metadata: authors: 0: author: Dall'Olio,Andrea Mario
1: author: Goodwin,Tanja K.
2: author: Martinez Licetti,Martha
3: author: Alonso Soria,Ana Cristina
4: author: Drozd,Maciej Adam
5: author: Orlowski,Jan Alexander Kazimierz
6: author: Patino Pena,Fausto Andres
7: author: Sanchez Navarro,Dennis
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docna: 0: docna: Are All State-Owned Enterprises Equal ? A
            Taxonomy of Economic Activities to Assess SOE Presence in
            the Economy
docty: Policy Research Working Paper
abstracts: cdata!: This paper proposes a sector taxonomy of
            the rationale for the presence of state-owned enterprises in
            specific industries. The taxonomy is conceptualized only on
            an efficiency-based rationale for state participation in
            different economic activities, abstracting it from social or
            political justification of state-owned enterprises, which
            can be subjective or conditioned to the country context. The
            taxonomy is leveraged on a standard industry classification,
            the Nomenclature of Economic Activities Revision 2
            four-digit level sector classification, which is
            sufficiently disaggregated to resemble specific markets, and
            thus more appropriate for analyzing the presence of
            state-owned enterprises through the lens of industrial
            organization. The proposed taxonomy deploys a decision tree,
            based on efficiency-based criteria, to classify 563
            disaggregated sectors into one of three groups: a
            &#x201c;competitive&#x201d; category, for which the
            presence of state-owned enterprises does not appear to be
            justified on grounds of economic efficiency/market failure;
            a &#x201c;natural monopoly&#x201d; category, which
            includes economic sectors whose market structure is
            characterized by economies of scale and subadditivity costs
            that could be corrected via the participation of state-owned
            enterprises; and a &#x201c;partially
            contestable&#x201d; category, which includes economic
            sectors characterized by some form of market power,
            externalities, or other market failures that could be
            addressed through state ownership. The application of the
            decision tree classifies 11 disaggregated sectors as natural
            monopolies, 45 as partially contestable, and the remaining
            505 as competitive.
display_title: Are All State-Owned Enterprises
            Equal ? A Taxonomy of Economic Activities to Assess SOE
            Presence in the Economy
listing_relative_url: /research/2022/12/33954974/all-state-owned-enterprises-equal-taxonomy-economic-activities-assess-soe-presence-economy
topicv3: State Owned Enterprises m1326323 721,Market Failures m1327149 1068,Governance in Public Sector m1327255 831
publishtoextweb_dt: 2022-12-13T00:00:00Z
dois: 10.1596/1813-9450-10262
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model_extractions: Policy Research Working Paper 10262 Are All State-Owned Enterprises Equal?

A Taxonomy of Economic Activities to Assess SOE Presence in the Economy _Andrea Dall’Olio Tanja Goodwin Martha Martinez Licetti Ana Cristina Alonso Soria Maciej Drozd Jan Orlowski Fausto Patiño Peña Dennis Sanchez-Navarro_ Finance, Competitiveness and Innovation Global Practice December 2022
Policy Research Working Paper 10262

# **Abstract**

This paper proposes a sector taxonomy of the rationale for the presence of state-owned enterprises in specific industries. The taxonomy is conceptualized only on an efficiency-based rationale for state participation in different economic activities, abstracting it from social or political justification of state-owned enterprises, which can be subjective or conditioned to the country context. The taxonomy is leveraged on a standard industry classification, the Nomenclature of Economic Activities Revision 2 four-digit level sector classification, which is sufficiently disaggregated to resemble specific markets, and thus more appropriate for analyzing the presence of state-owned enterprises through the lens of industrial organization. The proposed taxonomy deploys a decision tree, based on efficiency-based criteria, to classify 563 disaggregated sectors into one of three groups: a “competitive” category, for which the presence of state-owned enterprises does not appear to be justified on grounds of economic efficiency/market failure; a “natural monopoly” category, which includes economic sectors whose market structure is characterized by economies of scale and subadditivity costs that could be corrected via the participation of state-owned enterprises; and a “partially contestable” category, which includes economic sectors characterized by some form of market power, externalities, or other market failures that could be addressed through state ownership. The application of the decision tree classifies 11 disaggregated sectors as natural monopolies, 45 as partially contestable, and the remaining 505 as competitive.

This paper is a product of the Finance, Competitiveness and Innovation Global Practice. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/prwp. The authors may be contacted at adallolio@worldbank.org, tgoodwin@worldbank.org, mlicetti@worldbank.org, aalonsosoria@worldbank.org, mdrozd@worldbank.org, jan.orlowski@aiib.org, fpatinopena@worldbank.org, and dsancheznavarro@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **Are All State-Owned Enterprises Equal?**

**_A Taxonomy of Economic Activities to Assess SOE Presence in the Economy_**

Andrea Dall’Olio, Tanja Goodwin, Martha Martinez Licetti, Ana Cristina Alonso Soria, Maciej Drozd, Jan Orlowski, Fausto Patiño Peña, and Dennis Sanchez-Navarro

**JEL Classification:** L32, L10, L33, L50 **Key Words:** Public Enterprises, Market Structure, Market Failures
# Acknowledgments

The authors thank Mona Haddad, Caroline Freund, and Indermit Gill for their strategic guidance and support. We also thank the peer reviewers of the paper Mary C. Hallward-Driemeier, Natalia Manuilova, Andreja Marusic, John Nelis, and Sara Nyman. We gratefully acknowledge feedback and comments from WB colleagues during the elaboration of this paper (alphabetically) Ahmadou Moustapha Ndiaye, Ana Cristina Hirata, Ana Paula Cusolito, Andreja Marusic, Davida Louise Connon, Doerte Doemeland, Georgiana Pop, Graciela Miralles, Immanuel Steinhilper, Mariana Iootty, Mariem Malouche, Paul Phumpiu Chang, Ryan Chia Kuo, Seidu Dauda, Tania Begazo. We also want to thank external professors Bill Megginson, James Robinson, Ufuk Akcigit, and Richard Carney for early conversations on these findings.

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# I. Introduction

Understanding the rationale behind direct state participation in markets through state-owned enterprises (SOEs) is critical to the design of appropriate SOE reform policies. Not all SOEs are equal as they can participate in a diverse and wide range of economic activities in the economy. As evidenced in the novel WB Global Business of the State (BOS) database, there is a large heterogeneity in the sectors where the state intervenes as a market player. The economic costs and benefits from this intervention can also vary substantially depending on the type of economic activity where the SOEs operate.

This paper proposes how to classify economic activities where the state can be present as a market player based on their intrinsic characteristics and associated market failures.<sup>1</sup> Economic theory provides an efficiency-based rationale to identify instances (market failures) in which a non-profit-maximizing SOE would be able to pursue optimal policies (bringing benefits that improve overall welfare), provided that state capture<sup>2</sup> and other inefficiencies or distortions generated by public ownership (the costs) would not outweigh the benefits of SOE presence. Following the Industrial Organization (IO) literature that analyzes the exercise and control of market power (Tirole, 2014), this paper proposes how to classify the economic activities where the state can be present as a market player based on the intrinsic economic characteristics and market failures. In doing so, the paper contributes to filling the gap on how to connect IO research on the differences across markets and industry dynamics with the policy agenda related to the role of the state in markets.<sup>3</sup> The comprehensive taxonomy presented in this paper rationalizes the potential presence of SOEs at the level of disaggregated economic sectors and by doing so avoids a “one-size-fits-all” approach to analyzing the economic footprint of the state in markets. An efficiency-based rationale for SOE presence suggests heterogeneity of the companies with state participation across sectors, as they may be characterized by different technological and market features. Economic theory can provide guidance to distinguish between those sectors in which markets are able to achieve an efficient market equilibrium, such that there is no economic rationale for SOE presence, and those in which the presence of an SOE might potentially bring economic benefits. While the economics literature has analyzed individual sectors to understand market failures, SOE performance, and reform potential, no systematic attempt has been carried out to analyze sectors based on standard industry classifications that are sufficiently disaggregated to resemble specific markets, and thus more appropriate for determining SOEs’ potential impact on market efficiency. The analysis at the level of specific markets is justified on the basis of the industrial organization (IO) literature. The starting point of any competition analysis is the relevant market, which encompasses a product (service) dimension and a geographical dimension. The product dimension

> 1 Although there can be social or political rationale to justify state participation in certain economic activities, this paper only focuses on the efficiency-based rationale of state presence in markets. This is because social or political justifications can be country specific as well as subject to the agenda or preferences of policy makers. To avoid this country specific approach and minimize subjectivity, we base our classification only on efficiency criteria that are based on economic theory and empirical evidence documented in the IO literature.

> 2 Hellman and Kaufman (2001) define state capture as the efforts of firms to shape the “rules of the game” (laws, policies, and regulations of the state) to their own advantage by providing illicit and non-transparent private gains to public officials. In the case of SOEs, these gains take different forms. According to the OECD’s 2017 Survey of anti-corruption and integrity in SOEs, the top ten corruption risks observed in companies with instances of corruption cases include: 1) violations of data protection and privacy, 2) stealing or thefts of goods from the company, 3) fraud, 4) receiving bribes, 5) favoritism (nepotism, cronyism and patronage), 6) non-declaration of conflict of interest, 7) procurement/contract violations (delivering sub-par goods/services, violating contract terms with suppliers), 8) illegal information brokering, 9) receiving kickbacks, and 10) interference in decision-making.

> 3 There are two main waves of research in Industrial Organization. A key focus of the first wave of IO research was empirical industry research. This originated with Bain (1951, 1956) and dominated the 1960s. Much of this early inter-industry literature was concerned with the relationship between market structure, firm conduct, and market performance.IO research at the time shifted from case studies towards an inter-industry approach, as summarized by Schmalensee (1989). The first wave of IO research was later superseded by a second generation of theoretical IO. Tirole (1994) explains that this development was due to the fact that empirical inter-industry research fell short of establishing causal mechanisms. Empirical applications of this second wave are generally sector- and market-specific, not cross-sectoral, recognizing that industries are different and providing new knowledge to regulators to understand market power (Tirole, 2014).

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considers the demand and supply sides of the market. From the demand side, products must be substitutable from the buyer’s point of view, and from the supply side, sellers must be those that can or could easily produce the relevant product or close substitutes (OECD 1993). The location of buyers determines whether the market is local, regional, national, or international (OECD 1993). For the purposes of this paper, we have relied more heavily on the product (service) dimension of the market definition, however, the geographic aspect of the market should be taken into consideration when analyzing a specific country context, especially in the case of small, landlocked economies. A discussion on the level of disaggregation of industry classification and its relation to the definition of market is presented in section V.

This paper puts forward a “triage” of economic sectors to determine those without a specific economic rationale for SOE presence, those with a strong SOE rationale, and those with a weaker SOE rationale. The paper leverages the existing economic literature to categorize each economic sector into three groups: a “competitive” category, for which SOE presence does not appear to be justified on grounds of economic efficiency/market failure; a “natural monopoly” category, which includes economic sectors whose market structure is characterized by economies of scale and subadditivity costs that could be corrected via SOE participation; and a “partially contestable” category, a residual category which includes economic sectors characterized by some form of market power, externalities, or other market failures which could be addressed through state ownership.

