work on new processes, knowledge sharing, cost cutting or quality improvement.
Improvements in management methods such as co-creation with vendors and customers
or lean management, a competitive weapon that the Japanese corporations unleashed on
competition, and which has revolutionized management, are difficult to implement in
SOEs.

Function of the governance system: A governance system has to shift the balance
between autonomy and accountability as conditions change and a tradeoff is warranted
(5). Too much of autonomy increases risk, corruption or misuse of power while too much

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of accountability stifles discretion and initiative. Outcomes depend on the promptness
and effectiveness of the tradeoffs.

In the private corporate governance model, the Board of Directors and the key
executives operate in a joint mode for the realization of the objectives of the enterprise
and develop a consonant corporate culture. Adaptation to changing requirements is made
easier by such a culture. In the hybrid model, the supervisory system and the managers in
the SOE belong to three diverse cultures—managerial, bureaucratic administration and
political culture—which have to be in synch if SOE objectives are to be realized. Cultural
differences bring rigidities and friction for joint mode of operations. Frequent change in
the principal players responsible for the SOE in the three cultures aggravates
discontinuities. Timely and effective response to changing environment is an inherent
challenge for SOEs. SOEs are particularly vulnerable in fast changing or turbulent
environments.

Autonomy and accountability norms get rebalanced in the private corporate

governance model periodically. For example, the Harshad Mehta and Satyam scandals
have led to a number of regulatory initiatives designed to tighten accountability of
corporations and professional accounting and auditing standards and compliance
procedures. But these affect all in the corporate world leaving the private governance
model’s ability to respond to changing requirements affected uniformly across all
competitors.

While threat to survival emanates from performance requirements in a

competitive world in the private corporate governance model, survival for an SOE is
underwritten. It is a political or ideological decision, which is typically triggered only
when the situation becomes unacceptable for the government in power.

Influence of Socio-political context: The socio-political context influences both the

public governance and the private corporate governance models, but in different ways.
While the private corporate governance seeks to protect itself from adverse effects of the
external system, the SOE is enmeshed in the larger socio-political context as a way of
life.

John Nellis provides an interesting illustration of the ‘intrusion and importance of

socio-political factors in the ultimate fate of operation of an SOE’ (6). This example is
from Namibia, although one can find examples in any country, including developed
countries.

Like many other African countries, Namibia embarked on “commercialization” of

SOEs in the 1980s. A five-year management contract given to a private operator for
managing an energy infrastructure SOE was not renewed despite impressive economic
performance—improved service to an under-served rural area, reduction in system losses
from 45 to 7 per cent, doubling the number of customers, holding employment steady,
reduction in tariff for the smallest and poorest customers. Why was the contract not
renewed? The reasons provided were that the original contract was not dealing with the

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concerns of the local government authorities and that the private contractor’s results
showed up the inferior performance of the larger national SOE. The SOE, which had
shown no interest in bidding for the original contract, had lobbied to discredit the private
contractor. The stakeholders dismissed the improvement in service as ‘just management,’
which any one can emulate.

The example of the Tennessee Valley Authority in the U.S.A, although of an

earlier period, is equally illuminating. Several researchers—in particular, political
scientist Aaron Wildawsky, sociologist Philip Selznick and business historian Thomas
McCraw—have written about TVA, which can be deemed as an SOE in the U.S.
Societal beliefs in the U. S. were so strongly against government in business and the
private sector lobby was so powerful that, notwithstanding its superior performance,
TVA’s funding was restricted to what it can raise through revenue bonds and the
government was restrained from replicating the TVA model in other river valleys.

Purposive Statecraft: Socio-political context of an SOE is part of statecraft. The

differences in statecraft between China and India are brought out with on-the-ground
stories and research by Tarun Khanna (7). He writes: “While harmony through merit-
based autocracy is a defining characteristic of the Chinese state, the Indian state is
probably best characterized by pluralism.” India functions in a feudalistic, class and
caste-based society with widespread illiteracy and poverty. Indian democracy has
been ‘finding a way to balance the often inconsistent demands of various groups
with the needs of the collective.’

Statecraft in India is unable to provide a stable direction to SOE policies. With no

clear electoral mandate to any political party at the national level for nearly three decades
and a continuing decline in moral standards, India has had to settle for a slower growth
rate and ‘a proud tradition of pluralism, dissent, and debate’.

Khanna illustrates the working of the SOEs under different public governance
models with the example of railway services, which work far better in China than in
India. While China could launch its privatization through executive order, India’s
privatization during the 1990s came to a naught, ‘ensnared in the checkerboard of Indian
politics.’ Privatization is opposed by many political parties and vested interests in
India. .

An excellent illustration of how China has come to dominate the world rare earths
industry is a study by Nabeel Macheri, Lalith Sundaresan, and S. Chandrashekar of the
National Institute of Advanced Studies, Bangalore. They observe: “China has developed
a dominant position in most value chains of the rare earths ecosystem. U.S. has allowed
its dominant position to erode because of global market dynamics. …China seems to
have in place methods and processes to ensure that various arms of the government
associated with the implementation of strategy, function in an integrated way to ensure
that Chinese interests are well protected, ... through informal networks to major power
centres” instead of ‘formal rules and procedures.’ Statecraft in India, which is using the
hybrid model of the Indian SOE in rare earths industry is unable to develop an ecosystem

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connecting research and development with finance and marketing in order to achieve a
significant role.

