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COMPETITION AND REGULATION IN WATER STRIKING THE RIGHT BALANCE

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COMPETITION AND REGULATION IN WATER STRIKING THE RIGHT BALANCE Powered By Docstoc
					COMPETITION AND REGULATION IN WATER: STRIKING THE
RIGHT BALANCE

Regina Finn, Chief Executive, Water Services Regulation Authority
Beesley Lecture, 1 November 2007


1      Introduction
I would like to start by thanking Professor Robinson, the Institute of Economic
Affairs and London Business School for the invitation to speak here this evening. I
would also like to thank my colleague, Seán Lyons from the Economic and Social
Research Institute in Dublin, who helped me put together this lecture.

This is a forum which is much respected for the quality of the contributions and the
debate that is generated and I hope to rise to that challenge. I particularly look forward
to the opportunity for discussion and debate.

Ofwat, in its new structure and under the strategic guidance of its Board, is grappling
seriously with the challenge of how to develop competition in the water sector. The
UK water industry is unique in its structure and its history and therefore may be
unique in some of the challenges and opportunities it presents. While this means there
is no tried and tested blueprint developed internationally for us to follow, it also
means that we have the opportunity to examine this issue from first principles and
devise new structures and systems to deliver our goals. We have too the opportunity
to learn lessons from other utility sectors, both in the UK and elsewhere.

At this stage in our thinking therefore it is particularly useful for us to have the
opportunity for debate with the economic regulation community – academic and
practitioner – on a topic as large and seminal as the development of competition in the
water and wastewater sector.

The regulatory framework used in the England and Wales water sector has delivered
significant benefits for users over the past 18 years. It has accommodated a very large
programme of capital investment – by the end of this investment period in 2010 about
£70 billion will have been invested in the sector since privatisation – improved the
quality of service for customers significantly and provided incentives for efficiency
improvements worth about £100 per year in bill reductions for the average customer.
England and Wales score reasonably well in international comparisons of water and
sewerage quality and efficiency.1




1
    Ofwat, 2007a.


                                                                                        1
However, it has been clear for some years now that comparative competition alone is
not sufficient to deliver the best possible prices, quality and choice of services for
users in the long run.2 First, liberalised utilities in other sectors have offered
consumers even greater efficiency improvements than those in the water sector.
Second, the comparative competition model may be subject to diminishing returns
over time. Both theory and practical experience suggest that yardstick regulation is
better at improving static efficiency than it is at providing incentives for dynamic
efficiency and innovation.

I believe greater consumer benefits are possible in the future if we can strengthen the
incentives for dynamic efficiency and innovation in the water sector. The way to
realise these gains is to broaden and deepen effective competition in water and
sewerage services. Of course, in doing this we must also be conscious that regulating
liberalised markets can impose costs as well, and these must be borne in mind when
designing appropriate regulation.

In this lecture I will start with a few words on where we are now, and then focus on
where we hope to go and how we might get there. I will present some new results
from our ongoing work on the value chain for water in England and Wales, which
starts to show the size of the various activities in the value chain relative to each
other. This work is at an early stage and is prompting many questions for us and it
may prompt some discussion tonight. I will then conclude with a discussion of some
future options for liberalisation and regulation of the sector.


2    The story so far
Although there have been significant efficiency gains, commitment of capital
investment and improvements in quality of service in the England and Wales water
sector since it was privatised, competition has developed much more slowly than in
other liberalised sectors.

Improvements in quality have slowed as the worst inefficiencies have been squeezed
out of the system. Table 1 below shows that the big gains in most service indicators
between 1990 and 2002 substantially levelled off thereafter.3




2
 See, for example, Robinson, 1997; Ofwat, 2000.
3
 Increases in the DG6 and DG7 indicators after 2004 relate mainly to issues with data comparability
and problems in particular firms.