The resulting taxonomy is the first comprehensive categorization to rationalize the presence of SOEs in 563 economic sectors, based on economic theory and the empirical literature of industrial organization, filling an important gap in the literature. There does not appear to have been any attempt in the literature to classify economic activities at such level of disaggregation on the basis of economic theory and evidence. Previous work has focused on studying specific sectors characterized by market failures and the potential efficiency gains from government interventions, but this work has failed to comprehensively analyze disaggregated sectors according to a single analytical framework. As a result, most of the classifications developed so far have focused on aggregate sectors or a limited number of subsectors.<sup>4</sup> This paper analyzes each of the 563 economic sectors of the Nomenclature of Economic Activities (NACE) Revision 2 classification of economic activities at the four-digit level, recognizing that only by appreciating the nuanced differences in economic activities across disaggregated sectors can granular SOE diagnostics and reform recommendations be made possible.<sup>5</sup> State participation in the economy through the provision of goods and services may sometimes pursue public interest objectives in ways that private, profit-maximizing firms cannot, but it often implies significant costs as well. Unintended consequences may include crowding out private investment, allocating resources inefficiently, or introducing fiscal liabilities. These costs and benefits are not homogeneous across sectors, and policies that aim to improve this cost–benefit balance must be informed by a solid understanding of the objective, rationale, or motivation of state participation in a specific sector. The presence of SOEs is motivated by economic, social, or political considerations. These are the categories according to which the literature classifies justifications for state provision of goods and

> 4 World Bank (1995) distinguishes broadly between “natural monopoly markets” and “competitive or potentially competitive sectors”. Dall’Olio and Nelli (2017) extend this approach by categorizing aggregate sectors into four categories, based on a combined assessment of market structure characteristics and public policy objectives: finance, commercial sectors, strategic sectors (oil, mining), and utilities (gas, water, electricity). Nyman, Dauda and Koschorke (2018) analyze along similar lines the economic rationale for state presence of South Africa’s state-owned enterprises across 40 vertically integrated markets. Dauda and Drozd (2020) present the economic rationale for state participation in 44 sectors captured in the 2018 vintage of the Product Market Regulation indicators.

> 5 The Statistical Classification of Economic Activities in the European Community, referred to as the NACE classification, is the industry standard classification system used in the European Union to classify economic activities.

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services through SOEs (Sorrentino, 2020).<sup>6</sup> That is, governments may want to establish SOEs to carry out countercyclical spending during recessions, to create jobs and provide job security, to distribute incomes and benefits, to open up opportunities for historically disadvantaged population groups, or to exercise strategic control in productive sectors or geographic regions a result of public policy objectives.

While social or political motivations for SOEs are country-specific and influenced by policy makers’ preferences, justifications grounded in economic theory are more universal. Rationalizations of state presence based on socio-political considerations remain dependent on a country’s specific context and political setting, complicating systematic cross-country analysis.<sup>7</sup> However, from an economic perspective, state direct participation in markets through SOEs can be one of multiple ways to address specific market failures, which can be objectively identified on the basis of the underlying characteristics of the specific markets.<sup>8,9</sup> As explained by Putniņš (2015), under the assumption that governments seek to maximize social welfare, the rationale for state ownership should be based on a three-step process: establishing the presence of a market failure, determining whether an SOE is the most desirable policy intervention to address that market failure, and assessing the costs and benefits of using SOEs to address the market failure for a specific market. Other ways to rationalize state participation in businesses include the analysis of the subsidiarity role of state, which establishes that if there are or could be private agents interested in performing an economic activity, then the state does not need to participate as a market player and should focus on supplying essential goods or services that cannot be provided by private agents.<sup>10</sup> The advantage of analyzing SOEs through the economic lens of market failures or subsidiarity is that this analysis relies on intrinsic sector characteristics which are common across most countries, hence the analysis can be more easily standardized.

Hence, by classifying sectors based on intrinsic market characteristics, this paper provides a novel tool for nuanced country-level analysis of state presence in the economy with a view to guiding policy makers in their decision of whether to intervene in a market or to divest an SOE. Whether assessing the overall footprint of SOEs in the economy or understanding potential distortions from state ownership in the corporate sector, simply adding up all SOEs into one figure is insufficient. It ignores the underlying motivations for a given SOE, as well as the varied costs and benefits from SOE participation in different sectors. By proposing an objective taxonomy, this paper provides a robust tool for analyzing SOE 6 Cordella and Vagliasindi (2021) explain that different reasons explain the existence of SOEs, including political, social, and economic motivations. They suggest, however, that SOE performance should be measured against the objective for which they were created rather than the standard profit-maximizing measures of private firms. Heath and Norman (2004) identify five main categories of SOE responsibilities: macroeconomic, creation of good-quality jobs, redistribution, national interest, and addressing externalities.

7 For example, some countries consider strategic those sectors related to national or subnational control of the territory (such as the military), while others use a broader definition that includes electricity, transport, water, hydrocarbons, mining, or financial activity. There are also differences in what constitutes a development objective in different contexts. Some governments may, for example, pursue state ownership in agriculture given its relevance in the economy, even though there are no objective market characteristics to indicate that the private sector would otherwise not enter and invest. See also World Bank (2011), where in the context of underdeveloped private capital markets and weak intellectual property systems, SOEs were rationalized on the basis whether they acted as venues for developing capital-intensive industries in the absence of the private sector.

8 Market failures are cases where suppliers would provide goods and services in suboptimal quantities, resulting in an inefficient market equilibrium and social welfare loss.

9 For example, the provision of insurance is hampered by adverse selection and moral hazard, two types of market failures that are intrinsic to and ubiquitous in insurance markets.

10 In policy implementation, some governments have also developed frameworks to determine where SOEs operate in the economy based on economic and social considerations (Landa, 2016). The analysis of the subsidiarity role of the state is one of the principles to rationalize the role of SOEs in the economy. It establishes that when there is a private sector that is viable and supply goods and services and attend demand, the state should refrain from acting as market player in those activities, and if any intervention is needed it should be in the form of regulation. For instance, according to the Peruvian Constitution, the Government has to follow three criteria for assessing its participation (directly or indirectly) in business activities. First, the State participation in business activities should be authorized by a special law; second, the State participation in business activities should be subsidiary to private businesses such that the State intervention should not foreclose private businesses from the market, and finally the State participation in business activities can only by allowed for reasons of overriding public interest or manifest national benefit.

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participation in different markets through an economic lens, abstracting from the political and social preferences of individual policy makers. This also allows to provide guidance on the different alternatives and tailored solutions for SOE reform beyond ownership transformation and which can be strongly related to the type of sectors where these companies operate.<sup>11</sup> The proposed taxonomy is also critical to allow for cross-country comparison of the SOE footprint. Political economy and social objectives vary from country to country, and, as such, it is impossible to objectively justify the presence of the state in the market on the basis of those objectives. However, since economic market failures are uniquely identified based on the characteristics of the markets in which goods and services are produced and the technologies used, the proposed taxonomy allows analysts to compare SOEs’ presence in the economy across countries according to a homogeneous classification system. This taxonomy is already feeding into the Businesses of the State Database of the World Bank Group which is described in a companion paper to this work (Dall’Olio et al., 2022).

The remainder of this paper is organized as follows. Section II provides a review of the economic literature on SOEs and market failures. Section III provides the conceptual framework according to which economic sectors are classified. Section IV analyzes the economic sectors, disaggregated to the level of the NACE four-digit classification, and classifies each of them into the three proposed categories. Section V presents a data driven exercise to validate the taxonomy classification. Section VI concludes.

# II. Literature Review: SOE Participation and Market Failures

A systematic and comprehensive classification of the rationale for SOE presence in various economic sectors could usefully inform the analysis of SOEs from a policy perspective. As important is to have a harmonized definition on SOEs to allow cross-country comparison, it is relevant to have a unified conceptual framework to classify economic sectors based on the rationale for government presence in the provision of goods and services to inform assessments of SOEs, guide reform efforts in individual countries, and facilitate cross-country analysis of SOE presence in the economy.<sup>12</sup> Although several examples of sectoral analysis of SOEs can be found in the literature and efforts are being made by specific countries to provide a framework for analyzing the rationale behind SOE presence in various sectors of the economy,<sup>13</sup> a globally accepted approach guided by the economic literature has been missing. As a result, most SOE analysis remains either restricted to specific sectors (i.e., a number of studies cover universally accepted sectors in which SOEs are present across countries such as electricity and water

> 11 Sanchez-Navarro, Goodwin, & Kikeri (2021) present a full description of the different alternatives for reform building on this taxonomy is presented in the CPSD SOE Knowledge note indicating the different menu of options of reform. For instance, it proposes management arrangements and concessions can be more suitable for natural monopoly sectors, whereas divestiture may be more suitable for large SOEs in competitive sectors that could be served by (or in competition with) the private sector.

> 12 A caveat of previous academic literature and policy-related workstreams is the lack of a uniform definition of SOEs across countries and between economic activities, which hinders cross-country comparisons and analyses of SOE performance. To resolve this lack of harmonization, Dall’Olio et. al. (2022) building on the International Monetary Fund’s Government Finance Statistics Manual (2014) proposes a corporation as an SOE based on the government’s share of control for a corporation as well as the corporation’s role in the market. That is, an entity is considered a StateOwned Enterprise if it satisfies the following conditions:

> i. It is controlled by government units or by other public corporations, as proxied by a level of direct or indirect (i.e., through subsidiaries) participation of above 10% at each of the level;

> ii. It is recognized by law as a legal entity separate from its owners; iii. It can generate profit or other financial gain for its owners; iv. It is set up for the purposes of engaging in market production (i.e., it provides goods and/or services in exchange of a price).

> 13 For example, in the case of Peru, the Constitution in its article 60 of constitution establishes: “The government recognizes economic pluralism. The national economy is based on the coexistence of several forms of ownership and enterprise. Authorized solely by an express law, the government may subsidiarily engage in business activities. directly or indirectly, for reasons of overriding public interest or manifest national benefit. Business activity receives the same legal treatment, whether public or private.”

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supply)<sup>14</sup> or conducted from the perspective of a specific country (i.e., SOEs in China, given the significant role played by SOEs in Chinese markets).<sup>15</sup> In theory, markets that function competitively will attain allocative (Pareto) efficiency in the absence of any policy-related distortion. However, for markets in which certain environment or product characteristics generate a market failure, competitive allocation (in the absence of policy intervention) would not maximize social welfare (or, therefore, achieve Pareto efficiency). These market failures include primarily market power (arising from technological/cost structure characteristics),<sup>16</sup> externalities or public goods, and information frictions. In the presence of market failure, state participation in the economy via an SOE could be justified as a tool to bring back allocative efficiency (OECD 2017). In many countries, SOEs are also viewed as a tool to build capabilities in products or services. Such policy can be framed as responses to externalities and coordination failures (Hausmann and Rodrik 2003; Mazzucato 2013; Antonelli et. al. 2014; Castelnovo and Florio 2020). While potentially valid on grounds of economic efficiency, these justifications are outside the scope of this paper as they are difficult to generalize across countries and frequently relate also to spillovers _across_ and not _within_ sectors. At the same time, an important subcategory of these justifications – knowledge spillovers – are captured insofar as research and development sectors have been classified as sectors with an economic rationale for state presence.

