Public enterprises and risk behavior

Since the work of Arrow and Lind1 first appeared, it has been widely agreed that the returns from a public investment should be evaluated using a risk-free rate of discount to the extent that such returns are uncorrelated with other sources of income. The implication is that managers of state-owned enterprises (SOEs) should behave in a risk-neutral manner as long as the risks associated with the enterprise are borne by the government.

It is extremely difficult to clearly observe whether or not an enterprise is behaving in a risk-neutral manner. Nevertheless, few would dispute the observations that many SOEs do not in fact adopt a risk-neutral policy. SOEs are too vast and diverse a group of organizations to permit a simple generalization to be made on this matter; however, it seems safe to say that in many countries they exhibit an aversion to risk. This creates a problem, as normative theory would require them to be risk neutral.

Risk-averse behavior occurs because the manager of an enterprise may act to maximize not the net income (or profit) of the enterprise but rather his own utility. As Arrow and Lind note: “Their careers and income are intimately related to the firm's performance. From their point of view, variations in the outcome of some corporate action impose very real costs. In this case, given a degree of autonomy, the corporate managers, in considering prospective investments, may discount for risk.”