1872Lq Viewpoint4 Note No. 164 December 1998 Improving Water Services through Competition Mlichael Webb Water sector reforms in recent years have concentrated on involving the private sector in the antcd David operation and management of monopoly water utilities. Much effort has gone into regulation to Ehrhardt stop utilities from abusing their monopoly power, but relatively little into considering ways to reduce that monopoly power. This Note explains how to bring competitive pressures to bear in the water industry. It shows that while it can be difficult to implement conventional product market competition (in which two or more rival operators compete to sell water services to customers in one area), this option should not be ruled out. Better, cheaper water services can also be achieved by increasing the use of competition in purchasing inputs, relying on competitive bidding for the right to supply an area, and benchmarking rival utilities in different areas. Scope for competing products a single network and competition between ver- tically disaggregated retailers that share access In principle there are four means of introducing to a single network and purchase water from product market competition: competing net- competing bulk suppliers. Nworks, private supply, retail competition, and common carriage competition (table 1). The high Opportunities for competitive supply include cost of installing competing networks makes it providing improved service to areas willing to hard to envisage this as a serious option. But it pay for it. Intermittent supply often forces husi- should not be ruled out. Some utilities are so nesses and hotels to install their own tanks and inefficient or provide such poor service that the backup arrangements, at a higher cost than construction of a competing network in some would be required to provide a secure piped areas could be economic. Private supply occurs system. Retail competition can help them cut when one consumer (self-supply) or a group of costs by providing secure supply to an area. consumers (cooperative supply) supply them- Another opportunity is providing supply to cus- selves rather than rely on the incumbent utility. tomers who are willing to pay the full cost but But this is not an option where there are no are currently unserved. Such customers could suitable water sources close to customers. Re- be in slum areas and urban peripheries, for ex- tail competition occurs when an entrant takes ample. where consumers often pay more than over supply in an area while continuing to pur- the cost of piped service to water vendors or chase hulk water from the incumbent utility. An- for self-supply. other form of retail competition is reselling, in which an entrant exploits a price differential he- The main obstacle to such competitive service tween hulk and retail supply but does not in- is that competition-and operations, such as vest in distribution facilities. Common carriage private abstraction, that make competition competition can include competition between possible-are prohibited by law in many vertically integrated suppliers sharing access to countries. But for reasons explained below, The World Bank Group * Finance, Private Sector, and Infrastructure Network 2 Improving Water Services through Competition TABLE 1 OPTIONS FOR PRODUCT MARKET COMPETITION Competing Competing suppliers XI Xb No ban on competition networks each establish their own distribution system. Private supply Customers supply v No ban on private supply Jamaica (on-site themselves (and their sanitaion for hotels), neighbors). Bahamas (on-site desalt),ia India (privatewell s), among many others Retail An entrant purchases bulk Bulk supply prices that The United Kingdom competition' water supply from the neither disadvantage nor and informally in incumbent and constructs subsidize the entrant sufficient many places, its own distribution bulk water to supply entrants including Maputo, network to customers Mozambique without service or with poor service. Common Several water utilities XI' Appropriate network access; U.S. and U.K. .arriage use a single network to technical pa for waer railwas U.S comnpetition supply custome, and quality ps lysepar of telecommunications customers can,choose netwo n dfrsevice :wi their water supplier.p o i n The United Kingdom to and administratve X hcapaciy 0;is mpovingtward thskind of May ;;be inappropriae fr coetion in the deteriorate d ne torks, and tmay wa tSector. 0 0 0 0 t \ ; 0 0 ; 0 tf Xb~~e acomaied by development Ofa wlelewamarket,to allowtradingbetweenwte prvides a. In all models of product market competition, social objectives need to be met through market-friendly mechanisms, not exclusive franchises and cross-subsidies. Environmental and health regulations need to be competitively neutral. b. Unlikely to be economic. c. Facilities-based with bulk supply. d. Small towns probably cannot support competing providers. The World Bank Group 3 governments should be reluctant to grant exclu- information on their network. Many do not sive franchises or to otherwise place legal limits know exactly how much leakage is occurring, on competition. And sometimes it is desirable or even where their pipes are. to go beyond allowing competition and actively promote it. For example, a new supplier could Other network industries faced similar (though not set up a competing water supply network generally less severe) problems in introducing if there are no suitable water sources close to competition. From their experiences have come the potential customers. In such cases it may many workable solutions, including: be efficient to require the incumbent to pro- * Requiring the parties to agree on a price and vide bulk water from its network to the new resenTing the right of a regulator to intervene entrant. (This approach will work only where or arbitrate if they cannot. the incumbent utility has adequate water. * Setting a price that approximates marginal Where that is not the case, the approach will cost initially, and then refining it over time. work only if combined with other strategies to u Requiring an incumbent to charge an entrant increase water supply, such