Both economic theory and the empirical literature have shown, however, the pitfalls of SOE participation in markets, including poor financial performance, risks of political capture, direct and contingent fiscal liabilities, and distortionary effects on other companies, sectors, and the overall economy. The economic literature has explored widely whether, _ceteris paribus_ , SOE performance could be comparable to that of private sector firms. Economic theory posits that SOEs underperform private sector companies due to agency problems (Dharwadkar, George, and Brandes 2000; La Porta and Lopez-de-Silanes 1999), soft budget constraints (Kornai 1979; Kornai et al. 2003), clientelism (Shleifer and Vishny, 1994; Kopecký and Spirova 2011; Wang and Wang 2013; Liu and Zhang 2018; Jian et al. 2020; Szarzec et al. 2020), and mixed political and business objectives (Bai and Xu 2005; García-Canal and Guillén 2008; Shirley and Nellis 1991; Stan, Peng, and Bruton 2014), among others. This is confirmed by a number of empirical papers that have shown SOE performance to be consistently poorer than that of private sector enterprises.<sup>17</sup> Interestingly,

> 14 Andrés, Guasch, and Azumendi (2011) analyze the governance structure and performance outcomes of SOEs in water and electricity sectors in Latin America. Gassner, Popov, and Pushak (2009) study the economic implications of SOE privatization in the water and electricity sectors of all regions in which the World Bank provides development assistance. See (2014) studies the performance of SOEs in the water sector for countries in Southeast Asia. Matuszak and Kabacinski (2021) analyze the financial performance of SOEs in the electricity sector for countries of the European Union.

> 15 Bai, Hsieh, and Song (2016); Cong et. al. (2019); Huang, Pagano, and Panizza (2020); Song, Storesletten, and Zilibotti (2011); and Dollar and Wei (2007), among others, have used China as a case study to analyze SOE performance.

> 16 The rest of this paper will refer to market power only as the pricing power that is derived from cost-structure (e.g., economies of scale, subadditivity of costs) and other inherent market features. That is, it refers to ‘naturally arising’ market power, as opposed to market power derived from legal instruments (e.g., statutory monopoly rights, regulatory protection), or firm behavior (e.g., collusion or abuse of market dominance). Evidently, exclusivity rights granted by the government may confer market power to a specific firm. But this taxonomy builds on the concept of ‘market power’ as a market failure in the spirit of industrial organization literature where it is understood as being derived from the cost-structure.

17 Wang and Shailer (2018) conduct a meta-analysis and confirm that, compared to private ownership, government ownership is associated with inferior firm performance. Goldeng, Grünfeld, and Benito (2008) use returns on assets, as well as costs relative to sales revenue, to study firm performance in various markets where SOEs and privately owned companies compete, finding that SOEs generally perform worse than private firms. Dewenter and Malatesta (2001), in a global study of very large firms across sectors, find that the SOEs in that group are significantly less profitable, more highly leveraged, and more labor-intensive than private sector comparators. Drawing on empirical evidence for South Asia, Melecky and Sharma (2019) show that SOEs are more likely to be financially distressed than their domestic and foreign private counterparts.

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findings pertaining to poor SOE performance are valid across sectors. Finally, SOE performance is linked with economy-wide performance, growth, the government’s fiscal position,<sup>18</sup> and productivity trends.<sup>19</sup>

# III. Framework to Classify Economic Activities Based on an Efficiency Rationale for State Participation

The conceptual framework put forward by this paper stems from the simple consideration that, given the pitfalls connected to SOEs, these should be present only in sectors for which a strong economic rationale for state participation exists. Gaining an understanding of the pros and cons of government intervention in individual sectors through an SOE, rather than letting private enterprises compete, is critical for informed policy making. SOE participation is just one of several alternative ways in which a government can intervene to correct a market failure; often, SOEs are not the best alternative. Market failures can be addressed through other forms (and perhaps less distortive and costly) of state intervention, ranging from information provision to regulation to direct state provision of the good or service, and do not themselves justify state participation _per se_ . In the absence of a market failure (for example, in the manufacturing of food products or textiles), only the distortionary effects of SOE participation could arise, while the SOE’s presence could not be justified by the aim of improving social welfare. While there are other important factors that shape SOE performance beyond the intrinsic market characteristics of the sector in which the company operates –for example, the level of independence of management, the quality and capacity of state supervisory mechanisms, regulatory regimes governing SOEs—they fall beyond the scope of this paper.

The proposed taxonomy is centered around the assumption that the presence and degree of market failures that could be corrected through an SOE can help differentiate among economic sectors. By distinguishing between economic sectors according to the presence (or absence) of specific market failures connected to the process of producing its goods or services, their intensity, and the appropriateness of an SOE as a (potential) corrective measure, one could explore the justification for the presence of SOEs and, as a result, be alerted to the risks of distortive consequences or unintended consequences of SOE presence. A natural conclusion is that sectors with little or no economic rationale should be the first to be considered for SOE divestiture/privatization, given that the well-documented performance gap and distortionary effects of SOEs (the “cons”) cannot be compensated for by a specific economic benefit (the “pros”) (Figure 1).

> 18 SOEs may operate with a surplus or with systematic losses that impact the government’s budget or balance sheets through numerous transmission channels: taxes and dividends on the revenue side, subsidies and transfers on the expenditure side, government loans to SOEs generating interest receipts, government takeover of SOE debt, and valuation effects, which tend to be correlated with SOE performance (Soler and Sy 2021).

> 19 For example, Szarzec, Dombi, and Matuszak (2021) analyze a micro-level data set on the aggregate economic weight of SOEs in European countries according to leading business indicators, and on that basis assess the overall growth effects of SOEs and their relationship with governmental institutional quality, finding that better institutions entail a more favorable growth effect of SOEs. Böwer (2017) argues that the negative productivity aspects of SOEs in general could spill over to affect the economy at large. Mattera and Silva (2018) focus on firms in the steel sector across countries, finding not only that SOEs are associated with poorer economic performance and higher levels of indebtedness than private enterprises, but also that they have contributed to increasing overcapacity. Ehrlich et al. (1994) and Karpoff (2001) corroborate the exposition above by showing that direct government participation in markets, through SOEs, should be reduced, as private companies are higher performers in terms of productivity growth and managerial efficiency. Similarly, Boeing et al. (2016) and Wei et al. (2017) find that private firms benefit the most and carry out more research and development investments relative to SOEs, providing empirical evidence that SOEs underperform private companies with regard to productive investments. Harrison et al. (2019) document that SOEs and recently privatized SOEs in China perform less well than private companies in terms of profitability.

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_Figure 1 . Benefits and costs of SOEs_<sup>_20_</sup> <!-- Start of picture text --> Costs<br>-Crowding out private investment<br>-Inefficient resource allocation<br>-Uneven playing field<br>-Fiscal liabilities<br>-State capture and corruption<br><!-- End of picture text --> <!-- Start of picture text --> Benefits<br>- Addressing market failures<br><!-- End of picture text --> Source: Authors’ elaboration The taxonomy builds on an analysis of the intrinsic features of economic activity that could lead to market failures, independent of the specific country and policy context. The conceptual framework applies a sectoral lens to various economic activities to assess the economic rationale for SOE participation as a tool to address a sector-specific market failure. The conceptual framework is grounded in economic theory— that is, on supply-side and demand-side characteristics, such as the cost structure of production and the rivalry and excludability of consumption. Since these are intrinsic characteristics of the demand and supply side, they are independent of the specific economic context. As such, the taxonomy can be applied across countries. Indeed, the analysis abstracts from the specific policy environment, which could, for example, generate market power in an otherwise potentially competitive sector.

Based on the economic rationale for state intervention, the proposed taxonomy categorizes sectors into three groups. The proposed classification distinguishes _competitive sectors_ for which there is no economic rationale for SOE presence; _natural monopoly sectors_ , where SOEs could be a well-suited tool to correct a strong market failure; and _partially contestable sectors_ characterized by some weaker form of market failure which could potentially be addressed via an SOE. The rationale for the categorization is the following: 1) **Competitive Sectors** : These are sectors in which it is economically viable for multiple firms to compete to provide the good or service in question. Inherent market features, such as cost structure, technology, or demand characteristics, make entry into these sectors largely unproblematic. Furthermore, firms in competitive sectors are typically engaged in the provision of goods or services, the consumption of which is either rivalrous or excludable. Given the competitive nature of these markets, private sector firms competing in them tend to achieve economic efficiency. As such, no strong economic rationale for an SOE can be identified. At the same time, according to the theoretical and empirical literature, there are various inefficiencies associated with provision by the state, in that SOEs are less efficient than private companies under a competitive setting (Boardman and Vining 1989; Vining and Boardman 1992; Ohlsson 1996; Shleifer 1998; Domberger et al. 2002; Goldeng et al. 2008; Stiglitz 2008). These additional costs usually arise from agency costs (Jensen and Meckling 1976; Vogelsang 1983; McCubbins et al. 1987; Estrin and Perotin 1991; Bai and Wang 1998; Majumdar 1998; Dong and Putterman 2003; Lin and Li 2008; and others), imperfect information (Putniņš 2015), and

> 20 The potential benefits refer to a simplified view abstracting the potential intended benefits that governments could foresee when deciding to create an SOE.

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rent-seeking behavior (Datta-Chaudhuri 1990; Tullock, Seldon, and Brady 2002; Dal Bó 2006; Estache and Wren-Lewis 2009; and others). In competitive markets, therefore, state provision would most likely generate a government failure that harms social welfare (Le Grand 1991). This is the reason why, in the proposed taxonomy, competitive sectors are color-coded in red: given the higher risks of introducing market distortions and the absence of clearly defined economic benefits, the cost-benefit analysis of the SOE presence in those sectors will necessarily be negative.

2) **Natural Monopoly Sectors** : The economics literature identifies sectors in which it is more efficient for one operator to provide the good or service in question, as compared to many producers. Typical examples are network industries (such as electricity transmission) that are characterized by subadditivity<sup>21</sup> in costs and economies of scale. Under such circumstances, while provision by a single market player is the least costly (most efficient) form of production, allocative efficiency cannot be achieved through profit maximization, as the price that maximizes social welfare is below the average cost. For this reason, the government might want to control the market power of the monopolist, either through regulation or direct provision. If ownership is chosen, the government will be forced to cover the SOE’s losses with some form of tax revenue or subsidy as a trade-off to maximizing social welfare (Putniņš, 2015).<sup>22</sup> While, over time, technological developments have restricted the set of industries that fall into this category, activities in this category nevertheless have the strongest rationale for state provision. These sectors are color-coded in green since the cost-benefit analysis of SOE presence in these markets might yield a positive result, given that the benefits might exceed the costs associated with an SOE (i.e., inefficiency, market capture, etc.) and unregulated monopolies will not provide socially optimal quantities if they seek to maximize profits. The categorization does not imply a direct “justification” of SOE in those sectors, since SOE is - as discussed above - just one of the potential alternatives, and not necessarily the optimal one, to correct market failures.

