6.3 Water System Privatization

The issue of private sector participation in the provision of water services is one of contemporary debate in many of the world’s nations. For example, the 1994 World Bank Annual Report advocated a much-increased role for the private sector in the provision of what are commonly considered to be public goods. The report drew its conclusions from many observations and analyses the found that private sector efficiencies were large enough to more-than-offset private sector needs to make a return on investments from their operations. Also the Bank produced evidence that even the poorer classes would benefit from privatization, including water system privatization.

In many countries of the world, and for a variety of reasons, governments have recently experienced rising annual deficits and increasing national debts. As part of the effort to control these perceived problems, programs are being established to control deficits by decreasing spending. One of the results of these fiscal pressures has been a realization that formerly pure pubic services have significant potential to be funded through private markets as an alternative to reducing services, they can utilize the market system to achieve their objectives. This trend can be attributed to a number of factors, from a renewed interest in the possibilities arising from the use of Adam Smith's "invisible hand" concept to Savas' (1986) conclusion that "a more educated, critical and sophisticated citizenry no longer regards government action as synonymous with the public interest." Also, in many areas, a public perception has grown that governments have grown too large and inefficient to be effective (Watts, 1988). The solution to these problems frequently suggested for the municipal water industry is partial privatization to achieve reduced government, increased efficiency and least cost production. Such suggestions often have considerable merit, but require close examination, for they imply substantial changes in the municipal water industry that may or may not be justified.

The subject of water system privatization is a huge one, and one which is controversial in many quarters. It pertains most directly to one of the public policy issues dealt with in the last part of the book (Chapter 22). That chapter includes an in-depth economic analysis of the issue. In the present chapter, the aim is to examine privatization as a major sociopolitical issue in water demand management. This section discusses what is meant by privatization, or public-private partnerships (PPP), and attempts to present a balanced view of the advantages and disadvantages of the PPP debate. The literature is quite polarized on this particular issue, and the discussion here draws no conclusions, in favour of presenting the main facts in the debate. Canada’s National Round Table on Environment and Economy was unable to reach a consensus on this issue after extensive stakeholder discussions (NRTEE, 1996). This is one example of how contentious the PPP debate can become.

 

6.3.1 Definition

In the simplest terms, PPP (or privatization, as it is often called) refers to individuals or businesses in the private sector performing a task previously done by the government. Some argue that this method is efficient and cost effective while others refer to it as being profit-minded at the expense of the public water user. To a significant degree, the private sector has always been involved in municipal water servicing, most significantly in the design and construction of various water system components. What distinguishes PPP currently from past practice is the degree of private sector involvement, and, in many cases, the possible equity position of private operators in the ownership of systems

In the municipal water servicing industry, PPP may involve transfer of ownership to the private sector (as was recently done in Great ), but may also include municipal ownership and private sector operations of water servicing facilities; private sector design, building, financing and lease-back of system parts; and full franchising of municipally owned systems to private management. This wide variety of options permit municipalities a large degree of flexibility in choosing alternatives for providing water services.

One basic economic principle is crucial in making a PPP decision. In a situation of natural monopoly, which characterizes the municipal water industry, it is socially undesirable to privatize water services completely, for reasons to be described below. But, increases in economic efficiency are possible by employing PPP alternatives, such as franchising or contracting out part of the service. For example, firms could be asked to place bids for the right to operate a municipality’s water service system over an extended period of time (e.g., 20 years). Under conventional contracting practices, the right would be awarded to the firm that offers the lowest bid, thereby achieving service provision at least cost and an efficient allocation of resources. Table 6.1 provides an overview of various PPP options. The options run from current practice in most nations, whereby design and construction of facilities is done under contract by private sector firms to full private sector ownership and operation of systems. For most of the options, the public retains ownership of the water system. "Privatization" therefore seldom means full private ownership. This is an important consideration when discussing some of the economic aspects of this issue.

Table 6.1 Options for Municipal Water System Privatization

 

Option

Design Construction Operation Ownership
1 Design by Private Sector Consultant Competitive Construction Bids Public Operation Public Ownership
2 Design by Private Sector Consultant Competitive Construction Bids Short Term Contract with Private Firm Public Ownership
3 Design by Private Sector Consultant Competitive Construction Bids Long Term Contract with Private Firm Public Ownership
4 Design and Construction by Public Agency Public Operation Public Ownership
5 Design and Construction by Public Agency Short Term Contract with Private Firm Public Ownership
6 Design and Construction by Public Agency Long Term Contract with Private Firm Public Ownership
7

Full Privatization

20 Year Contract with Private Firm Private Ownership and Financing
(Maclaren, 1995, p.7)

6.3.2 Advantages of PPP for the Public

The advantages and disadvantages of PPP are assessed here from the viewpoint of the public, not the private sector. Clearly, the latter view the PPP issue as a profit-making opportunity. The public sector, on the other hand, has a different set of values and motivations. This section provides a summary of the main advantages of PPP for the public, while the following section discusses some of the disadvantages.