as competitive pro- the same cost that it charges itself. This may curement of build-own-operate water supply require accounting separation of the incum- projects or of leakage reduction services.) An bent's business into bulk supply, distribution, analogous situation arises in telecommunica- and retail. tions, where phone companies are required to interconnect with one another. Differences in water quality are a serious issue for common carriage arrangements. Water from It would also be possible to have several water different sources may vary in chemical compo- utilities that compete for customers using a sition, bacteria levels, turbidity, color, and other single set of pipes. The network owner would parameters. But once it flows into the network, be required to allow other water suppliers to water from all sources is mixed, which can re- use the network for a cost-reflective, nondis- sult in such problems as: criminatory fee. This approach, known as com- * Contamination, If one company puts water mon carriage, has been successfully used to contaminated with fecal coliform into the sys- introduce competition in gas and electricity in tem, customers of all the companies will get many countries (box 1). sick. * Disruption in industrial users' processes. Food The experience of England and Wales, where processors, breweries, and other water users small, dynamic, innovative companies are calibrate their processes to the water's usual setting up to compete in the water industry, chemical composition. If this composition provides an interesting example of how com- changes, product quality will be affected. petition in water can develop (box 2). * Changes to the network. The inner walls of pipes reach a chemical equilibrium with the Promoting competition-regulating for bulk water flowing through them. Changing the access and common carriage composition of the water could cause faster corrosion, increased buildup of residue inside To promote competition, govermrients may the pipe, or the release of previously accu- have to develop an efficient bulk supply or mulated residue into the water. network access regime. The most important part of such a regime is the price of bulk supply or Water operators tend to argue that these prob- network access. To ensure efficient competi- lems are unique to water and that they rule tion, this price should reflect costs. But esti- out common carriage competition. Neither mating the cost of providing access or bulk assertion is true. All network industries must supply can be difficult for w ater utilities in de- ensure consistent minimum quality standards veloping countries, which often have limited and technical compatibility in use of the 4 Improving Water Services through Competition network. In electricity, where failure to observe Costs versus benefits of competition standards could bring down the entire system, voltage and frequency limits are tightly pre- Social and environmental concerns are often scribed and monitwfokd p r all generators. In the teason for limiting competition. These water workable common carriage competition concerns are valid. For example, uncontrolled will require specifying parameters for all water grous dwater abstraction can lower the water put into the network. Such parameters would table, causing subsidence (as in Bangkok and include maximum levels for harmful substances, Mexico City) or saline intrusion. Similarly, un- permissible ranges for substances that affect controlled on-site sanitation can pollute ground- industrial processes or the network, and per- wate:r. Package sewerage plants are often missible ranges for such characteristics as color poorly operated, create smells, and discharge and turbidity. inadequately treated enuent into rivers or the The World Bank Group 5 sea. Cross-subsidization is often a deliberate social policy, used to provide services at be- low cost to households or to promote a uni- BOX 2 INSET APPOINTMENTS IN ENGLAND AND WALES form tariff throughout a town or country. It is generally better to achieve environmental During privatization of the water and sewerage sector in 1989 the U.K. and social objectives througb competitively government allowed limited competitive entry. "Inset appointments" neutral mechanisms, however. For example, an -licenses issued by the regulator, the Office of Water Services independent water resource or environmental (Ofwat), to new entrants to supply a defined area-were permitted agency should control all water abstraction and for sites that were not already connected and that were more than 30 discharge, regardless of whether done by an meters from the local water utility's distribution main or sewer. incumbent water utility, a new entrant, or some- In 1992 the scope for competition was increased. The 30-meter one supplying themselves. Social objectives can be met through direct subsidies to low-income rulewasremoved.Andlargecustomersatqualifyingsites(sitesnot households or through the general tax-benefit connected to a supplier's distribution main or sewer) taking 250 system. million liters or more a year were given the right to choose a new (inset) supplier. But common carriage or bulk supply arrange- At the same time inset entrants were allowed to apply for bulk ments demand skilled policymaking and well- supply from the local water utility. The terms of this bulk supply developed regulatorv capacity. Complex developeract d reguatory canpacity. Complex would be decided by Ofwat if negotiations between the parties contracts and metering and paymient systems are needed to control relationships between failed. Residential customers were also allowed to connect to a companies that compete while sharing a single neighboring water utility, at their own expense. network. Would the efficiency gains from com- A 1995 review led to proposals to further increase competition. petition in water outweigh the costs of these? These included relaxing the definition of a qualifying site for inset The case for common carriage competition in appointments, removing the water utilities' monopoly on making water is less compelling than that in other net- pconnecions to the water main, and allowing