3) **Partially Contestable Sectors** : we propose a residual category covering sectors in which is it economically viable for more than one firm to operate but the sectors are characterized by some form of market failure that could potentially be corrected through government ownership. The name of the category is emblematic of one such market failure which is the under-provision of goods and services caused by market power. Also in this case, the color coding is to signal that, taken ex-ante, the cost-benefit analysis of SOE presence might result in an efficiency-based justification for SOE, although weaker than the natural monopoly rationale presented above. Based on a comprehensive literature review, three typologies of market failures can be identified which could be associated with the sectors color-coded in yellow below:

- i. **Market power generated by structural barriers to competition** : Barriers to competition, such as high exogenous setup costs or other entry barriers, will naturally limit the number of players in the market. As a result of the initial fixed costs, entry of firms occurs until the profits of entrants cover the initial setup costs, breaking the free entry assumption that holds under perfect competition and generating a social welfare loss. Theoretical and empirical evidence suggests that, if the size of the market (demand) is low relative to the setup costs, so that the scale economies generated by the fixed costs are significant, then concentration will be high. On the contrary, as market size expands relative to initial costs, economies of scale will reduce, and concentration decrease (Sutton 1991). Scherer (1996) explains that the

> 21 Subadditivity means that the cost function for a single-product firm is characterized by declining average total costs over the relevant range of industry output such that it is less costly to supply the output with a single firm rather than split it among two companies or competing firms (Joskow, 2007). Cost subadditivity implies that the cost of a combined business operation is less than the sum of the cost of two separate businesses (Anand and Kim 2018).

> 22 Although for an efficient and optimal result, even an SOE might require additional regulation and enforcement to avoid potential abuse of dominance.

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petroleum refining industry is characterized by economies of scale to a degree determined by a country’s market size and leading to concentration. Baumol, Panzar, and Willig (1982) explain that, even under scenarios in which technology may imply the presence of a singleplayer market (such as the airline industry), entry and exit of firms can result in a more competitive structure and less market concentration relative to a monopoly (for example, an oligopolistic structure). However, the resulting oligopolistic market structure may still lead to inefficient outcomes, such as persistent overcharges or excess capacity. In such circumstances, direct participation in markets through SOEs can be a means to control the market power of other suppliers.<sup>23</sup>

- ii. **Under-provision in the presence of positive externalities**<sup>24</sup> **or uncertainty** : Some economic sectors produce goods or services that generate positive externalities to other sectors and/or economic actors. A profit-maximizing agent will underinvest in those goods and services, as this agent will not internalize the additional welfare benefit associated with the production of its good. As explained by Sorrentino (2020), in such instances, direct state participation can often be proposed as a solution to address the risk of under-provision. In addition, Putniņš (2015) posits that state participation is the most appropriate government intervention when it is difficult to correct the positive externality with subsidies or difficult to measure the quality or quantity of a good, making government-funded private sector contracting inefficient. Examples of activities associated with positive externalities are research and development, disease and pest control, firefighting, or security services. In agriculture, for instance, empirical evidence shows that there are considerable externalities from reducing and controlling pests (Grogan and Goodhue 2012; Carlson 1989). Similarly, sectors characterized by information frictions and uncertainty can be affected by under-provision due to externalities. In the case of mining, for instance, uncertainty about deposits may lead to suboptimal investment and trade decisions over time. There are also goods and services sold in a market that have positive externalities linked to public goods. By definition, pure public goods are not sold in a market; since they are non-excludable and non-rivalrous, buyers would not be willing to pay for them. Military equipment can be sold, but its production is linked to the public good of national security. Fire-fighting services can be sold but the positive externalities are linked to the public good of non-rivalrous and non-excludable fire protection. However, not all positive externalities are linked to public goods nor motivate SOE participation (e.g., positive externalities of construction/renovation of a specific building increase the value of adjacent buildings; pharmaceutical companies may save lives but do not obtain the full economic benefit of their product).

- iii. **Risks connected to large/irreversible negative externalities** : While economic activities should be regulated to control for negative externalities (such as pollution), there are cases in which the corrective taxes are not sufficient to repristinate economic efficiency.<sup>25</sup> Using a tax system to correct a negative externality is conditioned on the fact that the government can precisely estimate the magnitude of such a tax (Putniņš, 2015). This is a more difficult exercise when the negative externality can be catastrophic. As explained by Sorrentino (2020), one of the responsibilities of SOEs is to control potentially harmful externalities in industries like uranium processing and nuclear energy generation. Hence, the rationale for

> 23 At the same time, there is no economic justification for granting this SOE the exclusive right to provide the good or service.

> 24 As a market failure, the positive externalities account to an important extent for the under-provision of public goods. As the latter are non-rival and non-excludable, they are by definition associated with benefits that are not priced by the market for that particular good and service.

> 25 Other mechanisms to mitigate negative externalities include subsidies (e.g., to farmers to avoid polluting practices), quota (permit) systems, and performance standards, among others.

11
government intervention through direct provision in cases where large negative externalities exist stems from the fact that a non-profit-maximizing agent such as an SOE may be better placed to minimize the risks stemming from these harmful externalities than a private economic agent, which might undertake higher risks to pursue profits without internalizing the negative consequences of those risks.

# IV. Classification of Disaggregated Economic Activities

This taxonomy uses an internationally recognized classification scheme to categorize disaggregated economic activities into the three categories described above (natural monopoly, partially contestable, or competitive). Since the objective of the proposed taxonomy is to allow for an exhaustive, granular classification and thus support cross-country comparisons, the taxonomy leverages the NACE Revision 2, an internationally validated classification of economic activities. For the purposes of this paper, we refer to the NACE sections as “industries,” to the divisions as “sectors,” and to the classes as “disaggregated sectors.” Of the 615 disaggregated sectors at the four-digit level, 52 activities are excluded from the taxonomy (Table 1). Some industries are excluded altogether (such as Public Administration and Defense, Education, Human Health and Social Work, Activities of Households as Employers, and Activities of Extraterritorial Organizations). In addition, some disaggregated sectors in Finance and Insurance (2 activities), Arts, Entertainment, and Recreation (8 activities), and Other Services (6 activities) are not considered. Some of these sectors either provide public goods of strategic interest that cannot be sold commercially (Public Sector, Defense, and International Organizations), or the entities that provide these services are either not capable of generating profits or their purpose is not market production (Other Services). The rationale for their exclusion is that the entities providing such goods and services do not satisfy the definition of an SOE adopted by the paper. For industries in Health and Education, and some disaggregated sectors under Arts, Entertainment and Recreation, the operating models differ so much across countries that crosscountry comparisons are of little use and risk distorting those cross-country comparisons, as for example one could end up contrasting a “public good” approach for some countries, in which services are provided at zero or symbolic costs, with a “private,” profit-maximizing modality.<sup>26</sup> This is in line with recent work on SOEs (Szarzec, Dombi, and Matuszak, 2021), in which the education, health and public administration are excluded from the analysis of the effect of SOEs on economic growth, on the premise that companies in these sectors cannot always be privatized.

_Table 1. NACE Revision 2 –Aggregate Industry Classification_

|**Code**|**Aggregate Industry**|**No. of**<br>**Disaggrega**<br>**ted Sectors**|**No. of**<br>**Disaggregated**<br>**Sectors Included**|**Rationale for Sector Exclusion**|
|---|---|---|---|---|
|A|Agriculture, Forestry, and Fishing|39|39||
|B|Mining and Quarrying|15|15||
|C|Manufacturing|230|230||
|D|Electricity, Gas, Steam, and Air<br>Conditioning|8|8||
|E|Water Supply and Sewerage|9|9||
|F|Construction|22|22||
|G|Wholesale and Retail Trade|91|91||
|H|Transportation and Storage|23|23||

> 26 For example, health provision in Europe versus the United States.

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|I|Accommodation and Food Services|8|8||
|---|---|---|---|---|
|J|Information and Communication|26|26||
|K|Financial and Insurance Activities*|18|16|_Pension funding (6530) is excluded on the basis that it_<br>_involves principally (voluntary) employer pension plans,_<br>_activities proximate to compulsory social security activities._<br>_Central Banking (6411) is also excluded._|
|L|Real Estate Activities|4|4||
|M|Professional, Scientific, and Technical<br>Activities|19|19||
|N|Administrative and Support Services|33|33||
|O|Public Administration and Defense|9|0|_Excluded because it involves the provision of public goods._<br>_Defense is also deemed to be of critical strategic interest._|
|P|Education|11|0|_Excluded because it generally involves the provision of_<br>_public goods and characterized by positive externalities._<br>_Activities in this area are deemed to concern_<br>_developmental or national public interests._|
|Q|Human Health and Social Work<br>Activities|12|0|_Excluded because it involves the provision of public goods_<br>_and is characterized by positive externalities. As such, it is_<br>_typically deemed to be of critical national interest across_<br>_countries, meriting state ownership._|
|R|Arts, Entertainment & Recreation*|15|7|_Some disaggregated sectors within this code are excluded_<br>_due to their not-for-profit nature, such as activities_<br>_performed by libraries and museums._|
|S|Other Services*|19|13|_Disaggregated sectors excluded from the analysis include_<br>_activities performed by entities that do not provide services_<br>_for profit and/or their purpose is not market production._|
|T|Activities of Households as Employers|3|0|_Excluded because it involves activities that are not priced_<br>_by markets._|
|U|Activities of Extraterritorial<br>Organizations|1|0|_Excluded because it involves the provision of public goods._|

_Source:_ Authors’ elaboration based on NACE Rev. 2 Industry Classification.

To classify the remaining 563 disaggregated sectors of the NACE Rev. 2 classification into the three categories described in section II, the proposed taxonomy deploys a decision tree. The decision tree includes three nodes (Figure 2). The first node identifies the natural monopolies by assessing whether or not the production function supports a market-efficient equilibrium with just one firm. Sectors in which higher efficiency is attained with just one firm are classified under the natural monopolies category (green). The second node of the decision tree assesses whether, even in the absence of a natural monopoly, structural barriers to competition exist that could result in market power. Wherever an oligopolistic market structure is identified, those sectors are classified under the partially contestable group (yellow). Finally, all sectors that are not placed in the partially contestable category based on market power considerations are assessed in the third node to determine whether they are characterized by positive externalities or other market failures that may result in under-provision or generate negative externalities on the rest of the economy. If this process identifies positive externalities that lead to underprovision, large negative externalities that cannot be corrected by a Pigouvian tax,<sup>27</sup> or other market failures, such as information frictions, the sectors are also included in the partially contestable category. All remaining activities for which no market failure can be identified are classified under the competitive category (red).

> 27 A Pigouvian tax is defined as a tax to correct inefficiencies of the price system that are due to negative external effects (Sandmo, 2008).

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economic sector—differences that could have important policy implications.<sup>28</sup> For example, while the aggregate manufacturing sector is competitive in principle (as confirmed by the fact that 217 out of 230 activities fall into the competitive sector category according to the proposed taxonomy), 13 disaggregated economic sectors within manufacturing fall under the partially contestable category, including the manufacture of fiber cement (which has high costs that serve as barriers to entry) or the manufacture of explosives (which poses potential negative externalities). Similarly, within the aggregate electricity, gas, steam, and air conditioning supply sector, three activities are natural monopolies (such as the distribution of electricity), four are partially contestable (such as the production of electricity), and one is competitive (steam and air conditioning supply).

