USC Study Examines The Issue
Of Privatized Public Water Service

A briefing paper on a new report
by the University of Southern California

prepared by the Association of California Water Agencies
December 1996

Successful privatization efforts, such as Britain's sale of British Air and Rolls Royce to private sector companies, are touted by some pro-privatization scholars and politicians as examples of what could be accomplished by the privatization of public utilities, such as water service.

Now a new research paper by Stephen P. Morgan, D.P.A., and Jeffrey I. Chapman, Ph.D., of the University of Southern California School of Public Administration, Sacramento, debates some of the common assumptions - for example, "government bureaucracies are inefficient," "the private sector is naturally more efficient" - behind the privatization of public water service.

The paper, titled "Issues Surrounding the Privatization of Public Water Service," states that since the Progressive Movement began its effort to "modernize" local government at the turn of the century, public sector reformers have pushed reform measures aimed at making government more businesslike. Since 1955, the federal government has issued a series of directives urging its agencies to look to the private sector before initiating any efforts to "...provide a commercial product or service if the product or service can be procured more economically from the private sector."

Without competition, the private sector does not function efficiently. Prices are allowed to rise because buyers have no alternative
to compare.

In January 1996, the Reason Foundation released a report calling for the privatization of water. Called "Restructuring America's Water Industry: Comparing Investor-Owned and Government-Owned Water Systems," the report concluded, "California and other states should adopt policies which encourage the termination of government [production of water service]."

After reviewing over 45 studies, papers and books on the topic of public utility privatization, the USC study concluded that many services are not suitable for privatization, and in those instances when privatization might benefit utility customers, local government should often continue to be involved.

Specific conclusions of the paper include:

• Private sector companies work well in competitive environments, but do not perform as well when competition is absent, such as in industries where natural monopolies occur.
  
  
• Utility functions, such as water service, are natural monopolies, where it is expensive and inefficient to have more than one service provider in a given geographic area.
  
  
• The regulation of private sector companies operating in a natural monopoly can lead to inefficiencies.
  
  
• The public sector is often more sensitive to public needs such as quality of life and equity of service.

Public Sector vs. Private Enterprise

There is a tendency to assume that the private sector is a naturally efficient, responsive deliverer of products and services, and that the public sector is naturally bureaucratic and inefficient. In truth, the two sectors exhibit different strengths and weaknesses.

While the private sector is motivated to maximize earnings for its shareholders, the public sector has the dual responsibility of providing equitable and responsive service to all its citizens while spending tax dollars and fees wisely.

Because monopolies create inefficiency in the private sector, private water service may lead to market failure. The public sector is at its best when addressing market failures such as those that occur in monopolistic situations.

Competition is essential for the private sector. The discipline of a competitive marketplace provides the incentives private business needs for efficient production of quality goods and services at low prices. To succeed in a competitive environment, sellers must make sure the price and quality of their products are comparable to those offered by competitors. The more competitive a market is, the stronger the incentive is to be as efficient as possible.

The private sector has little incentive to function efficiently without competition. As a result some sort of regulatory body must intervene to maintain low prices and high quality. Regulators are not as effective at holding down prices as a competitive marketplace.

Water supply is considered a "natural monopoly" because it has the following characteristics: it is capital intensive (having significant fixed costs); it is viewed as a necessity (or essential to the community); it is non-storable (yet subject to fluctuating demands). For example, it is not economical for multiple companies to run parallel pipelines into the same neighborhoods since the prohibitive costs of doing so would more than offset any advantage customers might gain by being able to choose their own water supply provider.

A natural monopoly does not support efficiency in the private sector because there is no market to impose price and quality sensitivity on a product. On the other hand, if the public sector provides these services, rates are set by elected officials who are accountable to the voters of the community. If they are to continue to hold office, they must respond to citizen interests, which include access to information, low rates and responsiveness.

It must be acknowledged that government is not perfect. Parallel to the concept of market failure, for example, is the concept of government failure. There are three basic reasons why government may be inefficient: problems that are inherent in a direct democracy; problems inherent in representative government; and problems inherent in bureaucratic supply.

Limits to Regulation

Private water utilities are accountable to two groups, neither of which directly represents their customers. First, they are accountable to shareholders, whose interest is in maximizing profits and who likely do not live in the communities served. Second, they are accountable to a public regulatory body whose purpose is to represent the interests of the citizens, but may be hundreds of miles away from the service area, and often provides a poor substitute for marketplace discipline or ballot box accountability.

Private water companies are accountable to shareholders, whose interest is in maximizing profits, and regulators, who may be hundreds of miles away from the service area.

Regulation is imperfect for a number of reasons. The most important of these reasons is that in private sector settings, regulators tend to become "captured" by the industries they control because they are reliant on these industries for much of the information they need to do their job.

Also, regulators set prices without the natural pressures of a competitive marketplace. Regulators usually follow two approaches to protect consumers from unfair rates: rate-of-return price setting, or price regulation. Rate-of-return allows utilities to cover their legitimate costs and pass along a reasonable profit to their shareholders. Unfortunately, because costs can be passed through to customers, it is in the interest of the utilities to justify costs rather than contain them. Since the companies provide information which documents their cost, it is often relatively easy for them to justify higher fees.

