Presentation to the Annual Conference of the Rural Sector of Local Government New Zealand: July 1, 1998, Dunedin.

Keywords: Regulation & Taxation; Environment & Resources;

My conclusion is a simple one. There is no simple answer to the question of the ownership, management, and regulation of water and wastewater supply and services: there is no one answer which suits every locality, circumstance, and system. It is easy for extremists to claim everything should be privatised, while other extremists as equally shrilly argue they should be kept in local government control. It soon becomes evident that the practicalities of the general circumstances rule out any extremist argument, while the choice between the middle options depends on the local circumstances. This presentation details the argument that leads to the conclusion.

Charging for Water

Before exploring these issues I need to consider user charging for water, because the demand side impacts on the supply side arrangements. Subject to a number of caveats, if there is a need to conserve water, user charges makes good sense. (I shall come to wastewater in a moment), A charge is a self-enforcing signal to encourage users to husband the water they use, and to use alternative sources, such as rain water for low quality purposes. There are a number of caveats.

First, if the cost of charging is high relative to the cost of water, a fixed charge may be better. So a scheme which uses fixed charges for households may meter big users such as factories. Because watermetres are easier to install in a new development, they may be introduced there, and only slowly installed across all households. And so on.

Second, I am less sure about user charging for wastewater. Direct metering is not commonly proposed, while adding to the wastewater charges to the water charges may cause distortions. For instance the household which uses rainwater for its loo, will avoid the charges and yet create wastewater.

The third caveat is that typically a water supplier is a monopoly. Optimal social pricing is not a major concern of a private monopoly, so there is a practical problem of ensuring that the pricing rules are enforced.

Fourth, there are only significant benefits if there is some limitation on the availability of water. For instance, if the scheme has to be expensively enlarged, a user charge which encourages conservation may enable the extension to be delayed, reducing costs to the community by – among other things – avoiding capital charges. On the other hand, if there is surplus capacity in the planning future, the optimal unit charge may be negligible.

That leads to my fifth caveat. The economically efficient charge for water use is the marginal cost of supplying the unit of water. Defining marginal cost is a bit complicated, but basically the marginal cost of a commodity is the value of the resources which can be saved if a unit of resources is not consumed. In the case of water supply, the marginal cost may be negligible (in the case of supplying a litre of water from a system with much spare capacity), or it may be enormous if there is no spare capacity and expensive water works are required.

It is a basic rule of economics that the optimum charge rate for a commodity is the marginal cost. Usually the marginal cost is about the same as the average cost, in which case – subject to various caveats that need not be considered here – user charging by the private market will supply the commodity in an efficient and efficacious way. However when the marginal cost of water differs greatly from the average cost, charging for it at marginal cost will not cover total costs when the marginal cost is low (there is lots of spare capacity), and will generate too much revenue when it is high (when there is a shortage of spare capacity). In either case the best price is not going to conform to the standard assumption for private supply. There are various ways of establishing a suitable price, but because the water supplier is a monopoly it has an incentive to manipulate the price in its favour, and against economic efficiency.

The final caveat is that a switch from existing pricing arrangements to user charging may be seen as inequitable. That ought to result in a response by central government which takes responsibility for distributional policy. In practice central government does not always act so responsibly, and the local government has to take equity into consideration.

A good charging system may be equitable. It would involve a fixed charge, with water consumed above a particular level would be paid for by the unit at marginal cost. By adjusting the free entitlement a reasonably equitable outcome can be obtained. This may not be an ideal solution, but there may not be a better one.

This brief run through of the demand side shows that any shift towards improved pricing, raises problems for the supply side of ownership, management and regulation. The water supply is likely to be a monopoly, and its optimal pricing policy is likely to be a complicated mixture of fixed charge and user charge at marginal cost.

The issue of getting the right charging regime is especially important for rural supply where many users may have capital intensive alternatives to replace or substitute for public supply. They should be encouraged if they are more efficient than public supply. Since the charging regime signals whether they will be encouraged, right pricing is crucial.

Supply Side Options

I simplify the exposition of supply side regimes by considering five basic options. (The most important omission is where the supply is a mutual cooperative, owned, managed, and regulated by the users.) Note how I have divided the features of water supply into three components which are responses to three questions:
– who owns the system?
– who manages the system?
– who regulates the system?
Regulation refers to setting a context for water service and price. (The standard means, market competition, inhibited because of the natural monopoly). I am also assuming that while there may be some central government regulation, say on water quality, there is so much diversity there has to local regulation for local conditions.

The attached table gives the five basic options, organized from left to right. The extreme left regime is a bureaucracy, which was familiar up to the 1990s, in which the local government bureaucracy owned and managed the trading enterprise. Typically the arrangements are not very transparent, so nobody what are the pricing rules, what are the investment rules, how efficient is the management and operation. Very often the system was managed for obscure, multiple and conflicting purposes, which changed over time. Provision of a cheap quality supply of water is not always the highest priority. Bureaucracy is not a very satisfactory way of running a trading enterprise.