In some network industries, SOE often operate in multiple disaggregated sectors and restructuring reforms should first target the vertical and horizontal unbundling of incumbent state-owned monopolies.<sup>29</sup> Network industries such as telecommunications, railroads, electricity, and transportation are characterized by returns to scale in production, increasing returns to scale in consumption (network effects), and a high degree of complementarity between the different nodes and links in the production chain, which implies that to be delivered, services need to make use of multiple—if not all—network links (Economides 2004). Historically, SOE have been operating in those sectors by providing goods and services in multiple disaggregate sectors. In such cases, reforms aimed at improving economic efficiency and attracting private sector investment in network industries often entail the separation of the distinct nodes in the production chain (Foster et al. 2017). In the electricity sector, for instance, vertical unbundling involves allocating electricity generation, transmission, and distribution activities to different entities, while horizontal unbundling introduces competition by creating multiple entities that may have responsibility for providing the same services (USAID 2022).<sup>30</sup> At a disaggregated level, the sectors conforming to network industries often exhibit market power, including across complementary markets (Economides 2004), and for this reason, they are mostly classified as partially contestable and/or natural monopolies in this taxonomy. Table 2 presents a list of network industries and their corresponding disaggregated sectors (grouped under a bold margin), which roughly correspond to vertically unbundled activities, except for telecommunications and service and support activities for transportation, where the NACE classification does not align with the modalities of unbundling. For example, in the telecommunications industry, unbundling requires the incumbent to allow entrants to lease certain individual building blocks that make up a telecommunications network, with considerably less sunk investment in some or all components of a competing network (Blackman, Colin; Srivastava, Lara, 2011). In the rail transportation industry, unbundling requires the separation between train service and train infrastructure provision.

> 28 According to the European Commission (2008), the four-digit-level classification was developed so that two conditions would be fulfilled whenever possible: (1) the production of the category of goods and services that characterizes a given class accounts for the bulk of the output of the units classified according to that class; and (2) the class contains the units that produce most of the category of goods and services that characterize it. In other words, at this level, the NACE categorization is relevant for the detailed industrial classification of economic units, and all economic units falling within each four-digit code will be similar with respect to the activities they perform.

> 29 In some cases, SOEs can operate in multiple sectors that are not bundled. The benefit of this taxonomy is to provide a clear tool to classify the activity where the SOE is operating rather than the company itself. To apply the taxonomy classification for an SOE with multiple sectors, one option for policy makers would be to identify the branches of the company that carry out the different economic activities and apply the classification to its branches.

> 30 These segments can also fall under different sector types as per the taxonomy: electricity production could be served by several market players but is partially contestable while some segments such as transmission correspond to a natural monopoly.

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_Table 2_ **_. List of network sectors with potentially unbundled disaggregated sectors_**

|**Sector codes**<br>**ELECTRICITY, GAS, STEAM AND AIR CONDITIONING SUPPLY (D)**<br> <br>||**Taxonomy classification**<br>|
|---|---|---|
|Electricity, gas, steam and air<br> <br>Production of electricity|3511|Partially Contestable|
|conditioning supply (35)<br>Transmission of electricity|3512|Natural Monopoly|
|Distribution of electricity|3513|Natural Monopoly|
|Trade of electricity|3514|Competitive|
|Manufacture of gas|3521|Competitive|
|Distribution of gaseous fuels through<br>mains|3522|Natural Monopoly|
|Trade of gas through mains|3523|Competitive|
|**TRANSPORTATION AND STORAGE (H)**<br> <br>|||
|Land transport and transport via<br> <br>Passenger rail transport, interurban|4910|Partially Contestable|
|pipelines (49)<br>Freight rail transport|4920|Partially Contestable|
|Warehousing and support activities<br>for transportation (52)<br>Service activities incidental to land<br>transportation|5221|Natural Monopoly|
|Cargo handling|5224|Competitive|
|Other transportation support activities|5229|Competitive|
|Postal and courier activities (53)<br>Postal activities under universal service<br>obligation|5310|Natural Monopoly|
|Other postal and courier activities|5320|Competitive|
|<br>**INFORMATION AND COMMUNICATION (J)**<br> <br>||<br>|
|Telecommunications(61)<br>Wired telecommunications activities|6110|Natural Monopoly|
|Wireless telecommunications activities|6120|Partially Contestable|
|Satellite telecommunications activities|6130|Partially Contestable|
|Other telecommunications activities|6190|Competitive|

_Source_ : Authors’ elaboration.

The following subsections present the classification of the 563 disaggregate economic activities and the rationale used for the classification, based on the decision tree of Figure 2, for. For exposition, the classification of disaggregated activities is presented separately by aggregate economic sector.

- A. Agriculture, Forestry, and Fishing Industry (A)

The agriculture, forestry, and fishing industry encompasses 39 disaggregated sectors at the four-digit level. The sectors included within this category are related to the planting and growing of crops, the raising of cattle and other animals, activities supporting animal and crop production and seed propagation, silviculture, logging, and other forestry activities.

The majority of the disaggregated sectors (36) are classified as competitive, while the remaining ones (3) are partially contestable (Table 3). As expected, the agricultural sector is broadly competitive: none of the disaggregated sectors are characterized by market features that would influence market structure and lead to a natural monopoly. Three disaggregated sectors, however, are strongly associated with positive externalities and can lead to classifying the sectors as partially contestable (Table 3). This is confirmed by the literature (Grogan and Goodhue 2012; Carlson 1989), which finds empirical evidence that considerable externalities are associated with crop and silviculture activities to reduce and control pests 16
or other risks, such as fire (support activities for crop production, 161; silviculture and other forestry activities, 210; and support services for forestry, 240). The classification for each disaggregated sector in this industry is provided in Appendix 2, Table A.1.

_Table 3. SOE taxonomy in agriculture,_ _<u>forestry, and fishing</u>_

|**Agriculture, Forestry, and Fishing**<br>_Distribution of disaggregated sector_<br>**Competitive**<br>**Natural Monopoly**|**Industry (A)**<br>_s by category_<br>**Partially Contes**|**table**|
|---|---|---|
|36<br>0||3|
|92%<br>0%||8%|

Source: Authors’ elaboration _Table 4. Non-competitive disaggregated sectors in agriculture,_ _<u>forestry, and fishing</u>_

|**Agriculture, **<br>**NACE**<br>**Sector**|**Forestry, and Fishing (A)**<br>**Code Classification**<br>**Disaggregated sector**|**Code**|**Market**<br>**power**|**Partially contest**<br>**(+)**<br>**externalities**|**able**<br>**(-) **<br>**externalities**|
|---|---|---|---|---|---|
|(1) Crop and animal production,<br>hunting and related service<br>activities|Support activities for crop<br>production|161||X||
|(2) Forestry and logging|Silviculture and other forestry<br>activities|210||X||
||Support services to forestry|240||X||

Source: Authors’ elaboration

# B. Mining and Quarrying Industry (B)

The mining and quarrying industry covers all activities pertaining to the search for, and extraction and processing of, natural resources. The industry includes 15 disaggregated sectors that carry out the various steps needed to exploit natural resources, including coal, petroleum, natural gas, iron, uranium, and other metals and minerals. In NACE, activities related to the extraction and basic processing of crude materials (0510-0899) are separated from activities linked to mining support services such as exploration (09100990).

Contestability in mining sectors is limited by the scarcity and concentration of deposits. The geographic concentration of coal, petroleum, natural gas, iron, uranium, and other metals and minerals, and the high costs of extraction, leads to sunk costs and indivisibility of production. These factors naturally limit contestability in mining sectors. They are exacerbated by extreme scarcity of known deposits, for instance in the case of uranium or lithium (Rumble, 2018), and/or relatively high transport costs, for instance in the case of natural gas which is generally transported through pipelines (Mulder, 2006). This distinguishes the economics of mining from many quarrying activities or other extraction (e.g., salt, peat) wherein the natural resource is more abundant and dispersed.

Information frictions and related externalities can also exacerbate market functioning in mining. Information on mining and quarrying deposits is valuable as it allows market participants in upstream and downstream sectors to price natural resources accurately. Conversely, imperfect information on deposits can lead to suboptimal investments/trades over time. At the same time, obtaining information on reserves is costly as it requires significant investments into exploration. The market may not price information externalities accurately and provide less information than is optimal from a welfare perspective. This market failure justifies government involvement in the provision of information on reserves, either 17
directly (e.g., through the provision of geological surveys) or indirectly (e.g., through the allocation of property rights).

As a result of these economic features, out of the 15 disaggregated mining and quarrying sectors, 10 are classified as partially contestable (Table 5). Of the 10 contestable sectors, eight are deemed to be partially contestable due to sunk costs: mining of hard coal (510), mining of lignite (520), extraction of crude petroleum (610), extraction of natural gas (620), mining of iron ores (710), mining of uranium and thorium ores (721), mining of other non-ferrous metal ores (729), and mining of chemical and fertilizer minerals (891) (Table 6). Mining of uranium and thorium ores is also associated with negative externalities (Sorrentino 2020). The two remaining partially contestable sectors do not appear to have high entry barriers, but they are associated with possible market inefficiencies due to uncertainty; these include support activities for petroleum and natural gas extraction (910) and support activities for other mining and quarrying (990).

Five disaggregated sectors are considered competitive (Table 5). These sectors are quarrying of ornamental and building stone, limestone, gypsum, chalk, and slate (811), operation of gravel and sand pits and mining of clays and kaolin (812), extraction of peat (892), extraction of salt (893), and other mining and quarrying (899), which includes the mining and quarrying of different materials. The classification for each disaggregated sector in this industry is provided in Appendix 2, Table A.2.

_Table 5_ **_. SOE taxonomy in mining and quarrying_**

|_Dist_<br>**Competitive**|**Mining and Quarrying Indus**<br>_ribution of disaggregated secto_<br>**Natural Monopoly**|**try (B)**<br>_rs by category_<br>**Partially Contestable**|
|---|---|---|
|5|0|10|
|33%|0%|67%|

Source: Authors’ elaboration _Table 6_ **_. Non-competitive disaggregated sectors in mining and quarrying_**

|**Mining **<br>**NACE C**|**andQuarrying (B)**<br>**ode Classification**||**Market**|**Partially contest**<br>**(+)**|**able**<br>**(-) **|
|---|---|---|---|---|---|
|**Sector**|**Disaggregated sector**|**Code**|**power**|**externalities***|**externalities**|
|(5) Mining of coal and lignite|Mining of hard coal|510|X|||
||Mining of lignite|520|X|||
|(6) Extraction of crude petroleum<br>|Extraction of crude petroleum|610|X|||
|and natural gas|Extraction of natural gas|620|X|||
|(7) Mining of metal ores|Mining of iron ores|710|X|||
||Mining of uranium and thorium<br>ores|721|X||X|
||Mining of other non-ferrous<br>metal ores|729|X|||
|(8) Other mining and quarrying|Mining of chemical and<br>fertilizer minerals|891|X|||
|(9) Mining support service|Support activities for petroleum<br>and naturalgas extraction|910||X*||
|activities|Support activities for other<br>miningandquarrying|990||X*||

Note: *Other market failures include information frictions that may lead to under-provision. Source: Authors’ elaboration 18
# C. Manufacturing (C)

Manufacturing includes the largest share of disaggregated sectors, as it generates vertical and horizontal linkages with almost all other industries. A wide range of disaggregated sectors are covered under manufacturing, including the manufacture of food, beverages, tobacco, textiles and apparel, wood, paper, and leather products; the production of chemicals, rubber, plastic, metal, and non-metal products; and the manufacture of electrical equipment, electronics and machinery, motor vehicles, and other transportation, among others.