                                                                                                      2
      Table 1: Industry performance on service indicators, 1990-91 to 2006-07
Description                           1990-95   1995-00   2000-01   2001-02   2002-03   2003-04   2004-05    2005-06   2006-07
                                           %         %         %         %         %         %         %          %         %
DG2: Properties at risk of low
pressure.                                1.33      0.35      0.11      0.10      0.06      0.04      0.03       0.03      0.02
DG3: Properties subject to
unplanned supply interruptions of
12 hours or more.                        0.33      0.21      0.11      0.12      0.05      0.14      0.07       0.08      0.15
DG4: Population subject to
hosepipe bans.                            14        15          0         0         0         0         0         7        30
DG5: Properties subject to sewer
flooding incidents (overloaded
sewers and other causes).                0.03      0.03      0.03      0.02      0.02      0.01      0.02       0.02      0.02
DG5: Properties at risk of sewer
flooding incidents (once in ten
years).                                     -      0.07      0.09      0.05      0.04      0.03      0.03       0.02      0.02
DG5: Properties at risk of sewer
flooding incidents (twice in ten
        1
years).                                  0.08      0.05      0.03      0.02      0.01      0.01      0.01       0.01      0.01
DG6: Billing contacts not responded
to (within five working days).
                                        21.78      5.39      0.86      1.23      0.53      0.47      0.48       4.44      4.79
DG7: Written complaints not
responded to (within ten working
days).                                  21.42      3.22      0.44      0.66      0.15      0.14      0.31       3.08      1.85
DG8: Bills not based on meter
readings.                                   -      1.51      0.72      0.45      0.16      0.15      0.21       0.52      0.86
DG9: Received telephone calls not
                           2
answered within 30 seconds.                -      16.16      7.64        6.37      5.89      5.85     4.87         -         -
DG9: Performance Score                  25% Calls not abandoned, 25% All lines not busy and 50% Customer
                                                              Satisfaction Survey                                38        32




The sector has also changed somewhat since privatisation. The original 39 statutory
water undertakers have combined and merged until now there are 22 following the
most recent merger between Mid Kent and South East Water. There have been a very
limited number of “new entrants” in the form of inset appointments, of which there
have been only 14. Throughout this period, the incumbent water companies have
remained fully vertically integrated.

The water supply licensing regime was introduced in 2005, designed to facilitate both
retail competition and the entry of competitors who would provide new water into the
system to supply customers – “combined supply” licensees. The regime, as Ofwat has
said publicly, has not led to competitive entry. A total of seven licences have been
awarded but no customers have successfully switched.


3     Markets in the water sector where competition is feasible and has
      the potential to be economically significant
It is widely accepted nowadays that public utilities should be subject to competition
where feasible. In segments where market failures (usually natural monopoly) make
competitive supply unattainable, economic regulation should be applied to maximise
consumer welfare.

In this section, I want to say a few words about which segments of the water sector
are likely to have the potential for competition and where in the sector competition
might be expected to make a significant contribution to societal welfare if it were
introduced.


                                                                                                                            3
Ofwat is presently looking into the definition of economic markets within the water
sector and the value chain for water. While these studies are at a preliminary stage, I
can describe some of the early results we are seeing so far.

Provision of water and sewerage services to industry and households involves a series
of activities with varying economic characteristics (see

Table 2 below).

I will start with the water business. For the collection and abstraction stage, access to
a source of suitable water is required, along with a legal right to abstract water from
the source. The water then requires more or less treatment, depending upon the
required level of quality (eg, potable or non-potable). These two stages are sometimes
grouped under the heading of production. The scope for competition in this stage of
the chain depends crucially upon the initial distribution and trading conditions
governing access to water sources and abstraction rights. In England and Wales such
rights are administered by the Environment Agency and the primary goal of
regulation is environmental regulation designed to reduce or eliminate damaging
abstractions, rather than economic regulation designed to reflect the value of the
resource or the abstraction right. Some parallels could be drawn with the way
frequency spectrum used to be regulated – as a public good with an administratively
priced licensing regime. Of course, the frequency spectrum market has changed
significantly over time with the high-profile auctioning of 3G spectrum probably
being the most dramatic illustration of a move from administrative to economic
pricing of a scarce resource.