utilities to supply large work industries, for several reasons: The costs of introducing product market com- customers in a competitor's interconnected system by paying a fee petition in water are likely to be as high as for using the system (common carriage). those in other industries-and they may even Only three cases of inset competition have occurred so far, but be higher as a result of the lack of informa- many applications for inset appointments have been made to Ofwat tion in the sector. In response to the threat of competition, twenty-two of the United * Water is generally less valuable than the prod- K ucts or services provided by other network Kingdom'stwent-eightwatercompanieshaveloweredtariffsfor industries. For example, the combined turn- large users, making cuts ranging from 1 percent to about 25 percent. over of the regional electricity companies in England and W7ales last year was more than twice the turnover of the water companies Still, the net gains from competition have been serving the same area. So a given percentage huge in many industries. If even a fraction of gain in efficiency is worth less in water than these gains could be realized in water, the costs in other industries. could be worthwhile. As a general rule com- * In water a greater share of costs is in the plex forms of competition involving common network (which will remain uncompetitive) carriage arrangements are worth contemplat- than in the potentially competitive areas. This ing where: is the reverse of the situation in electricity, * Administrative and regulatory capacity is high. for example, where more than 50 percent of * Water is high cost. the costs are in the competitive generation * The incumbent's network is in reasonable and retail segments. shape. 6 Improving Water Services through Competition While rare, these conditions do exist in some companies often have high costs as a result of places in Central and Eastern Europe and Latin overstaffing and restrictive labor practices. America. And they are likely to arise in more and more places as a result of other reforms, But competitive contracting can go beyond oper- such as introducing private sector participation. ations and maintenance. For example, services So it is a good idea to build in the potential for to reduce water losses can be contracted out to competition rather than locking in monopolies competing teams. If contracts with the teams for thirty or so years, as often happens when are well defined, they can provide strong per- concessions are granted today. forrmance incentives. Toulon, France, for ex- ample, has awarded a five-year contract in which In most places it will be desirable to allow self- the contractor's only payment is a 50 percent supply as well as competitive entry by suppli- share of the value of the water saved. ers that can meet a market need by providing both a source of water and a distribution Expansion of supply capacity can also be con- system. This can be a simple and effective way tracted for competitively. Build-own-operate to put pressure on incumbents to keep costs (BOO), build-operate-transfer (BOT), and down and limit cross-subsidies. The main ex- build-own-operate-transfer (BOOT) projects for ceptions will be where, as a result of a severe water supply and sewerage have been used in lack of administrative capacity, pressing social many countries. needs can be met only through cross-subsidy, or effective control of abstraction of water or Such approaches could be used more exten- discharge of wastewater can be achieved only sively as a way of increasing competition. Utili- through an outright ban on small abstractors ties wishing to increase water supply or sewage and dischargers. treatment capacity could be required to pub- lish their needs and call for bids. That would It might also be argued that granting an exclu- allow bidders complete freedom to design any sive concession is essential to attract the pri- scheme that would achieve the objective. For vate sector. Exclusivity could reduce risk to example, a water utility might intend to ex- private investors and provide a secure base to pand water supply by building a pipeline to finance expansion of the system to new areas. bring water from far outside the town. Calling Where these goals are important, it might be for bids for bulk water supply (rather than for best to draw on experience in telecommunica- bids limited to the project the utility has in tions, where it is now common to grant newly mind) opens the way to innovative solutions. privatized incumbents exclusive rights for only One bidder might offer to provide the water a limited period, typically four to seven years. by fixing leaks in part of the network. Another might offer to rehabilitate a pumping station Competition to supply inputs to increase its capacity. There is a growing trend toward expanding the Network extensions can also be competitively scope for competitive procurement to include procured by adapting BOOT ideas. For example, larger and more important services. There are the contractor could be made responsible for three main reasons why putting operating and designing and building the network and then maintenance functions out to tender can lower maintaining it for a set number of years after costs. First, independent providers of functions construction, with penalties payable if leakage such as cleaning may reap economies of scale rises above the target. beyond the reach of individual water compa- nies. Second, small specialist companies have Whether efficiency gains are realized depends lower overhead and adopt new technologies on the monopolist's cost-consciousness. A pri- faster than large utilities. Third, public water vate concession holder subject to an incentive- The World Bank Group 7 compatible regulatory regime (such as a price ter sector reforms in recent years have used cap) could be expected to contract out operat- competition for the market as an efficient way ing and maintenance functions if this lowered of introducing private sector participation, and costs. Publicly owned utilities or those subject the approach has delivered benefits to con- to cost-plus regulation