At the right extreme is private monopoly in which the water supply system is sold to a private corporation, which owns and manages it. The only regulation is general law, which is not very powerful over natural monopolies. (This is demonstrated by the electricity reform bill currently before parliament, only necessary because the Commerce Act is so inadequate.) Aside from private enterprise ideologues, consultants who expect large fees from any privatization, and investors anxious to get their hands on the milch cow of an unregulated natural monopoly, the private monopoly looks as extreme and unsatisfactory as that of the bureaucratic option.

The Local Authority Trading Enterprise, where the local government owns, manages, and regulates the activity, but there is a separation of the ownership and management from the bureaucracy and from the regulator, is one of the three middle options. The franchise option involves the management being contracted out to another agency. It may be a private corporation, but could be another LATE. Franchising to another neighbouring local authority agency may be effective if the operation is small. The third middle option is the where the system is owned and managed by a private corporation (perhaps following privatization), but unlike in the case of the private monopoly, the local government remains the regulator. (Note there are a host of sub-options between franchise and private enterprise including BLT, BOOT, BOT, BTO, DBO, and DCFM, typically associated with new installations.)

Which one of these three basic options is the best? There is no clear answer. There are those who argue vigorously for the private enterprise option, and others as equally vigorously for the LATE option. Each’s arguments involve assumptions which may not be plausible, and ignore damning weaknesses. Most of the argument is rhetoric. Consider the following passage from a paper to last April’s conference of the New Zealand Water and Wastes Association.

What the wise man does is look around for the evidence; the things he can see …. Regardless of theory, the evidence … tells us that, particularly when compared with political structures, commercial structures deliver better infrastructural outcomes – for taxpayers and ratepayers, the economy, the environment and for individual consumers. Those who argue to the contrary (and there are still some) ignore the evidence. (J.K. McLay, A Way Forward. Proceedings of Conference, p.31)

(What would be a wise woman’s assessment – greater insight?)

I happen to be very interested in the question of the respective merits of private and public supply. I even wrote a book on it: The Commercialisation of New Zealand. I have looked at the evidence which purports to show that private commercial structures are superior to public ownership and management and vice versa. The supportive evidence is unconvincing – often assuming that which is to be proved – and mixed. The valid research usually concludes with so many caveats that there is no clear conclusion.

So I looked at the paper I have just quoted, but despite the claim it provided no useful evidence. Other papers at the conference – from the Business Roundtable and ACT – even more strongly argued the case for private enterprise, again without providing any evidence – only assertion. The presenters know their policy answers, but they are quite unable to provide any convincing case.

My conclusions from reading the research literature is as follows:
– bureaucratic supply is likely to be relative inefficient;
– private monopoly supply is likely to be relative inefficient;
– there is little difference between the efficiency of a public enterprise and a private enterprise if they have the same operating objectives;
except that
– there is some evidence that a regulated public monopoly may be more efficient than a private enterprise.

These tentative conclusions suggest the choice of ownership and management will depend on particular circumstances. For instance if the system needs a major extension, involving a substantial financial investment, a private enterprise or BOOT (or one of the other acronyms) may be appropriate. A small scale operation may be wise to franchise the management. In other circumstances a public enterprise could be serviceable. In all cases the local government should be an effective regulator. Often the regulatory regime and best pricing practices will determine the best ownership and management form.

Conclusion

That should not surprise the rural community. While reading of the New Zealand literature on the best ownership and management of water supply, I was struck by how much of it was about major urban water supply systems, and how it had little connection with rural schemes. That may be because the big profits are to be made from privatisation of the big schemes, so there is less enthusiasm to think about rural needs.

If there is any national policy conclusion to be drawn from this it is that it would be manifestly wrong for central government to direct local government on how to own, manage, and regulate its water systems, because any national direction would be too inflexible to deal with local circumstances.

At the local level, my advice is to commission a study which sets down alternatives. Try to avoid a consultant who is an ideologically predisposed to any one outcome. If by mischance you select one, the report will favour one option uncritically, and not identify the option’s weaknesses, nor the alternatives strengths. An indicator of a good report will be how thoughtful it is about pricing options, and how its conclusions integrate pricing with the supply side recommendations.

To conclude then, as I began. There is no simple answer to the question of the ownership, management, and regulation of water and wastewater supply and services: one that suits every locality, circumstance, and system. In particular the simple answers of the extremists of left and right are almost certainly wrong.

MONOPOLY>

	OWNER	MANAGER	REGULATOR
BUREAUCRACY	Local Government	Local Government	None
PUBLIC ENTERPRISE	Local Government via LATE	LATE	Local Government
FRANCHISE	Local Government via LATE	Private Corporation or Agency other than LATE	Local Government
PRIVATE ENTERPRISE	Private Corporation	Private Corporation	Local Government
	Private Corporation	Private Corporation	None