       Table 2: Illustration of value chains for water and sewerage services


                                      Water
     Collection
                                                                           Supply
    Abstraction                 Treatment           Distribution
                                                                          (Retail)
 (Water Resources)




                           Waste Water

                                Treatment
        Collection
                               (Sewage and            Disposal              Retail
       (Sewerage)
                                 Sludge)




                                                                                          4
The distribution stage includes the infrastructure used to move the water from
production to users. This activity requires the commitment of very substantial sunk
costs, and water networks are generally regarded as economically non-replicable. In
other words, apart from a few areas of the world where potable and non-potable water
networks run in parallel, it tends not to make economic sense to build multiple water
distribution networks in parallel. These conditions imply that there are high barriers to
entry to the network segment of the industry, and most of it can probably be regarded
as a natural monopoly.

The supply or retail segment includes a range of activities that would be familiar in
other utility sectors: metering, billing, customer service, and so forth. This segment
has historically been regarded as having the most potential for competition, because
sunk costs and economies of scale are less important here. The sub-market with
probably the lowest barriers to entry is supply to large industrial customers, where
contracting costs can be spread over a large quantity of demand. There may also be
economies of scope between some supply activities and similar activities in other
sectors, and if these are sufficiently important they might support competition for
customers with lower levels of demand.

Turning to sewerage, collection of wastewater is the infrastructure-intensive stage of
the chain. Treatment may occur either at the customer‟s premises, which often
happens in large-scale industrial operations, or it can be done centrally after
wastewater has been aggregated from large numbers of customers. The
disposal/discharge segment is heavily influenced by environmental regulation.

As I said earlier, our work on defining and analysing the market and understanding
the cost base and value of the various segments is still at an early stage. However,
using the very broad (and preliminary) descriptions of the various elements of the
value chain as we have described them here, we can begin to see what percentage of
the value chain each one comprises. I should stress that this is based on a range of as
yet unconfirmed assumptions and uses a stylised water and sewerage company and so
should be treated with caution.

Table 3 below shows the percentage of the value chain represented by each of the
activities I have described so far, with water represented by blue blocks and waste
water by green.




                                                                                         5
      Table 3: Illustration of value chain element as % of total value chain

                       Water and Sewerage Value Chain

     100%

       90%

       80%                                                         Sewerage

       70%                                                         Sludge treatment
                                                                   Sewage treatment
       60%
                                                                   Sludge disposal
       50%                                                         Sewerage Retail
       40%                                                         Water Retail
                                                                   Water Distribution
       30%
                                                                   Water Treatment
       20%                                                         Water Resources

       10%

        0%



In the first place, we see that the combined activities of water and sewerage retailing
make up less than 7% of the value chain, with wastewater retail representing 4% of
the total value chain and water retail representing less than 3%. While these are only
preliminary results, it may point towards opportunities for competition in combined
retail for water and sewerage services rather than purely for water. I will come back to
this later.

The largest segment of the value chain for the water sector is the distribution business
at 22% or so of the combined water and sewerage value chain. When we consider
water alone, distribution represents about 50% of the value chain. This seems to
indicate that the monopoly water network comprises a large part of the business.
Interestingly the “pipes” part of the wastewater market – the sewerage network –
represents only about 15% of the value chain – or a quarter of the value chain for
wastewater alone. Sewerage and sludge treatment by comparison make up more than
30% of the combined value chain. This is interesting in that this is a segment of the
market where there is already scope for competition through on-site treatment for
example. If we add in sludge disposal, where there is also scope for competition, these
activities combined (sewerage and sludge treatment and sludge disposal) make up
more than 35% of the total water and sewerage value chain – well over half of the
sewerage business alone.



                                                                                        6
We are carrying out some market analysis work which will be informed by these
results. For example, given that sewerage and sludge treatment make up such a
significant part of the value chain, we will be looking carefully at what is currently
happening in this market, what alternative products are available to customers, how
competitors operate and whether there are any barriers to competition in the market.
We will also consider how to best develop the regulatory regime in the light of
competition to date and any opportunities for this segment of the market to act as a
catalyst for driving competition in other segments.

Water resources and treatment combined make up just over 20% of the value chain
with water resources – abstraction and collection – being by far the smaller element at
about 4%. Again, this is something that bears further analysis but raises some initial
questions about the costs involved in abstraction and possibly, the value of the raw
resource, including environmental and social value of abstraction.