Countries with weak public governance have not been able to provide good
governance to the SOEs. However, when national importance is attached to a mission,
the Indian public governance model is able to create a structure within itself for success.
The Indian Space Research Organization (ISRO) is not an SOE. ISRO’s mission is highly
regarded in the country. Its importance has been institutionalized in a unique manner. A
technical organization, ISRO functions in the Ministry of Space, under the Prime
Minister’s charge. The head of ISRO is the Secretary of the Department of Space and
also Chairman of the Space Commission, which includes the Cabinet Secretary and
Prime Minister’s Secretary as members. The Commission evaluates major project from
all perspectives--technical, financial and administrative—and has the de facto technical,
financial and administrative powers of the Government of India. Thus, a non-political
technical organization operates under a fully-empowered and well-coordinated set up
within the political governance structure.

ISRO experience shows that more than the legal form of an SOE, three
requirements for success are: (i) quality leadership that respects and supports the
mission, (ii) enduring non-controversial political support for the mission, and (iii)
effective coordination of technical, financial and administrative functions.

Mechanisms such as MOUs or Performance Contracts, and Management

Contracts or Public and Private Infrastructure initiatives are not able to deliver
results, when these three requirements are not satisfied. Recently, Controller and Auditor
General of India noted that there was a 14-year delay in HAL developing intermediate jet
trainer aircraft, with serious costs to the Air Force, and that BEML had not indigenized
the Tatra trucks used to carry radars and missiles, even after a decade. Both SOEs and
have been entering into MOUs with the government year after year. That has not enabled
the SOEs to achieve their strategic objectives, while ISRO succeeded in Mangalyaan
without an MOU.

Conclusion and Implications

The assumption that a hybrid model of governance of SOEs would comfortably

combine the benefits of accountability and public purpose of the public governance
model and the autonomy, efficiency and initiative of private corporate governance model
appears incorrect. Because the two models operate differently, the hybrid model puts
the SOEs in a disadvantageous position vis a vis private corporations. They are prone
to under deliver on both commercial and non-commercial objectives.

The government should explicitly examine what non-commercial objectives it

wants to achieve through each SOE. Non-commercial objectives are better achieved
through alternative structures in the public governance model. The commercial objectives
are better achieved through a simulated private corporate governance model.

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 Profit-making SOEs in a competitive market, with no non-commercial objectives,
should be benchmarked against competition. Elaborate supervisory costs of governance
and SOE overheads should be reduced. Such SOEs should be encouraged to work as
independent professional corporations, with government ownership rights being
exercised through its nominees on the Board. The SOE’s hidden dependence, if any, on
the government for financial and non-financial support either directly or through
other SOEs should be phased out. Transactions between SOEs should be gradually
moved to arms length and market driven with full disclosure and subject to private
corporate governance norms. During the transition period, SOEs should function under
their Boards, with full control over investments, human resources, and pricing, and be
subject to the same regulations of SEBI and other regulatory bodies as private enterprises.
The government should develop ways of working through its nominees on the Board and
restrict its role in the SOE to strategic direction, which the Board can evaluate for
viability and appropriateness to SOE objectives. The Nomination Committee of the
Board should select the full-time directors and the Managing Director. Government
should exercise its option to sell its shares on the market to realize its investments
and profits. All government instructions as an owner should be exercised in writing
through the Board in a transparent manner. Annual MOUs need not be entered into for
these SOEs.

SOEs that are losing or not functioning, and which do not have any non-
commercial objectives, should not be revived with additional equity. The hybrid model
has basic weaknesses and is susceptible to vested interests espousing the cause of
employees or other stakeholders and pushing for revival with more investments. The
government should find ways to close such SOEs by taking care of employee interests in
a fair and humane manner. There have been many instances—Hindustan Photo Films,
HMT, ITI--where government has repeatedly restructured the SOE capital by converting
loans into equity, waiving the interest payments due and by providing additional equity
and/or loans to support revival plans. They have invariably failed, especially when the
SOE was suffering on account of wrong strategic investments, technology or other
factors.

Built-in weaknesses in a governance model cannot be rectified through

incremental improvements or additional investments. India is not what it was at the
time of Independence. SOEs are no longer the engines of development. Returns for their
asset base are low. Indian private corporate sector has grown and has demonstrated that it
has strengths in global competition. Better alternatives to SOEs exist today. A policy
shift is required to put the country on a faster track. Statecraft in India, with a single
political party in power, after three decades of coalition politics and government, can act
and shift gear.

The author wishes to thank Professor S. Chandrashekar, Dr. V. R. Narasimhan, and

Professor V. Ranganathan and Dr. Nirmala Murthy for their valuable inputs, comments
and suggestions.

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References:

1. Anurag Agarwal, “Corporate Governance: Changing Trends in Interpreting

Fiduciary Duty,” Vikalpa, vol. 39, no. 3, July-September 2014.

2. P. C. Parakh, Crusader or Conspirator? Coalgate and Other Truths

3. J. Sterling Livingstone, “Pygmalion in Management,” Harvard Business Review,

1969 and reprinted as a classic in 2002.

4. Edgar H. Schein, Organizational Culture and Leadership, Jossey-Bass, 1992.

5. Jonathan Charkham, Keeping Good Company: A Study of Corporate Governance

in Five Countries, Oxford: Clarendon Press, 1994.

6. Tarun Khanna, Billions of Entrepreneurs: how China and India are reshaping
their futures—and yours, Penguin/Viking, New Delhi, 2007.

7. John Nellis, “Back to the Future for African Infrastructure? Why State-Ownership
is No More Promising the Second Time Around,” Centre for Global
Development, Working Paper 84, February 2006.

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