Price regulation sets an allowable price for a specified period, and therefore is supposed to reward operators who increase the efficiency of their systems with higher profits. In Great Britain, however, where a version of price regulation is being tried, it has been demonstrated that there is a fine line between cutting costs and cutting corners. Companies can delay required maintenance in order to receive short-term profits, then argue for increased rates to cover suddenly-critical maintenance requirements. The British example also has shown that regulators may reconsider prices before the end of the fixed term, which makes this system untenable because companies must have confidence in their income stream if they are to make long-term investments.

There must be a regulatory body no matter what type of regulation is applied. The 1996 Reason Foundation report suggested agencies like California's Public Utility Commission provide alternatives to the democratic access citizens have with locally elected water boards. The regulatory alternative is an inferior one, however, because these agencies often meet hundreds of miles from the customers' service area. Additionally their commissioners are appointed, not elected; and rate proposals are but one of many decisions made each year. Conversely, rate change decisions are among the most significant for locally elected water boards.

Comparing Public and Private Sector Water Utilities

A series of studies, conducted over the past 25 years, has compared private and public sector utilities working in similar monopoly environments. These studies have failed to show efficiency advantages for private firms, and in fact, frequently show greater efficiencies for government-owned utilities. John D. Donahue has summarized the findings of major studies comparing the relative efficiency of public and private water companies as follows:

(Donahue, The Privatization Decision: Public Ends, Private Means, 1989)

The British Experience

The 1996 Reason Foundation Report used the privatization of Great Britain's water system to illustrate the positive potential for such an undertaking in this country. However, the British experience with water privatization has been considerably less than successful; in fact the Wall Street Journal termed it "a disaster." Selling the water system to privately owned monopolies proved the hypothesis that market failure can result from such actions:

• Prices have risen an average of 77 percent - much more in some cases.
  
  
• Salaries of executives at newly privatized utilities are many times higher than those of their public sector counterparts.
  
  
• In some areas, private companies have not been able to meet demand during a drought. In other areas, rationing has been imposed not because of drought, but because as much as 37 percent of the water supply is lost through leaks in the system.
  
  
• Companies have sent out bills more than two years in arrears, then illegally threatened to turn off the water of customers who fail to promptly pay.

High prices, low quality and inefficiency are not just textbook theories of monopolistic behavior. They are the daily realities of the British water privatization experience. The Wall Street Journal wrote:

Six years [after privatization], is efficiency up? Ask the thousands who can't water their roses. Prices down? Ask the millions whose bills have doubled. Competition? Not unless you count Perrier.

It seems the only people who have benefited from the privatization of the British water system are the shareholders of private firms. The government sold the system for $8 billion in 1989, but shares in the private companies are now worth $20 billion collectively. That makes it unlikely the British government could take back the water system, even if its citizens demanded it.

Checklists

Great Britain might have avoided these difficulties if decision-makers there had employed any of the privatization checklists compiled by several different authors. These checklists suggest the true magnitude and complexity of the privatization issue, as evidenced by these questions regarding privatization posed by Elizabeth Hill, director of California's independent Legislative Analyst's Office:

• What are the goals and objectives of privatization: coping with short-term financial problems, or gaining long-term effectiveness and efficiency?
  
  
• What is the proper form of the privatization? Who will be responsible for policy-making? Funding? Administration and oversight? Service delivery?
  
  
• Are the conditions right to privatize, with competition/contestability, abundant information and no free-riding problems? If not, privatization may lead to higher costs and deteriorating service.
  
  
• What are the potential problems and risks of privatization? Have accountability, the accuracy of cost comparisons, quality control and other considerations been fully analyzed?
  
  
• What remedies will the government have if the privatization turns out to be less desirable than initially promised?

These questions, and many more detailed in the Morgan and Chapman study, should be asked and answered when any policy-making body is considering privatizing water utility services.

Conclusion

Government must not be considered the institute of last resort. It plays an important role when the market cannot or does not respond to the needs or priorities of a community.

Myths about the relative efficiency of the private sector and the public sector make no contribution to a thoughtful discussion of the potential benefits of privatizing government service. The reality behind these myths is that private firms are better suited to a competitive environment - not because they are "naturally superior," but because market forces require them to be efficient. However, government may be better suited to provide service in the environment of a natural monopoly.

Prices tend to rise, quality goes down and inefficiencies abound in a monopolistic environment - not because the private sector fails, but because incentives to perform otherwise are absent. Additionally, rate-of-return regulation provides no incentive to contain costs further discouraging firms from being efficient. Regulation is intended to limit the negative effects of monopoly on private enterprise, but it is not as effective in holding down prices as a competitive marketplace or the ballot box.

Government, on the other hand, must not be considered the institute of last resort. Rather, it plays an important corrective role when the market cannot, or does not, respond to the needs or priorities of a community.