Bringing competition to segments of the water sector is not simply a matter of
removing legal impediments and standing back. History matters when a market is
being liberalised. Network utilities tended to be provided by public monopolies in the
past, and it is not normally possible to move instantaneously from state control to
robust competition. Liberalising potentially competitive activities usually involves a
dynamic process in which legal, structural and ownership changes happen first and
conduct regulation may be needed for a transitional period until effective competition
is established. The time this process takes depends upon the speed with which
competitive entrants can build up market share (often slowed by the presence of
consumer switching costs) and the requirement that the new political and regulatory
arrangements establish adequate credibility.

The liberalisation of the water sector may be viewed within this model, and there are
many parallels and lessons to be learnt from other sectors. Issues ranging from
transition concerns such as the potential for “cherry picking” have been tackled
successfully in other sectors, as has protection of customers through minimum service
standards and universal service obligations. The requirement for long-term investment
that arises in the water sector can be seen also in the electricity and gas sectors. For
there to be efficient incentives for investment in long-term projects with long-term
returns, regulation must be credible, and that in turn implies that the regime should
be transparent and stable. Under the current regime the water sector is proving very
attractive to investors.

But when we compare the sector to other network industries like electricity, gas and
electronic communications, several sector-specific complications are apparent. First,
the share of sector activity that is prospectively competitive may be smaller due to the
sector‟s cost structure. Supplying water involves moving “atoms, not bits”, so the cost
of transport is a relatively high proportion of the total cost of supply and the value of
the final product.




                                                                                         7
Second, there is no national network for transfer of water that is analogous to the gas
or electricity transmission networks. However, we must remember that the regional
and local nature of the water industry may lend itself to more interconnectedness at a
regional level, particularly as concerns about water shortages grow and the pressure to
share resources increases.

Third, environmental and social constraints have an unusually substantial impact on
sector costs and investment plans compared with other sectors. For example, health
externalities may rule out the sorts of disconnection policies that would be acceptable
for other utilities, and geographical averaging is prevalent for household charges.
Third, in common with telecoms, but in contrast to electricity and gas, water is being
liberalised while the incumbent firms remain vertically integrated.

These features of the water sector do not imply that there is no scope for competition,
but they suggest that active pro-competitive measures may be required, and even with
such measures, it is likely to take time to bring it about.


4      Policy options for the future
In this final section of the paper, I would like to discuss some alternative policy
options that might facilitate effective competition in segments of the water sector.
Ofwat does not have a settled position on all of these options; some are within the
powers of Ofwat to deliver and are under consultation at present,4 while others would
require primary legislation or action by other regulatory bodies.

I will divide the policy options into the usual economic categories of entry, conduct
and structural regulation. In the time available I will not be able to do justice to every
option I discuss, and many other options will have to be omitted. However, I hope to
give you some food for thought and discussion.

4.1      Entry regulation

Regulation of market entry tends to be frowned upon in economic circles. Stephen
Breyer memorably described the case for regulating to prevent excessive competition
as “the empty box.”5 Nevertheless, entry into water and sewerage supply markets is
regulated in England and Wales, and one of the policy options worth considering is
whether there is scope to allow entry to a wider group of customers or services.

I‟ll start with the current water supply licensing (WSL) regime. This mechanism is
intended to facilitate competitive entry into the supply of water, either through the
provision of retail services or what is known as “combined supply” where an entrant
introduces water into the network to supply that entrant‟s customers. The regime
requires that statutory water companies provide a range of wholesale services and
facilities, including network access, to entrants on a regulated basis, albeit the basis on
which these services and facilities are regulated is narrowly constrained. The scheme

4
    Ofwat, 2007b.
5
    Breyer, 1982, p.29.


                                                                                         8
currently has a minimum demand level of 50 Ml of water a year, which means that
about 2,200 large customers representing about 13% of the water usage in England
and Wales are eligible to choose a competitive water supplier. One obvious way to
increase the scope for competition is to lower this threshold.

The criteria applied by the Government for deciding on the threshold include effects
on the environment, resource planning, quality, financing costs and the complexity of
regulation required to facilitate competitive supply.