A large majority of manufacturing activities can be considered competitive. As expected, more than 90 percent of the disaggregated sectors in manufacturing (220 out of 230) can be considered competitive (Table 7), with little economic rationale for government provision. Furthermore, the tradeable nature of manufactured goods facilitates greater competition and technology diffusion among firms, which partly explains the industry’s historically important role in export-led growth dynamics (Nayyar, HallwardDriemeier, and Davies, 2021). The sectors categorized as competitive do not produce public goods and entry barriers in these sectors appear to be limited.

In the manufacturing industry, 7 disaggregated sectors are considered partially contestable (Table 7). Sectors in manufacturing are deemed partially contestable either because: (i) the sector exhibits high entry barriers, and thus associated market power (three sectors); or (ii) the sector relates to negative externalities (four sectors, one of which also exhibits high barriers to entry).

Some sectors in manufacturing exhibit externalities and market power as a result of high fixed costs. For example, the cement industry is characterized by technological features such as limited product tradability, large scale economies relative to market size, limited access to inputs, and demand-side features such as demand density (Beirne and Kirchberger 2021; UK Competition and Markets Authority 2014; World Bank 2016; Syverson 2004). Similarly, the production of refined oil and gas products exhibits barriers to entry that lead to market power. Scherer (1996) finds that the petroleum refining industry is characterized by economies of scale that may lead to concentration, depending on the country’s market size. In addition, Hastings and Gilbert (2005) find that vertical integration in refining activities (classified under manufacturing) is a source of market power. Sectors with high barriers to entry include manufacture of coke oven products (1910), manufacture of refined petroleum products (1920), and manufacture of fiber cement (2365).

Some manufacturing sectors are also subject to externalities. For example, the production of weapons can be associated with harmful externalities, including crime and fatalities (Efrat 2010; Metcalf 2018). These externalities do not necessarily imply the need to exert control over their production and commercialization through SOEs, as other potential avenues may be available, such as regulation. Sectors identified as posing negative externalities include manufacture of explosives (2051), processing of nuclear fuel (2446), manufacture of weapons and ammunition (2540), and manufacture of military fighting vehicles (3040). The classification for each disaggregated sector in this industry is provided in Appendix 2, Table A.3.

_Table 7_ **_. SOE taxonomy in manufacturing_**

|_Distr_<br>|**Manufacturing (C)**<br>_ibution of disaggregated sectors by category_<br> <br>|
|---|---|
|**Competitive**|**Natural Monopoly**<br>**Partially Contestable**|
|223|0<br>7|
|97%|0%<br>3%|

19
Source: Authors’ elaboration _Table 8_ **_. Non-competitive disaggregated sectors in manufacturing_**

|**Man**<br>|**ufacturing (C)**<br>||**Mk**|**Partially contest**<br>|**able**<br>|
|---|---|---|---|---|---|
|**NACE C**|**ode Classification**||**aret**<br>**power**|**(+)**<br>**externalities**|**(-) **<br>**externalities**|
|**Sector**|**Disaggregated sector**|**Code**||||
|(19) Manufacture of coke and<br>refined petroleum products|Manufacture of coke oven<br>products|1910|X|||
||Manufacture of refined<br>petroleumproducts|1920|X|||
|(20) Manufacture of chemicals<br>and chemicalproducts|Manufacture of explosives|2051|||X|
|(23) Manufacture of other non-<br>metallic mineralproducts|Manufacture of fiber cement|2365|X|||
|(24) Manufacture of basic metals|Processing of nuclear fuel|2446|||X|
|(25) Manufacture of fabricated<br>metal products, except<br>machineryand equipment|Manufacture of weapons and<br>ammunition|2540|||X|
|(30) Manufacture of other<br>transport equipment|Manufacture of military fighting<br>vehicles|3040|||X|

Source: Authors’ elaboration

# D. Electricity, Gas, Steam, and Air Conditioning Supply (D)

This industry includes disaggregated sectors related to the production, transmission, distribution, and trade of electricity and gas, as well as the supply of steam and air conditioning. In addition to increasing returns to scale, network industries—such as electricity and gas, telecommunications, and certain transportation and financial services—exhibit a high degree of complementarity among the different activities involved in the delivery of the service (Economides 2006). For this reason, many countries enforce the “unbundling” of these complementary services through regulation, to ensure the separation of generation, transmission, and distribution activities, some of which are more amenable to competition than others.

Of the eight industries in electricity, gas, steam, and air conditioning supply, three are natural monopolies (Table 9) and one is partially contestable (Table 10). The natural monopoly sectors involve the transmission of electricity (3512), the distribution of electricity (3513), and the distribution of gaseous fuels through mains (3522). These sectors exhibit economies of scale and subadditivity cost structures, such that the most efficient provision can be attained by a monopoly at the local level. The partially contestable sectors are associated with high entry barriers is the production of electricity (3511). The classification for each disaggregated sector in this industry is provided in Appendix 2, Table A.4.

While, traditionally, electricity, gas, and steam provision have been considered to be natural monopoly industries, recent technological developments and economic analysis have highlighted variations in these disaggregated industries. Taken as a whole, electricity provision has technological and cost structure characteristics that can lead to a natural monopoly. Its cost structure has promoted government involvement in many countries, including the United States. Over time, the unbundling of the various activities associated with electricity provision (generation, transmission, and distribution) has resulted in the entry of several market players, although high entry costs and economies of scale often result in market power and thus partial contestability. For example, electricity production relies on generating units that are large in size, such as hydroelectric dams, and sometimes rely on costly energy sources, such as nuclear energy, which act as barriers to entry. Empirical studies support the existence of scale 20
economies in electricity generation (Akkemik 2009; Rungsuriyawiboon and Stefanou 2007; Hiebert 2002; Kleit and Terrell 2001; Maloney 2001; Considine 2000). Similarly, the technological characteristics of transmission and distribution of electricity to final consumers, through grids that cover long distances and a large network of transmission lines, suggest that it is more efficient for there to be few market players (Kopsakangas-Savolainen and Svento 2008; Kwoka 2005; Yatchew 2000; Burns and Weyman-Jones 1996).

Electricity utilities in several countries are still vertically and horizontally integrated. Typically, network sector reforms aimed at unbundling start with the _corporatization_ of government authorities, or the establishment of separate SOEs in charge of different stages of the service delivery chain (USAID 2022). In many countries, SOEs have gone through full or partial privatization, with the goal of improving service delivery and access, company management, and commercial performance (USAID 2022).

_Table 9_ **_. SOE taxonomy in electricity,_** **_<u>gas, steam, and air conditioning supply</u>_**

|**Electricity, Gas, Steam, and Air Conditioning Supply (D)**<br>_Distribution of disaggregated sectors by category_<br>**Competitive**<br>**Natural Monopoly**<br>**Partially Contesta**|**ble**|
|---|---|
|4<br>3|1|
|50%<br>38%|12%|

Source: Authors’ elaboration _Table 10_ **_. Non-competitive disaggregated sectors in electricity,_** **_<u>gas, steam, and air conditioning</u>_**

|**Electricity, Gas**|**, Steam, and Air Conditioning Sup**|**ply (D)**|**P**|**artially contesta**|**ble**|**Natural**<br>**monopoly**|
|---|---|---|---|---|---|---|
||**NACE Code Classification**<br>||**Market**<br>|**(+)**<br>**tliti**|**(-) **<br>**tliti**||
|**Sector**|**Disaggregated sector**|**Code**|**power**|**exernaes**|**exernaes**||
|(35) Electricity,<br>|Production of electricity|3511|X||||
|gas, steam, and<br>air conditioning|Transmission of electricity|3512||||X|
|<br>supply|Distribution of electricity|3513||||X|
||Distribution of gaseous fuels<br>through mains|3522||||X|

Source: Authors’ elaboration

# E. Water Supply, Sewerage, Waste Management, and Remediation Activities (E)

This industry encompasses water collection, treatment, and supply; sewerage; collection, management, and treatment of waste; and dismantling, recovering, and remediation activities. Of the nine sectors in the water supply, sewerage, waste management, and remediation industry, two are categorized as natural monopolies, four are competitive, and three are partially contestable (Table 11 and Table 12). Activities related to water collection, treatment, and supply (3600) and sewerage (3700) exhibit high fixed costs, economies of scale, and subadditivity of costs similar to electricity transmission. In this case, the most cost-efficient provision is achieved by a single operator in the relevant market.

The three sectors classified as partially contestable are the collection (3812), treatment and disposal (3822) of hazardous waste, as well as the treatment of non-hazardous waste (3821). These services may be underprovided in the absence of direct government provision. Some water supply and sewerage activities are characterized by large, fixed costs as well as positive and negative externalities. For example, 21
water supply is characterized by large capital investments in infrastructure, such as wells, pumps, and storage facilities, which generate market power (Fabri and Fraquelli 2000). Empirical evidence shows economies of scale in water supply across countries (Romano and Guerrini et al. 2011, 2018; Carvalho and Marques 2014; Nauges and van den Berg 2007; Shih et al. 2006). In addition, some sewerage and waste management activities are associated with positive externalities, as they control the spread of diseases and pests, including diarrheal incidence, a leading cause of mortality among children in developing countries (Kresch et al. 2020; Fewtrell et al. 2005; ; Wolf et al. 2014; Prüss-Ustün et al. 2019; Motohashi, 2022), but could also lead to negative externalities in case the private sector were to underinvest and possible pollution were to be created, with potentially to create permanent damage to soil, air and water (Grimm & Mbavarira, 2021). The classification for each disaggregated sector in this industry is provided in Appendix 2, Table A.5.

_Table 11_ **_. SOE taxonomy in water supply and sewerage_**

|**Water Supply, Sewerage, Waste Management, and Remediation Activities (E)**<br>_Distribution of disaggregated sectors by category_<br> <br> <br>|
|---|
|**Competitive**<br>**Natural Monopoly**<br>**Partially Contestable**|
|4<br>2<br>3|
|44%<br>22%<br>33%|

Source: Authors’ elaboration _Table 12._ **_Non-competitive disaggregated sectors in water supply, sewerage, waste management, and remediation activities_**

|**Water Supp**|**ly, Sewerage, Waste Management,**<br>**Remediation Activities(E)**|**and**|**P**|**artially contesta**|**ble**|**Natural**<br>**Monopoly**|
|---|---|---|---|---|---|---|
||**NACE Code Classification**||**Market**|**(+)**<br>|**(-) **<br>||
||||||||
|**Sector**|**Disaggregated sector**|**Code**|**power**|**externaities**|**externaities**||
|(36) Water<br>collection,<br>treatment and<br>supply|Water collection, treatment and<br>supply|3600||||X|
|(37) Sewerage|Sewerage|3700||X|X|X|
|(38) Waste<br>|Collection of hazardous waste|3812||X|X||
|collection,<br>treatment and<br>|Treatment and disposal of non-<br>hazardous waste|3821||X|X||
|disposal<br>activities;<br>materials<br>recovery|Treatment and disposal of<br>hazardous waste|3822||X|X||

Source: Authors’ elaboration

# F. Construction (F)

The construction industry encompasses all kinds of construction and development projects, including residential and infrastructure projects, as well as site preparation and demolition, and all other activities related to construction, such as plastering, roofing, wall painting, and so on. Of the 22 sectors in the construction industry, all are classified as competitive (Table 13), as it is economically viable for several providers to operate and barriers to entry are generally low. At the same time the number of operators capable to carry out large construction projects, such as roads and motorways, is limited (De Valance 2011). Yet, evidence collected by the World Bank (Iimi and Benamghar 2012) suggests that even large road contracts attract multiple bidders. In Nepal, for instance, an average of six bidders participated in public procurement related to the construction of roads. Since the government is a major buyer of 22
construction services, it can also be proactive in promoting contestability, while bearing in mind the need for efficient scale. The classification for each disaggregated sector in this industry is provided in Appendix 2, Table A.6.