could be required to sumers.' For example, in Guinea competition procure many inputs compctitively. Such rulcs resulted in a tariff 30 percent lower than a would be beneficial as long as the utility has, benchmark price estimated by consultants, and or can develop, the ability to manage, coordi- in Manila the winning consortium for one of nate, and enforce contracts. the concession areas offered a tariff reduction of 74 percent. Competition for the market Drafting such contracts and holding a tender When the right to serve customers in an area are expensive. For small towns the cost of pre- is put out to competitive tender, the winner paring a tender is disproportionate to their size. might be the company promising the lowest Small towns are further disadvantaged because tariffs or the one requiring the lowest subsidy. private operators may be unwilling to incur the Competition forces the bidders to reveal the substantial cost of making a bid when the con- minimum cost of providing water and sanita- tract is small. These problems can be overcome. tion, allowing efficiency gains to be realized Several small towns can join together and award and passed on to consumers. Many major wa- a contract to supply all of them. FIGURE 1 SIMPLE UNIT PERFORMANCE MEASURES + II _ _ _ _ _I_ _ ~~I,. mm 11 8 Improving Water Services through Competition Competition for the market can be combined similar "report card" concept comparing utili- with other forms of competition: ties' performance in many aspects of service. * While it is common practice to award bidders an exclusive franchise, allowing product mar- Comparative competition is a powerful tool for ket competition could increase competition. improving performance, and it can be intro- * Requiring the concessionaire to contract out duced at relatively low cost in a wide variety many services can keep up the pressure for of settings. To ensure that it is effective, gov- efficiency during long-term contracts. ernments introducing such competition should: • Comparative competition between the con- * Divide municipalities or regions into several cessionaire and other utilities can boost per- zones, each served by a separate utility, where formance (see below). this can be done without sacrificing econo- mies of scale. Manila and Mexico City have Comparative competition both adopted this approach. Set up systems to share information on utili- Regulators and consumers can compare utilities ties in different areas (as in Brazil, Colom- to judge their performance. Several types of such bia, the United Kingdom, and elsewhere). comparative competition are possible, including: Link comparative performance to incentives. * A "pure" version, in which the price a firm T.his can be done by linking pay or profit- may charge is set by the costs of other firms ability to relative performance or making in the industry. This means that firms can renewal or expansion of contracts contingent Viewpoint is an open increase profits by reducing costs. If all firms on good performance. forum intended to lower their costs, a virtuous circle results in encourage dissemina- which all firms' costs and tariffs are driven It is also worth developing international per- tion of and debate on ideas, innovations, and downward. formance comparisons, as the Asian Devel- bestpracticesforex- * Regulatory benchmarking of companies opment Bank, the World Bank, and other panding the private against one another, to estimate efficiency and institutions have started to do. Since the United sector. The views pub- lished are those of the set price caps accordingly. Figure 1 shows a Kingdom has advanced furthest in compara- authors and should not hierarchy of cost indicators that can be used tive competition, the techniques and data defi- be attributed to the in this approach. These indicators can be nitions it has developed could provide a good World Bank or any of supplemented by sophisticated statistical tech- basis for an international system. tions. Nor do any of the niques that take into account differences in conclusions represent companies' operating environments. official policy of the c o This Note is based on "Improving Water Services through Competi- World Bank or of its - Publication of comparisons of compames'per- tion" (Water Resources Occasional Paper 6, U.K. Department for Inter- Executive Directors formance in the media. This can be a simple national Development, London, 1998) and a longer paper, "Competi- or the countries they but powerful tool. tion in Water" (avaiable from London Econormics, 66 Chiltern Street, represent. London, WI1d 1PR). I For details on concession contracts see Pierre Guislain and .Mdichel To order additional Sophisticated benchmarking using statistical Kerf, "Concessions-The Way to Privatize Infrastructure Sector Mo- copies please call techniques to compare companies' efficiency has nopolies" (Viewpoint 59, October 1995), Claude Crampes and An- 202-458- 1111 or contact a tonio Estache, "Regulating Water Concessions" (Viewpoint 91, Sep- Suzanne Smith, editor, 'worked in England and Wales to some extent. tember 1996), Penelope J. Brook Cowen, "The Private Sector in Room FllK-208, In Brazil a national agency concerned with wa- Water and Sanitation-How to Get Started' (Viewpoint 126, Sep- The World Bank, ter sector reforms the PMSS, has assembled tember 1997), and Helen Nankani, "Testing the Waters-A Phased 18l8 H Street, NW, ' ' .Aporoach to a Water Concession in Trinidad and Tobago" (View- Washington, D.C. 20433, consistent data on a full set of operating cost poi7t103.January1997). or Internet address variables for almost 100 municipal areas. Com- ssmith7@worldbank.org. parative competition can also focus on quality. lMichael Webb n(mikew@londecon.co.uk) and The series is also available on-line New Zealand grades potable water supplies from David Ehrhardt (davidenctyamaica.com), (www.worldbank.org/ A to E. This system has stimulated debate on London Economics, United Kingdomn html/fpd/notes/l). the cost-quality tradeoff in areas with low grades @ Printed on recycled and put pressure on utilities to improve. Con- paper. sumer groups in India have had success with a