6.3.2a Capital Requirements

As shown in Chapter, municipal water services are very capital intensive. One example of this is found in Canada, where Tate and Lacelle estimated that an estimated $45 billion was required over the 10-year period 1993-2003 for municipal water system renewal. This estimate was about $30 billion under the estimate made by NRTEE (1996), largely because of differing assumptions. Regardless of the differences, these projected costs are massive. The same type of finding has been made in the U.S. (Wade Miller and Associates, 1987), as well as in other nations. Quite simply, this reinforces a previous point that water infrastructure is the most expensive of all public utilities.

The obvious question arising relates to future sources for these funds. Governments once provided much of the funding, with the remainder being composed of user charges of various types. Typical percentages of municipal water system expenditures provided by governments in the past, for the four main water infrastructure components are given in Table 6.2. For various reasons, such as global competitiveness, new funding priorities, and growing government debt, public agencies are decreasing their contributions for water servicing drastically. Advocates of PPP maintain that the private sector could supply this capital need in return for a profit-making opportunity. Large private water companies, such as Lyonaise des Eaux in France, already operate effectively in many countries, and act as capital providers. Indeed, the private sector literally rebuilt the French water infrastructure following the massive destruction of World War II. Thus, there exist already many examples that PPP can be effective.

 


Water Acquisition and Treatment

Water Distribution

Wastewater Collection

Wastewater Treatment

Source: FCM (1985)

User Fees

75


76

55

66

Public Contributions

25


24

45

34

6.3.2b Competition for Available Capital Funds

As societies develop, an increasing need occurs for more and different kinds of infrastructure. These range from traditional public works such as water services, to much more visible undertakings, such as municipal arts centers, modern city halls, etc. Thus, the competition for limited available public funds increases and fairly often inground assets, such as water supply and treatment systems are downplayed in favour of the more "visible" public works. (It is difficult to name a water or sewer system, for example, in honour of a politician.) This means that capital availability for public water projects may decline over time, as they have in many nations throughout the world.

Under these conditions, the private sector has been suggested as a possible source of alternative funds. Capital would be raised in private markets and devoted to water servicing infrastructure. It has been suggested by private sector entrepreneurs that this is a feasible and viable method of municipal infrastructure financing. It would allow municipalities to divest themselves of the need to devote large portions of tax revenues to water servicing, in favour of other types of public works. This would apply not only to capital expenditures but also to annual operating and maintenance expenses.

6.3.2c Reducing Municipal Overheads

This point relates to the one immediately above. The private sector under a PPP arrangement would be responsible for all capital and O&M expenses, thus freeing municipalities to devote their tax revenues to other issues and possibly lower taxation levels.

6.3.2d Implementation of Full Cost Pricing

The implementation of full cost pricing is often constrained by the political process when municipal water systems are under the direct control of elected councils. It is certainly true that increased charges, such as those which would accrue as a result of the move to full cost pricing, could be conceived as additional taxation. In current political environments municipal councils the world over are reluctant to be perceived as raising taxes. Although, the issue of water rates is better conceived of as service charge similar to the payments made for telecommunication services, the public in general perceives increases in water rates to be additional taxation.

By introducing an element of private sector operation into municipal systems municipal councils could thereby avoid having to raise water rates directly. Rather increased water charges would be made by the private sector companies operating the municipal systems, thus avoiding potential embarrassment at the political level. In the author’s opinion, this factor is one of the best arguments on favour of PPP arrangements, for it minimizes direct political interference in the rate setting process. Although there will still be public oversight under PPP, the rate-making process itself would take place under a more rational set of circumstances than they do currently under direct political control.

6.3.2e Risk Considerations

It is commonly understood that if a party has an equity interest in a particular type of capital facility there is an inherent incentive to manage that facility effectively and even optimally. Because a municipal systems are owned by the public, for the most part, there is no equity interest on the part of personnel who operate the systems. This does not necessarily mean that facilities are badly run currently, for this can neither be proven nor disproven. Rather, it suggests that private firms with an equity interest in water system facilities may have the incentive to operate facilities much more effectively than public sector employees. This contention is not necessarily advocated in this book, but rather has been suggested in various pieces of literature (e.g. NRTEE, 1996).

6.3.2f Introducing Quasi-Markets for Water

Chapter Four emphasized that the lack of organized markets in the water industry was a definite factor in introducing inefficiencies in operations and constructed capital works. This lack of markets is partially responsible for the overusage of water and the overbuilding of water related infrastructure. Under PPP several firms would bid for the opportunity to operate and maintain particular municipal water systems. This competitive bidding process, assuming that is was free of collusion, would introduce a quasi-market into the water industry. This would establish some of the competitive forces which operate currently in private markets and would also be a force for technological innovation.