_Table 13_ **_. SOE taxonomy in construction_**

|_Distr_<br>**Competitive**|**Construction (F)**<br>_ibution of disaggregated sectors by category_<br>**Natural Monopoly**<br>**Partially Contestable**|
|---|---|
|22|0<br>0|
|100%|0%<br>0%|

Source: Authors’ elaboration

# G. Wholesale and Retail Trade and Repair of Motor Vehicles and Motorcycles (G)

This industry includes all types of sectors involved in the sale of goods, from wholesale to retail sale via stalls and markets, agents, and others. All 91 disaggregated sectors in this industry are categorized as competitive because none of them exhibit entry barriers relating to cost structure and they do not involve externalities or other market failures (Table 14). The classification for each disaggregated sector in this industry is provided in Appendix 2, Table A.7.

_Table 14_ **_. SOE taxonomy in wholesale and retail trade and repair of motor vehicles and motorcycles_**

|**Wholesale and Retail Trade and Repair of Motor Vehicles and Motorcycles (G)**<br>_Distribution of disaggregated sectors by category_<br>Competitive<br>Natural Monopoly<br>PartiallyContestable|
|---|
|91<br>0<br>0|
|100%<br>0%<br>0%|

Source: Authors’ elaboration

# H. Transportation and Storage (H)

The transportation and storage industry encompasses land transportation (including pipelines), water and air transport, warehousing, and other transport support activities such as cargo handling, and postal and courier services. Certain economic activities within the transportation sectors portray high entry barriers associated with large, fixed investments and economies of scale. Furthermore, the technological characteristics of some transport activities can lead to some degree of market power. For example, the economies of scale and network features of post office activities under universal service obligation imply that efficiency is attained by having one producer (Filippini and Koller 2012; Filippini et al. 2010; Bradley et al. 2006; Farsi et al. 2006; Filippini and Zola 2005; Mizutani and Uranishi 2003; Cazals et al. 2002; Gazzei et al. 2002; Wada, Tsunoda, and Nemoto 1997; and Norsworthy et al. 1991). Similarly, evidence of significant economies of scale has been found for airports, providing a rationale for their operation as local natural monopolies (Fuerst and Gross 2018; Martin and Voltes-Dorta 2010; Main et al. 2003; Rendeiro 2002; Tolofari et al. 1990). Other transport activities, such as air, land, and water transport of passengers and freight, are subject to barriers that deter entry to an extent, but do not eliminate competition among a few players.<sup>31</sup> For example, seminal work by Baumol, Panzar, and Willig (1982) shows that, even under scenarios in which technology may imply the presence of a single player market,

> 31 Pitt and Norsworthy (1999) document high fixed costs for airline transport. Caves et al. (1981) find economies of scale for railroad transport.

23
like the airline industry, entry and exit of firms can result in a more competitive structure and less market concentration relative to a monopoly. Transport industries, therefore, can be characterized by an oligopolistic structure.

The transportation and storage industry is composed of 23 activity sectors, of which five are categorized as natural monopolies, six as partially contestable, and 12 as competitive (Table 15 and Table 16). The natural monopolies exhibit significant economies of scale and are characterized by high fixed costs, which make it more efficient for one firm to supply these services relative to many competitors: transport via pipelines (4950); service activities incidental to land (5221), water (5222), and air transportation (5223); and postal and courier activities (5310). The sectors that are categorized as partially contestable have high entry barriers relating to cost structure and network economies: passenger rail transport, interurban (4910); freight rail transport (4920); urban and suburban passenger land transport (4931); passenger air transport (5110); freight air transport (5121); space transport (5122); Similar to the Electricity and Gas industries, some activities (e.g., courier services 5320) are marked as competitive even though contestability may be limited due to the bundling of services-based and infrastructure based activities. This is so because these activities do not have characteristics that inherently constrain contestability and unbundling reforms have opened the sector to competition. The classification for each disaggregated sector in this industry is provided in Appendix 2, Table A.8.

_Table 15_ **_. SOE taxonomy in transportation and storage_**

|_Distr_<br>Competitive|**Transportation and Storage (H)**<br>_ibution of disaggregated sectors by cat_<br>Natural Monopoly<br>Part|_egory_<br>iallyConte|stable|
|---|---|---|---|
|12|5||6|
|52%|22%||26%|

Source: Authors’ elaboration _Table 16_ **_. Non-competitive disaggregated sectors in transportation and storage_**

|**Tr**|**ansportation and Storage (H)**||**P**<br>|**artially contesta**<br>|**ble**<br>|**Natural**<br>**monopoly**|
|---|---|---|---|---|---|---|
||**NACE Code Classification**||**Market**<br>|**(+)**<br>|**(-) **<br>||
|**Sector**|**Disaggregated sector**|**Code**|**power**|**externalities**|**externalities**||
|(49) Land<br>transport and|Passenger rail transport,<br>interurban|4910|X|X|||
|transport via<br>|Freight rail transport|4920|X||||
|pipelines|Urban and suburban passenger<br>land transport|4931|X|X|||
||Transport viapipeline|4950||||X|
|(51) Air<br>|Passenger air transport|5110|X||||
|transport|Freight air transport|5121|X||||
||Space transport|5122|X||||
|(52)<br>Warehousing|Service activities incidental to<br>land transportation|5221||||X|
|and support<br>activities for|Service activities incidental to<br>water transportation|5222||||X|
|transportation|Service activities incidental to<br>air transportation|5223||||X|
|(53) Postal and<br>courier activities|Postal activities under universal<br>service obligation|5310||||X|

Source: Authors’ elaboration 24
# I. Accommodation and Food Services (I)

Accommodation and food and beverage service activities include those provided by hotels, short-stay accommodations, and other types of accommodations, as well as restaurant and catering services. All eight disaggregated sectors in this industry are categorized as competitive because none of them exhibit entry barriers relating to cost structure and they do not involve externalities or other market failures (Table 17). The classification for each disaggregated sector in this industry is provided in Appendix 2, Table A.9.

_Table 17_ **_. SOE taxonomy in accommodation and food services_**

|_Dis_<br>|**Accommodation and Food Services (I)**<br>_tribution of disaggregated sectors by category_<br> <br>|
|---|---|
|**Competitive**|**Natural Monopoly**<br>**Partially Contestable**|
|8|0<br>0|
|100%|0%<br>0%|

Source: Authors’ elaboration

# J. Information and Communication (J)

The information and communication industry includes a wide range of economic activities, including publishing; motion video and music recording and production; satellite, wired, and wireless telecommunications; computer programming, facilities, and consultancy services; and data processing and other information service activities, such as those provided by news agencies and web portals. Some sectors in telecommunications are associated with high entry costs, resulting in market power as well as positive externalities. As explained by Laffont and Tirole (1993), the telecommunications services sector has evolved in recent decades, from a highly regulated domain of a “secure monopolist” (public or private) due to “large fixed costs in several parts of the network, whose duplication was neither privately profitable nor socially desirable,” to a sector rendered more competitive by unbundling, privatization, and deregulation.<sup>32</sup> However, wired, wireless, and satellite telecommunications activities continue to have technological and network structures that limit market participation (Sridhar 2011; Noam 2010). Similarly, some telecommunications activities are associated with positive externalities, for example broadband access and firm-level productivity growth (Varian et al. 2002; Franklin et al. 2009), consumer welfare (Dutz et al. 2009; Greenstein and McDevitt 2011), and regional development (Jung and Lopez-Bazo 2020). Telecommunications infrastructure and mobile telephony have also been found to have impacts on economic growth more generally (Röller and Waverman 2001; Chavula 2013; Koutroumpis 2019).

The information and communication industry includes 26 sectors at the four-digit level, of which one is a natural monopoly, four are partially contestable, and 21 are competitive (Table 18 and Table 19). Wired telecommunication activities (6110) have market conditions characterized by high fixed costs, network economies, economies of scale, and subadditivity cost structures, which lead to the sector’s classification as a natural monopoly, as provision of these services is most efficient through a single supplier. The partially contestable sectors involve high fixed costs and network economies: wireless telecommunications activities (6120), satellite telecommunications activities (6130), radio broadcasting (6010), and television programming and broadcasting activities (6020). The latter three are characterized by positive externalities and low entry barriers. The classification for each disaggregated sector in this industry is provided in Appendix 2, Table A.10.

> 32 Laffont and Tirole (1999, Chapter 1). See also Cave (2002, Chapter 3).

25
_Table 18_ **_. SOE taxonomy in information and communication_**

|_Dist_<br>**Competitive**|**Information and Communication (J)**<br>_ribution of disaggregated sectors by category_<br>**Natural Monopoly**<br>**Partially Contestable**|
|---|---|
|21|1<br>4|
|81%|4%<br>15%|

Source: Authors’ elaboration _Table 19_ **_. Non-competitive disaggregated sectors in information and communication_**

|**Informat**|**ion and Communication(J)**|||**Partially contesta**|**ble**|**Natural**<br>**Monopoly**|
|---|---|---|---|---|---|---|
|**NA**|**CE Code Classification**||**Market**|**(+)**<br>|**(-) **<br>||
||||**r**|**tt**|**tt**||
|**Sector**|**Disaggregated sector**|**Code**|**powe**|**exernaes**|**exernaes**||
|(60) Programming<br>|Radio broadcasting|6010||X|||
|and broadcasting<br>activities|Television programming and<br>broadcastingactivities|6020||X|||
|(61)<br>Telecommunications|Wired telecommunications<br>activities|6110||||X|
||Wireless telecommunications<br>activities|6120|X||||
||Satellite telecommunications<br>activities|6130|X|X|||

Source: Authors’ elaboration

# K. Financial and Insurance Activities (K)

Outside of central banking and pension funding, which are excluded from the taxonomy, this industry includes all other kinds of financial and insurance activities, including credit granting, financial leasing, trust and fund management, financial brokerage services, and risk and damage evaluation. Of the 16 sectors included in the classification, two are deemed partially contestable and 14 competitive (Table 20 and Table 2).

Other monetary intermediation is classified as partially contestable on the basis of information frictions that result in asymmetric information (Freixas and Rochet 1998; Claus and Grimes, 2003; Sufi 2007; Wanniarachchige et al. 2017). Market failures that justify the role of state-owned banks include the presence of asymmetric information that limits access to finance for certain potential borrowers (for example, those without a credit history) as well as externalities that result in underfinancing of socially valuable projects, where profitability may not reflect the overall value of the project (Gutierrez et al. 2011). State-owned banks may also help crowd in private investment and finance long-term and large investment projects, such as those related to infrastructure (Gutierrez et al. 2011; World Bank 2013). The classification for each disaggregated sector in this industry is provided in Appendix 2, Table A.11.