Ofwat supports the idea of moving to a lower threshold. We don‟t think it will jump-
start competitive activity on its own, but in conjunction with other measures it should
help to do so. We have also made the point that a significant one-off lowering of the
threshold would offer more certainty to entrants, in contrast to a gradual or
conditional programme of reductions.

A related, but longer-term option is to extend competition to the household sector.
This would open up a considerably wider market for supply competition, and it might
encourage new types of services such as multi-utility service packages including
water and wastewater.

This option would require primary legislation. The Government has previously
decided against household sector water competition on social policy and public health
grounds; in particular, that it would lead to unwinding of cross-subsidies and might be
costly to implement. Another issue is that the extent of household metering varies
across the country, although it is growing and recent statements by the Minister for
the Environment recently indicate that it may grow even faster in the future. In my
view, there has been surprisingly little public discussion of the case for household-
level water competition.

Another possible area for changing the legal framework to encourage market entry is
in sewerage services. Markets for some sewerage facilities, such as treatment of trade
effluent, are already contestable and as mentioned earlier we expect to look more
closely at whether these markets are effectively competitive. But the option of adding
retail sewerage services to the WSL regime is worth considering, particularly when
the incumbent companies have the advantage of providing single bills for combined
water and sewerage services.

There is already scope for competition under the WSL for the “production” part of the
water value chain, but again, this is constrained by the threshold. The initial work we
have done implies that the majority of the value lies in the treatment of the abstracted
water, but there may be bigger issues to consider around the availability of rights to
abstract water and the transferability of those rights.

4.2   Conduct regulation

We regulate firms‟ actions (or „conduct‟) when market failures are likely to lead firms
to behave in ways that would harm consumer welfare. In the water sector, these
market failures normally have to do with possession of market power by firms, the
presence of externalities, or a lack of incentives to provide important information. The




                                                                                       9
Government may face choices about whether to achieve particular regulatory goals
through regulation of conduct or market structure, but I‟ll say more on that later.
Most of the economic regulation implemented by Ofwat consists of conduct
regulation, other measures are imposed directly by government, and there are also
significant obligations imposed at European and domestic level in pursuit of
environmental objectives.

I want to mention two issues that are currently „live‟ for Ofwat and three more that are
likely to be important in the longer term.

Earlier, I mentioned that the WSL regime includes regulation of access to the
networks of statutory water companies. Among the most important parameters in this
framework are the access prices charged to entrants wishing to buy access to facilities
(including common carriage) or network services. Access price limits are calculated
using a methodology known as the “Costs Principle”. This is set out in primary
legislation, and in essence it is a „retail-minus‟ price control. The access charge is
limited to the retail price, less avoidable costs, plus costs of providing access.

Ofwat is concerned that this methodology does not facilitate effective competition,
and we have recently consulted on how it might be improved. Our research suggests
that the access prices resulting from it leave little margin for entrants. The WSL
regime essentially creates a new link in the supply chain, and due to the Costs
Principle the costs of this new link fall entirely on entrants. Also, the „retail-minus‟
character of the control limits the entrant‟s ability to undercut components of the
incumbent‟s retail costs that are deemed unavoidable, even if they may be inefficient.

We have also suggested that putting detailed access pricing rules in primary
legislation leads to inflexibility in the regulatory system; it would be better if the
Government set out the principles behind the access pricing regime and required
Ofwat to apply a suitable methodology.

A second live issue at present is whether a licensed supplier that is owned by or
otherwise related to an incumbent water company should be allowed to offer services
in its parent‟s statutory area. This is sometimes referred to as “in-area” trading. This is
prohibited under current legislation, and one could make a case for its prohibition on
the grounds that affiliated companies might be able to deter competitive entry by
obtaining preferential terms and conditions for services from their parents. However,
Ofwat considers that affiliated suppliers are more likely to add to the overall intensity
of rivalry if they can offer aggregated contracts on a national basis. They can only do
this if in-area trading is permitted, which would require a change to primary
legislation. Concerns about market power can be addressed by other pro-competitive
regulatory tools including separation either of accounts or structurally, which I will
come back to.

Moving on to longer-term conduct regulation issues, I want to reflect a moment on
how best to handle water quality objectives when applying regulation. In particular, I
am going to argue that cost-benefit analysis is especially important for those
regulating quality standards.




