Viewpoint Note No.77 Regulating Water Companies Michael Klein The water industry differs in two key respects ter sellers have an incentive to sell water at a and Timothy from other network industries, such as gas, elec- price not much higher than its cost and to take Irvin tricity, and telecommunications. First, there are steps to show that the water is safe to drink. fewer opportunities for introducing competi- But the arrival of piped water changes every- tion among suppliers, since the network of thing. It is much, much cheaper than water pipes is a major element of the total cost of sold by vendors, as table 1 suggests. In the water and can be operated efficiently only as a Asian cities in the table, these lower prices are monopoly. Second, the quality of water is cru- due in part to government subsidies. But even cial, but hard for consumers to check. Together, when the subsidies are taken into account, these problems mean that getting the best per- piped water is still at least 50 percent, and usu- formance out of water companies requires regu- ally 75 percent, cheaper. At the same time, lation by the government of the price and however, consumers lose the choice of suppli- quality of water. ers that they used to have. To regulate well, however, the regulator needs In the nineteenth century, water companies laid to have an idea of how much it would cost an competing pipelines in towns in Canada, the efficient company to supply high-quality water. United Kingdom, and elsewhere But it is usu- One way of generating that information is to ally efficient to have just one network of pipes, auction the right to supply water every twenty and as a result of either free competition or years or so. Firms state the price at which they municipal regulation, the competing networks would be willing to supply water of a specified quality, and the firm offering the lowest price wins the contract. In between auctions, how- ever, regulators need to use other methods to lAgLE 1 PRICEOF VENDEDAND PIPED adjust the pnce in response to changing circum- WATER stances. No method is perfect; the best may be (U.S. cents per cubie meter) to increase the price every year by the rate of inflation, perhaps with an adjustment for ex- pected productivity changes, and review the Vended Piped pnce every three to five years to ensure that the water company's profits are reasonable The im- Bndig 616 10 portance of investments to maintain the quality Jakarta 185 17 of water means that regulators should be care- Manila 187 11 ful, when reviewing prices, to allow the firm to Kaarhi - 175 8 cover the costs of such investments. Ho Chi Minh 15t 8 Why regulate water companies? oSorce:Asian Development Bank, Water Utilities Data 8eok -Asian and Pacifi& Regiio(Manila. 1993). When water is sold by street vendors, consum- a e ers have a choice of suppliers. As a result, wa- Private Sector Development Department . Vice Presidency for Finance and Private Sector Development Regulating Water Companies of the nineteenth century soon turned into mo- plants (figure 1) could sell water to a company nopolies. Technically, the water supply system that distributed it to consumers through one is a natural monopoly the cheapest way to network of pipes Although such a system has supply water involves just one firm owning a recently been proposed in Chile, no one has network of pipes. Water monopolies, of course, yet succeeded in implementing this sort of com- can and do exploit their privileged position In petition The reason is probably that network- the worst case, they may even be able to charge related costs are a larger proportion of total as much for water as the street vendors, in costs in the water industry than in gas, elec- which case all the benefits of piped water ac- tricity, and telecommunications. The gains to crue to the monopoly be made from introducing competition in, say, water collection and water treatment are thus relatively small, and they have to be weighed against the coordination problems introduced FIG WI1 IN joWAGby splitting up ownership of the system Competitive water supply may be efficient near B- kto - - r' *g--e - -*-. .-the boundary of two water companies' territo- 4es irs ries or in regions where water is very scarce and therefore the cost of the network is lower relative to the cost of the water. Competition is . .>. . % SeSrvce . .also possible for services peripheral to the main m__ . ¢ t. - .- - service, such as connecting new users to the .. - . \. I > _ ' .. 1 . - ^. ....................... ; system. But for the time being, most water will be supplied monopolistically, and society needs -W. - .. .llYater - .- - ..\8t- a.................some way to encourage efficiency despite the . ~. trOattant f,,,,,. ..... *,,monopoly. -Wehtewafer , The difficulty of regulating well UJ'tr a w ste In villages, consumers can form cooperatives to wo6)trtt het f run the water system themselves, since the pro- biOIICttO _ ,55 ,ducers are also the consumers in such a system, - . . - e drainage . . ~ ~ they have good reason not to charge too much for water or to be careless about its quality. But in larger regions, consumers need to delegate Sie.NohWest Water, "the Wyaance WaterCycqd9}'.e O/*-\@ i - ; ,h West Wa, .Te A e W Cycle (1954). the problem of setting prices and quality stan- dards to someone else. The traditional option is to delegate it to the government. Government In some industries in which networks are impor- ownership doesn't automatically solve the prob- tant-gas, electricity, and telecommunications- lem, however. Monopoly suppliers of all types governments have limited the scope of the natural are tempted to charge high prices or to lower monopoly problem by separating production quality And government ownership introduces from transmission through the network. Thus, its own problems, since the government, as an competing electncity generators, for example, can owner, usually exerts relatively weak pressure send power to consumers usmg one network. on firms to lower their costs. Theoretically, this is possible in water too Whether the water firm is publicly or privately Competing water "production" firms that own owned, the key to achieving efficiency lies in the bulk storage reservoirs and water treatment the choice of a regulatory mechanism to over- see the firm's performance. Good mechanisms A big part of the regulatory problem, there- protect consumers from high prices and low fore, is to design rules that give the regulator quality But they also safeguard the legitimate access to better information about the appro- interests of the water companies, since, if the priate price of water. companies are to invest, they need to believe that the regulators will let them earn enough How to generate good information revenue to make a reasonable profit. Probably the best way of discovering the If the regulator had enough information-in par- appropriate price is to establish a competitive ticular, if it knew what it would cost an efficient system of tendering-or "auctioning"-the right water company to produce water of different to supply water The regulator says, for example, qualities-it could simply rule that the actual water company had to sell water of a certain quality for a price equal to the efficient firm's A small town in France managed to cost of production. That price would be just high enough to allow an efficient water company to cut the price of waterfrom 3. Ofrancs make a reasonable profit, but no higher. Nei- ther the company nor the consumer would be per cubic meter to 1. 