6.3.2g Summary

There are, accordingly, a number of valid arguments for why PPP should be introduced into municipal water servicing. However, these should be offset by a number of disadvantages, which are equally strong. Its is to the discussion of that we know turn.

6.3.3 Disadvantages of PPP for the Public

6.3.3a Privatization of Natural Monopolies

A natural monopoly occurs when economies of scale occur over a very wide range of production levels. This means that average costs fall and therefore that marginal costs, which are critical in price setting in a private market setting, will often be under average costs. This was illustrated in Chapter four. The argument against private ownership of natural monopolies is a traditional one and reaches back into the 19th century when the famous economist J.S. Mill argued that natural monopoly conditions would lead to private sector companies engaging in wasteful competition. Each firm would be inclined to decrease price in order to increase its market share and to reduce its average cost. The resultant economic warfare would lead almost inevitably to only one survivor - the natural monopolist. When this occurred the monopolist would have the incentive to raise price and lower output in order to maximize profit. This argument is documented in many microeconomic textbooks and is the subject of detailed discussion in Chapter 22. The counter argument is that competition might occur between firms to service and entire service area rather the individual customers. Firms would therefore compete to obtain these concessions, thereby introducing the competitive forces of the market. This point is covered in the preceding section. Demsetz (as cited in Hanke and Fortin, 1985) supported this idea that competitive results could occur even under conditions of natural monopoly. This advantageous outcome could be established simply by setting up a franchising situation and having firms compete to serve the franchise rather than individual consumers. Demsetz thus claimed that the inefficiencies of public enterprise could be avoided simultaneously with the inefficiencies associated with natural monopolies. The key here would be the bidding process itself. In order to achieve efficiency which agreed to the required service at the lowest price would be awarded the franchise. Public agencies would act as bargaining agents in this type of situation.

Thus, while the natural monopoly problem in the water industry is a real one, there may be methods of circumventing its more serious effects. The type of franchising operation suggested by Demsetz occurs very commonly in France, as mentioned above, and is also practised in many areas in the U.S. For example, it is claimed by the company vice-president, Limbach (1993), that the American Water Company, a private sector operation, supplies some 20% of municipal water service requirements in the U.S. It does this through competitive bidding at a competitive price and secures a profit from these operations.

6.3.3b Risks involved in Relying on Private Firms

While the advantages outlined above are no doubt real, it is possible that private sector firms chosen to operate franchises may encounter economic or technical difficulty and may be unable to deliver the promised degree of service. Thus, there is some risk in adopting PPP in relation to traditional public sector operations. In the case of water resources, this is particularly critical because the service provided has an "essential" characteristic to it. In many other areas of public infrastructure, such as solid waste disposal, private sector companies are known to have failed to provide the required level of service (Denham, 1993). While the contract for franchising may include penalty clauses, it is possible that private sector firms could become financially unviable and, thus, unable to provide service. This type of situation although uncommon would leave the public agency ultimately in charge of the service in a very difficult position.

6.3.3c Diversion of Revenues into Profits

It is well known that private sector operations rely for their viability on making a profit. Often the criteria for profitability is over 10% of operating revenue. Accordingly, these profits must be derived from the revenues paid through user fees. The private sector claims that efficiencies introduced through private operations will more than offset this need to make a profit and might even result in lower user charges. This claim remains unproven in aggregate, although there are many anecdotal claims that the efficiencies of privatisation are so great that they need for profitability is more than offset.

There is also evidence from some areas, for example in Great , that private water companies may diversify into other areas with water servicing becoming relatively less important. For example, in , where large sections of watersheds have been turned over to private water companies, the water companies are actively pursuing profitable land sales, an activity not anticipated when the very substantial privatisation services occurred.

6.3.3d Labour Concerns

A common objection to increasing private sector involvement has been the objection of various labour organizations and their members. The argument proceeds that public sector jobs are relatively secure and relatively high paying as compared to those in the private sector. To some degree this is correct because public agencies must be perceived to be operating in a socially responsible manner and part of this responsibility is viewed as providing adequate income. The labour movement is apprehensive that private sector involvement means reduced wages for their members and job loss. These concerns have been inadequately addressed in any of the privatisation literature.

6.3.4 Summary

The material presented here has attempted to cover both sides of the privatisation debate. It is at this point not possible to draw any conclusion for or against PPP. Despite the fact that many public officials are actively advocating such a move. Chapter 22 will deal with the economic issues underlying privatisation in more rigorous fashion than was done in this section. To anticipate the result of that discussion it can be stated that with effective pricing practices there appears to be no good reason that the public sector cannot operate water systems as well as the private sector. However, this finding cannot be conclusive and the debate of this issue is likely to proceed over a fairly lengthy period of time.