                                                                                         10
Quality regulation in a water context may have a narrow focus, for example on the
purity of a unit of delivered water, or more broadly on the environmental effects
arising from production and consumption of water services. Regulation is applied at
both levels.

Water quality in the narrow sense is regulated both because it has health implications
and because a statutory water company with market power might use that power to
offer a less attractive combination of price and quality than it would in a competitive
market. Note that most other markets allow customers to choose among a set of price-
quality bundles. If a water network can only deliver one level of quality to a given set
of customers (eg, a residential area), that means someone must choose the common
quality level centrally. Those setting the quality level should take account of how
much users are prepared to pay for higher quality, and there is no guarantee that
unregulated monopolies would choose the socially optimal level.

Water quality is regulated in the broad, or if you like „environmental‟, sense because
water supply markets are subject to externalities. In particular, suppliers and users do
not bear all the costs arising from their production and usage activities. Some of these
costs fall on third parties.

This problem may be corrected using regulation, but to do so requires that the body
applying the regulation identify the level of quality that is optimal for society. In
economic terms, the marginal benefit to society from water quality should equal the
marginal cost of quality. If this is not done, there is a risk that too much or too little
quality will be mandated, leading to lower welfare for society than could have been
achieved if a cost-benefit analysis had been done.

Of more direct relevance to Ofwat, it is worth mentioning that encouraging
competition can make it more difficult to apply and enforce centralised quality targets
in the narrow sense I mentioned earlier. The more competition there is in different
parts of the value chain, the more likely it is that different parties will be sharing
responsibility for the quality of a given unit of water. Attributing a quality problem
among vertical suppliers is likely to be more difficult than it was when suppliers were
vertically integrated. Moreover, competition may increase the tendency for suppliers
to differentiate water and sewerage services by some dimension of quality. Such an
improvement in choice for users is to be welcomed, but it may eventually imply a
shift in the emphasis of quality regulation from monitoring of common standards
towards regulation of customer information.

Another medium - to long-term option for strengthening water sector competition is to
require that statutory water companies produce some form of separated accounts. I
mentioned earlier that this could help address concerns in relation to in-area trading.
Imposing accounting separation would not require primary legislation, and it is a
measure on which we have recently consulted and which could deliver other benefits
as well as facilitating competition.

This sort of obligation is commonly employed in other sectors, including
telecommunications, gas and electricity, and it normally involves separating the
regulatory accounts for units within an incumbent firm that operate in competitive


                                                                                             11
segments of the market from those of units that are in monopoly segments,
particularly those that supply important wholesale services or facilities to competitors.
Accounting separation can make it easier to ensure that there is no unfair
discrimination between internal and external customers for access services, and it can
help to verify costs used in regulation of access prices.

I will speak in a moment about the possibility that structural regulation may reduce
the need for conduct regulation: accounting separation would certainly form part of
the overlap between them.

The final long run issue I want to raise concerning conduct regulation is whether we
will need to place more emphasis on identifying and eliminating barriers to switching
as we make the transition to competitive markets. The present focus of regulatory
activity is on getting the conditions right to foster competition, in particular by
removing barriers to entry and ensuring that required wholesale services and facilities
are made available at appropriate prices. Experience from other sectors suggests that
in the future we will need to place increasing emphasis on removing barriers to
switching by users. These sorts of measures have been particularly important in
sectors where small businesses and households are open to competitive supply, and
they normally involve actions to reduce switching costs such as administrative
burdens, time delays and operational disruption. It is also important that entrants and
customers can get the information they need to offer services and make informed
choices, respectively. There are also potential second-order switching issues such as
what happens if someone wants to switch from one competitive supplier to another or
to switch back to their local incumbent. This latter issue has already arisen in the
context of whether a formal „supplier of last resort‟ obligation should be imposed on
statutory water companies.

4.3      Structural regulation

Following a consultation in 2002, the Government decided that vertical integration of
the statutory water companies should be maintained. Vertical integration can be
beneficial for consumers, depending upon the cost structure of the sector. However,
we also need to recognise that when one is trying to introduce competition into a
sector, vertical integration of the incumbent firms leads to a need for more complex
and intensive regulation of firms‟ conduct.