7francs when it exploited. And, as technology and demand changed, in this perfect system, the regulator decided in 1994 to auction the right would revise the price and the quality standard so that they were always at the right levels. to supply water In fact, of course, the regulator cannot easily tell how much it would cost an efficient firm that it wants a firm to provide water of a speci- to produce water At best, it can observe ac- fied quality. It then asks firms to propose a price tual firms' costs, but these can be concealed for supplying the water The firm that proposes by clever accountants. Moreover, an important the lowest price wins the right to supply the part of a water firm's cost is the cost of the district at that price (or perhaps at the price of financial capital tied up in the firm. Estimating the next-lowest bidder-the details of the auc- the cost of that capital requires an estimate of tion can vary). In prnciple, the most efficient the riskiness of the investment, complicating supplier of water will win the auction, and the the regulator's information problem yet further. resulting price will be appropriate. With imprecise cost estimates, there's always a risk that the regulator will set the price too Experience confirms the value of auctions In high, hurting consumers and unnecessarily dis- Buenos Aires in 1993, for example, the win- couraging water use, or too low, encouraging ning bidder offered to deliver water at a price the wasteful use of water and discouraging in- about 27 percent lower than the price under vestment by water companies state ownership Although the price later in- creased, it remained lower than it had been In addition, because the regulator probably What's more, the new supplier agreed to in- guesses what it would cost an efficient firm to vest US$200 million a year for the first five years, produce water partly by observing the actual compared with annual investment of US$20 mil- water company's costs, the water company no lion to US$40 million in the preceding years. longer has such a strong incentive to produce In another example, a small town in France efficiently. Since lower costs would lead the managed to cut the price of water from 3.0 regulator to lower the price the company can francs per cubic meter to 1.7 francs when it charge, the company would not get all the ben- decided in 1994 to auction the right to supply efits of cutting costs. water Regulating Water Companies Yet auctions are no panacea To keep up with pany a strong incentive to invest more-in any- changes in technology and demand would re- thing at all quire repeating the auctions every couple of years-which is what happens, for example, More recently, therefore, the United Kingdom with garbage collection in many cities Water has chosen to change the price by means of a companies, however, must make investments formula, known as RPI-X, that increases the with a life of decades that have little value in water price by the increase in the retail price other uses. Ptpes, once laid, will last for years, index adjusted by a factor, X, to account for and digging them up later to move them to a expected productivity gains and other changes. new site is prohibitively costly A water com- Under this method, the company has incen- pany that could easily lose its contract in an tives to lower costs, since it keeps the result- auction next year would therefore be justifi- ing profits. The method can also be refined by ably cautious about long-term investments. choosing a price index that relates more spe- cifically to the input price inflation experienced The problem is partially addressed by requir- by water companies. Care needs to be taken, ing a new winning firm to pay the old firm for however, to avoid re-creating the problem of the pipes and other immovable assets But compensating the company for cost increases working out the price the new firm should pay it could have avoided. is difficult For one thing, the pipes are under- ground and their condition is hard to assess. RPI-Xprice adjustments are probably better than To encourage valuable investments, then, auc- rate-of-return price adjustments, but the differ- tions must be repeated only infrequently (ev- ence between them is not as big as it might ery twenty years perhaps), or the incumbent seem RPI-X formulas need to be reviewed ev- The Note ierieis ISan open forum intended to must be given an advantage over other bid- ery three to five years or so, since the regulator encourage dissemina- ders But either way some of the benefits of does not know exactly how large X should be tion of and debate on the auction are lost First, an incumbent with a and, in reviewing whether Xwas set appropri- ideai, innovations, and best practices for privileged position has weaker incentives to ately, will take into account the profits being expanding the private offer the lowest possible price at the next auc- made by the firm: for example, if they are very sector The views tion Second, technology and demand-and large, X is probably too small In addition, the published are those of the authors and should therefore the appropriate water price-change importance of quality means that regulators not be attributed to the during the term of a twenty-year contract. Be- should allow firms to pass on the costs of rea- World Bank or any of its tween auctions, the regulator must again try to sonable investments that maintain water quality. affiliated organizations Nor do any of the con- estimate how the right price has changed. clusions represent The undesirable incentive effects of both RPI-X official policy of the How to adjust prices and rate-of-return adjustments can be reduced World Bank or of Its Executive DBrectors between auctions by comparing the prices charged by other wa- or the countries they ter companies in different, but sufficiently simi- represent How should regulators adjust prices between lar locations, as happens in the United Kingdom. Comments are welcome auctions? Over three- to five-year periods, the If comparable companies can profitably sell wa- Please call the FPD best option is probably to adjust them in a ter at lower prices than the company under ex- Note line to leave a mechanical way Traditionally, regulators in the amination, the regulator may be justified in or contact Suzanr5e United States have adjusted prices so as to keep keeping prices low despite low profits Smith, editor, Room the company's rate of return on capital at a G8105, The World Bank, constant level. if the company's rate of return Michael Klein, Alanager, Private Sector 1818 H Street, NW, f r Washington, D C 20433, falls below that level, the regulator allows prices Development Department (email. mklein@ or Internet address to rise The problem with this method is that it worldbank org), and Timothy Irwin, Private ssmith7@worldbank org gives the company little incentive to limit its Sector Development Department (email. OPrinted on recycled costs and, when the target rate of return is tirwin@worldbank org) paper higher than the cost of capital, it gives the com-