_Table 20. SOE taxonomy in financial and insurance activities_

|_Dist_<br>**Competitive**|**Financial and Insurance Activities (K)**<br>_ribution of disaggregated sectors by category_<br>**Natural Monopoly**<br>**Partially Contestable**|
|---|---|
|14|0<br>2|
|88%|0%<br>13%|

Source: Authors’ elaboration 26
_Table 21_ **_._** _Non-competitive disaggregated sectors in financial and insurance activities_

|**Financial and**<br>**NACE**|**Insurance Activities(K)**<br>**Code Classification**<br>||**Market**<br>|**Partially contest**<br>**(+)**<br>**lii**|**able**<br>**(-) **<br>**lii**|
|---|---|---|---|---|---|
|**Sector**|**Disaggregated sector**|**Code**|**power**|**externates**|**externates**|
|(64) Financial service activities,<br>except insurance and pension<br>funding|Other monetaryintermediation|6419|X|X*****||

*Other market failures include asymmetric information and risks.

Source: Authors’ elaboration

# L. Real Estate Activities (L)

This industry includes buying and selling of own real estate, rental and operation of leased real estate, real estate agencies, and the management of real estate on a fee or contract basis. All four of the fourdigit sectors in this industry are categorized as competitive because none of them exhibit entry barriers relating to cost structure and they do not involve externalities or other market failures (Table 22). The classification for each disaggregated sector in this industry is provided in Appendix 2, Table A.12.

_Table 22_ **_. SOE taxonomy in real estate activities_**

|_Distr_<br>Competitive|**Real estate activities (L)**<br>_ibution of disaggregated sectors by category_<br>Natural Monopoly<br>PartiallyContestable|
|---|---|
|4|0<br>0|
|100%|0%<br>0%|

Source: Authors’ elaboration

# M. Professional, Scientific, and Technical Activities (M)

The professional, scientific, and technical activities industry includes a wide range of activities, including legal activities; accounting, business, engineering, and architectural services; research; advertising; and other activities. There are 19 sectors in this industry, four of which are classified as partially contestable and the remaining 15 as competitive (Table 23 and Table 24). The partially contestable sectors concern research activities on biotechnology (7210), natural sciences (7211), engineering (7219), and social sciences and the humanities (7220); and veterinary activities (7500), which includes vaccination of animals. These sectors do not appear to exhibit high barriers, but they do seem to generate positive externalities (Alston et al. 2014; Brooks and Barfoot 2006; El-Zein and Hedemann 2016; Harris 2008). The classification for each disaggregated sector in this industry is provided in Appendix 2, Table A.13.

_Table 23_ **_. SOE taxonomy in professional, scientific, and technical activities_**

|**Profes**<br>_Distr_<br>**Competitive**|**sional, Scientific, and Technical Activities (M)**<br>_ibution of disaggregated sectors by category_<br>**Natural Monopoly**<br>**Partially Contes**|**table**|
|---|---|---|
|15|0|4|
|79%|0%|21%|

Source: Authors’ elaboration 27
_Table 24_ **_. Non-competitive disaggregated sectors in professional, scientific, and technical activities_** <!-- Start of picture text --> Professional, Scientific, and Technical Activities (M) Partially contestable<br>NACE Code Classification Market (+) (-)<br>power externalities externalities<br>Sector Disaggregated sector Code<br>(72) Scientific research and Research and experimental<br>development development on biotechnology 7211 X<br>Other research and<br>experimental development on<br>natural sciences and<br>engineering 7219 X<br>Research and experimental<br>development on social sciences<br>and humanities 7220 X<br>(75) Veterinary activities Veterinary activities 7500 X<br><!-- End of picture text --> Source: Authors’ elaboration

# N. Administrative and Support Service Activities (N)

This industry includes rental and leasing activities, employment activities, travel agency and related services, security, and investigation services, building services, and other administrative and office support activities. All of the 33 disaggregated sectors in this industry are categorized as competitive because none of them exhibit entry barriers relating to cost structure and they do not involve externalities or other market failures (Table 25). The classification for each disaggregated sector in this industry is provided in Appendix 2, Table A.14.

_Table 25_ **_. SOE taxonomy in administrative and support service activities_**

|**Adm**<br>_Distr_<br>|**inistrative and Support Service**<br>_ibution of disaggregated sector_<br>|**Activities (N)**<br>_s by category_<br>|
|---|---|---|
|**Competitive**|**Natural Monopoly**|**Partially Contestable**|
|33|0|0|
|100%|0%|0%|

Source: Authors’ elaboration

# O. Arts, Entertainment, and Recreation (R)

This industry encompasses creative arts, entertainment, cultural activities, such as those performed by libraries and museums, as well as sports and recreation activities. Of the 15 sectors within the arts, entertainment, and recreation industry, eight are excluded<sup>33</sup> and seven are classified as competitive (Table 26). The excluded sectors involve the provision of public goods, and private participation would generally be considered undesirable given that the underlying activities relate to matters of national cultural and historical interest (for example, creative arts and entertainment activities, libraries, archives, and museums). Competitive sectors in this industry group are classified as such because they do not involve public goods and none of them exhibit entry barriers relating to cost structure. The classification for each disaggregated sector in this industry is provided in Appendix 2, Table A.15.

> 33 Eight sectors classified under codes 90 and 91 at the two-digit level are excluded on the basis that they relate to education and national cultural heritage.

28
_Table 26_ **_. SOE taxonomy in arts, entertainment, and recreation_**

|**Arts, Entertainment, and recreation (R)**<br>_Distribution of disaggregated sectors by category_<br>Competitive<br>**Natural Monopoly**<br>**Partially Contestable**|
|---|
|7<br>0<br>0|
|100%<br>0%<br>0%|

Source: Authors’ elaboration

## P. Other Service Activities (S)

Other service activities include those performed by membership organizations, trade unions, and religious and political organizations, as well as the repair of personal goods and appliances and other personal services such as hairdressing, among others. Of the 19 sectors at the four-digit level in this industry, six are excluded from the taxonomy and 13 are classified as competitive (Table 27). The excluded sectors involve membership organizations, which generally do not provide services for profit and/or their purpose is not market production. As such, these sectors are excluded on the basis that any state-owned entities operating therein do not satisfy the paper’s definition of SOEs as entities engaged in production for the purposes of generating a profit. The remaining sectors are classified as competitive because they do not involve public goods and none of them exhibit entry barriers relating to cost structure. The classification for each disaggregated sector in this industry is provided in Appendix 2, Table A.16.

_Table 27_ **_. SOE taxonomy in other service activities_**

|_Distr_<br>**Competitive**|**Other Service Activities (S)**<br>_ibution of disaggregated sectors by category_<br>**Natural Monopoly**<br>**Partially Contestable**|
|---|---|
|13|0<br>0|
|100%|0%<br>0%|

Source: Authors’ elaboration

# V. Application: Empirical Exercise to Validate the Sector Taxonomy

An analysis of the average number of firms operating in each disaggregate sector was conducted using data published by Eurostat. In recent years, granular data on the number of firms has increasingly become available at a disaggregated sector level. Data on the number of firms at the level of NACE 4-digit sectors was obtained for 30 high-income countries and 5 upper middle-income countries in Europe using from Eurostat’s Structural Business Statistics (SBS). The data is compiled yearly by national statistical institutes based on information from statistical business registers, administrative sources, and surveys. SBS covers NACE Rev. 2 sections B to N and division 95, corresponding to 505 out of the 615 4-digit sectors in NACE Rev. 2. The analysis used the most recent data for 2019, cleaned to remove country sectors with missing information and country sectors with zero firms. In the latter case the sector has been presumed as nonexistent in a country, hence not relevant for the analysis.

The number of firms operating in disaggregated sectors is used to review and validate the proposed taxonomy. It is important to note that the number of firms proxy is imperfect because the number of firms observed in a sector does not automatically indicate whether a sector is competitive or not. This is due to two reasons. First, the number of firms in a sector may be high but composed of several markets (e.g., local markets) that are not competitive. Secondly, the observed number of firms can be different from 29
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# VI. Conclusion

The taxonomy put forward in this paper provides a common ground on which to compare countries over time and in a more granular way than before. Countries that have deregulated, unbundled, and privatized their electricity sectors, for example, will only feature an SOE in the natural monopoly segments (transmission and distribution), and this can now be differentiated from a country that still has an SOE operating in every electricity subsector. Similarly, paired with data on SOEs, this taxonomy has the potential to provide valuable insights on the sectoral footprint of the state across different countries, as in the World Bank’s new Businesses of the State (BOS) database and provide guidance on the options for SOE reforms (World Bank, PSD Toolkit, forthcoming).<sup>3637</sup> Preliminary cross-country analysis (World Bank 2022, forthcoming) shows that the state’s footprint in competitive sectors is bigger than previously captured: on average across 80 economies covered in the BOS database, more than half of businesses with state ownership operate in fully competitive sectors.

There are important caveats to the taxonomy, however, which relies on the NACE Revision 2 and is therefore subject to the same shortcomings as any other industry classification or methodology based on industry classification. For example, the disaggregated sector classification of one specific SOE is not necessarily representative of the main economic activity in which that SOE is engaged, nor does the classification accurately capture multi-product SOEs that operate across sectors. SOEs may have changed their main business line entirely and may serve in multiple (related) sectors in different ways. These shortcomings are the same for public entities and private entities.

Perhaps more challenging is the fact that sector characteristics (and market failures) are not constant across countries, across markets of different sizes, or across countries and markets at different stages of development. Electricity generation, for example, may be a natural monopoly in a small economy, but when the economy grows, the sector may be able to profitably sustain more than one generator. Similarly, the economic rationale for state ownership in mobile telecommunications is stronger in countries with a wholesale access network because such a network is a natural monopoly.

Furthermore, the taxonomy may not capture differences in market features among some subsectors within sectors disaggregated to the four-digit level. For instance, the economic rationale for SOE presence is weaker in the generation of electricity from wind energy, but stronger in the generation of electricity from nuclear energy. To accommodate this reality, the taxonomy classifies sectors into the three categories in a generally conservative way—that is, it considers an economic activity to be a natural monopoly even when in some (more advanced or larger) economies it may already be competitive. As a result, the sector categorization is indicative only; the economic rationale for SOE presence may still vary among countries and should be analyzed in detail in the context of any country-level diagnostic.

Technological innovations that affect the fundamentals of certain sectors, including their cost structures and barriers to entry, represent another challenge to industry classification. New technologies may disrupt previous natural monopolies and make those sectors contestable, for example by lowering fixed costs. Innovations in the field of financial technology, for example, could potentially transform the market structure of traditional insurance markets through the analysis of real-time data on risk profiles, dynamic underwriting, and personalized premium setting (Ricci and Battaglia 2021). As a result, the categorization

> 36 EFI SOE Global Database Project, led by Andrea Dall’Olio (TTL), Tanja Goodwin (co-TTL), and Mariem Malouche (co-TTL).

> 37 The CPSD Knowledge note (Sanchez-Navarro, Goodwin, & Kikeri, 2021) and the forthcoming toolkit on state footprint and private sector development offer a good set of tools for practitioners on how to implement the findings of the global BOS database and the taxonomy of sectors to design SOE reforms including the sequence, prioritization of sectors, as well as the definition of the right instrument of reform (beyond privatization).

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of sectors may vary over time and would thus need to be reassessed periodically to ensure its temporal relevance. As technologies change in the future, this information can be used to inform the recategorization of sectors as necessary.

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