Some observers in academia and industry, not least Professor Robinson,6 have
suggested that it might be better to impose structural or functional separation between
the network operations of the statutory water companies and their operations in
prospectively competitive segments such as water abstraction, treatment and supply.

The idea is that structural separation would remove the incentive that network
operators have to favour water production, storage and supply companies within their
own groups. With all vertical transactions taking place on a commercial basis, barriers
to entry to supply and production/storage should be reduced. The informational needs
of the regulator should also be lessened, since sales of network services would switch
from being predominantly internal transactions to being traded openly on the market.

6
    For a recent contribution, see Robinson, 2004.


                                                                                       12
Of course, it is important to remember that even in this scenario, the network
businesses would continue to require economic regulation going forward. Experience
from energy and telecoms markets also suggests that even the prospectively
competitive market segments would require some regulation of retail prices and
service quality until competition was fully effective.

The possible downside to structural separation is that the total costs of providing
water and sewerage might increase. This depends upon whether there are significant
economies or diseconomies of scope in these services. Ofwat and others have
considered this issue in recent years. The weight of evidence for economies of scope,
both between water supply and sewerage and between production and distribution,
seems to be stronger for small water-only companies than for the large water and
sewerage companies.7 There is also evidence that increasing returns to scale in water
supply and sewerage are limited to smaller firms, and more particularly to the
production segment, whereas larger firms in England and Wales may be operating in a
regime where there are diseconomies of scale.


5    Conclusions
Privatisation and yardstick regulation are due some credit for improving efficiency
and service standards in the water sector. However, to go further we need to
encourage competition where it is possible to do so.

This will not be easy, as shown by the slow development of the WSL regime and the
limited amount of inset-based competition over the years since privatisation. Vertical
integration, a sectoral cost structure dominated by long-lived capital assets and
strongly differentiated across localities, the social significance of water services and
the low per unit value of the sector‟s final product each contribute in different ways to
making it difficult to establish robust competition.

Nevertheless, I believe competition in some segments of the water sector is both
possible and desirable. I would welcome your thoughts on ways of strengthening
competition or otherwise improving the contribution of water services to the welfare
of society.


6    References
Breyer, S., 1982, Regulation and its reform, Cambridge, Mass: Harvard University
Press.
Byatt, I., Ballance, T and Reid, S., 2006, “Regulation of water and sewerage services”
in Crew, M. and Parker, D., International Handbook on Economic Regulation,
Cheltenham: Edward Elgar.




7
 See Garcia et al., 2007; Stone & Webster Consultants, 2004; Fraquelli et al., 2004; Saal and Parker,
2000. Additional research is surveyed in Byatt, et al., 2007, pp. 375-6.


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Fraquelli, G., Piacenza, M., and Vannoni, D., 2004, “Scope and scale economies in
multi-utilities: evidence from gas, water and electricity combinations”, Applied
Economics 36, 2045–2057.
Garcia, S., Moreaux, M., and Reynaud, A., 2007, “Measuring economies of vertical
integration in network industries: An application to the water sector”, International
Journal of Industrial Organization 25, 791–820.
Ofwat, 2000, The current state of market competition, July.
Ofwat, 2007a, International comparison of water and sewerage service, 2007 report,
April.
Ofwat, 2007b, Consultation on market competition in the water and sewerage
industries in England and Wales, 13 July.
Robinson, C., 1997, “Introducing Competition in to Water”, in Beesley, M.E. (ed.)
Regulating Utilities: Broadening the Debate, Readings 46, Institute for Economic
Affairs in association with the London Business School.
Robinson, C., 2004, “Water Privatisation: Too Much Regulation?”, Economic Affairs
24(3), 24-31.
Saal, D.S. and Parker, D., 2000, “The Impact of Privatization and Regulation on the
Water and Sewerage Industry in England and Wales: A Translog Cost Function
Model”, Managerial and Decision Economics 21, 253–268.
Stone & Webster Consultants, 2004, Investigation into evidence for economies of
scale in the water and sewerage industry in England and Wales: Final Report.




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Description: COMPETITION AND REGULATION IN WATER STRIKING THE RIGHT BALANCE