Private vs. public supply of

Private vs. public supply of water

Ernesto Schargrodsky reviews Thirsting for Efficiency: The Economics and Politics of Urban Water System Reform, edited by Mary Shirley, in the most recent Journal of Economic Literature. (Sept 2004, pages 882-884). Thirsting (Elsevier Science, 2002) is a collection of papers on private operation of municipal water supply in developing countries. Schargrodsky gives it a good review.

One lesson from the book:

"...the benefits of contracting out water services to private operation seem larger for countries with weaker institutions."

Schargrodsky finds this counter-intuitive:

"This last conclusion may sound surprising since a first intuition would suggest that weak institutions should lead us to favor public ownership, as private investments would remain underdeveloped for fear of appropriation. Weak institutional settings, then, should tilt things in favor of public participation in the incentives-versus-externalities trade-off. Inversely, strong institutional settings should foster private management."

But, what we see happening in the world is different:

"However, this is not the case: today most developed countries in the world operate water systems publically."

This could be because:

"To understand this paradox, the chapter by Keith J. Crocker and Scott E. Masten on the shift towards public water ownership through U.S. development suggests that the social value of these externalities grows with development."

On the other hand:

An alternative hypothesis, I believe, could also be advanced: these same institutional weaknesses usually induce low quality in the public sector bureaucracy and low constraints on the political misuse of resources, resulting in a more severe deterioration in the performance of water systems under public management. In better institutional environments, the relative disadvantage of public provision in terms of efficiency may diminish, making public provision relatively more appealing at similar externality levels."

Scott Masten illustrates the potential for appropriation in his paper, "Public Utility Ownership in 19th-Century America: The 'Aberrant' Case of Water". Arguing that public ownership of water and sanitation utilities has become far greater than public ownership of other public utilities, Masten asks why.

He finds the main answer in the greater difficulty of contracting for water and sanitation services, and the greater opportunities for one side or the other to take unilateral steps to redirect the rents from service provision.

"...I argue that a variety of factors did indeed leave water and sewer transactions more vulnerable than other utility transactions to appropriation hazards...

The nature of water supply (low marginal costs, high metering expenses) made pricing through access fees problematic:

The nature of water and sanitation limited the pricing of these services compared to other utilities in adverse ways, particularly, by constraining the application and size of fees tied to use of the services. First, water and sanitation services are unique among utilities in having both substantial metering costs and, under normal circumstances, (nearly) nonrivalrous consumption. The often negligible resource cost of water and sewer services combined with the self-operating character of the corresponding systems made the incremental cost of supplying these services, in many cases, virtually zero. Moreover, even if incremental service costs were nontrivial, the positive public health externalities of centralized water and sewer use (both directly and in relation to each other) dictated against significant service charges. The appropriate unit price for water and sanitation services in light of these considerations would typically have been too low to justify the cost of installation and reading of meters.

Other utilities, by contrast, had either substantial marginal costs of service or low metering costs. Thus, although utilities like gas and electricity had metering costs comparable to water’s, the inefficiencies that would have resulted from failing to assess charges based on usage given the substantial variable costs of generating electricity and manufacturing gas would have justified metering of these services. And although telephone and telegraph services had low marginal service costs, these services also enjoyed exceptionally low metering costs: Monitoring of use could be performed from a central office, avoiding the expense of installing and gathering data from on-site meters.

At the same time that metering costs discourage the application of usage charges, the relative difficulty of excluding access and preventing resale of water and sanitation services limited the size of access or connection fees. Whereas electricity and gas are difficult, even dangerous, to transport and store, water can be carried or stored in barrels or other containers or diverted with pipes or hoses with little cost or risk. Moreover, to the extent that access fees deterred use, public health and nuisance concerns also constrained the fees municipalities would have wanted charge for access to water and sanitation services."

Because there were problems with private water companies cost recovery through user fees, private companies were more dependent on government transfers for revenue - increasing their exposure to attempts to appropriate rents:

"The need of water and sanitation utilities to rely more heavily than other utilities on inframarginal payments (payments unrelated to either use or access) to recover their capital costs...

...a privately-owned utility that cannot recover its costs through access or usage charges must to some degree rely on transfers from the government for its revenue. Dependence on transfers from municipal authorities, however, increases the utility’s exposure to appropriation efforts: Transfers make tempting targets for redistribution. The need of water and sanitation franchises to rely relatively heavily on inframarginal payments from municipal revenues for their income would have increased the need for negotiated adjustments and occasioned greater opportunities for conflict and appropriation."

Both sides could have scope for manipulating the terms of the contract:

"...If a party to a water or sewer contract did become dissatisfied with the terms of the agreement, the nature of water and sanitation systems provided that party with ample opportunities and a set of tactics to evade or amend the contract. First, compared to utilities such as electrical and telephone service whose delivery primarily entails installation of aboveground poles and wiring, the installation and repair of the underground distribution network of water and sewage systems has the potential, particularly in urban settings, to cause significant disruptions to traffic and commerce. Second, and in some ways more important, water is essential for fighting fires. To assure that firefighters have access to water supplies that are adequate in terms of both quantity and pressure, water systems must be capable of providing large volumes of water at high pressure. Historically, the failure of water systems had been responsible for or contributed to a number of major urban conflagrations. The potential for disruption and, in the case of water, destruction from the withholding of cooperation or simply from exercising less-than-full diligence made cooperation important but also created a valuable tactic that private suppliers of water and sewer services could exploit in search of price or other concessions from the city. On the other side, city officials could attempt to use feigned dissatisfaction (or even interference) with the utility’s provision of these services to justify reducing payments or revoking a utility’s franchise."

Contracting problems would be expected to be worse the more densely populated the city:

"Since the disruptiveness of installation and repair activities and the hazards of fire increased with population density, the potential for and cost of conflicts over contract to terms were likely to become more acute as cities became more congested."

Masten does find that,

"...cross-section analysis of waterworks at the turn of the century [the 19th to 20th, not the 20th to 21st - Ben] shows population density, which aggravated two of the central sources of contractual friction between cities and private water companies, to be the most important determinant of public municipal ownership."

Revised later in the evening, 11-8-04