Public, private or a bit of both?

No one has yet found the answer to water industry control

No one has yet found the answer to water industry control

Before privatisation the water industry was largely in the public sector, and for good reasons. It is a natural monopoly, there are strong environmental considerations and the public has difficulty with the concept of such an essential service being the source of profit for private investors. After the war the idea was to have autonomous agencies with political supervision but not control. But in the event, ever more complex and contradictory rules emerged, and political interference grew. The resulting industry was not efficient, and the mechanisms for deciding on appropriate investment were too weak.

By the 1980s the investment required to meet new quality standards and a backlog of maintenance was large. Privatisation meant that these investments would not have to be met through the public purse and, importantly, it fitted the prevailing ideology of bringing private-sector incentives and efficiency improvements into a sluggish public-sector industry.

Although the problems have not gone away, the privatised industry has tackled them better. A huge investment programme has been financed, and there have been large and sustained efficiency improvements. But the public disquiet remains, particularly as increased efficiency has led to high profits. It also did not help that the benefits of the huge investment programme were largely invisible (for example, reductions in nitrates), while a series of long, hot summers placed an intolerable strain on infrastructure designed to cope with average weather and demand.

The basic issues of how to procure investment and how to drive efficiency improvements exist under both public and private regimes. The problem - economists call it "principal/ agent" - is one of differences in information and incentives between players. Companies know best about their businesses but do not have the same motivations as politicians. So regulators are needed to protect consumers from excessive prices and to ensure quality standards, investment and efficiency.

With the rise of the economic regulators of the privatised utilities has come recognition that rule-based regulation is imperfect. Rules are approximate and cannot provide the detail needed in a world where both the environment and companies' behaviour are constantly changing. This has led to increasing use of "discretion" by regulators as they seek to avoid the clumsy constraints of a pre-defined regulatory process. The difficulty is that too much discretion in turn destroys the incentives of the regulated firms and hence can negate the benefits of privatisation.

In other industries the answer often lies in using competition to protect customers and provide incentives for companies. But herein lies the other problem for water. The huge replacement costs of its pipe system make direct competition infeasible, because it is too expensive to build parallel underground water and sewerage systems. And the fact that prices to the customer are so far below the level needed to pay for these assets makes the design of a rational system of competition rules almost impossible.

The alternative - comparative competition across different regional monopolies - has also been found to be flawed. It turns out to be very difficult to compare, for example, the cost of providing water and sewerage services in Wales with that in Greater London, given their very different physical circumstances. International comparisons are even harder, because different political and regulatory systems invariably serve to hide or subsidise costs in different, and often inconsistent ways.

Thus regulation will be an enduring feature of water. But when enduring regulation is coupled with principal/agent problems, the same old problems inevitably re-emerge. Without the prospect of serious competition, a structural solution is not possible, and one is left with the regulator attempting to decide on a whole series of trade-offs: between price and investment; between intrusive regulation and preserving incentives; and between the wishes of politicians, consumers and shareholders.

What are the alternatives? Other methods of injecting private capital have their own problems, often reflections of the problems discussed above.

In France the problems of regulating and rewarding a heavily monopolistic industry were avoided by franchising out the operation of much of the system while leaving the ownership of the pipes under public control. But in such a capital-intensive and geographically specific industry, the advantages of the incumbent in the bidding process are high. Hence it is difficult to ensure that repeat franchises are genuinely competitive, and there is considerable scope for corruption.

Australia and Scotland have chosen to seek private-sector finance for investment in a public-sector industry. Yet here the same problems merely emerge in a different form. In Australia issues of cross-subsidy between irrigation systems and conurbations, and between the newly created regions within, say, Victoria, cause difficulties. In Scotland, although the authorities remain publicly owned, a new raft of monitoring is already being introduced. Private finance has so far been limited to relatively large projects; as smaller projects are attempted, so the transaction costs and difficulties in defining risks will increase.

There is no clear-cut answer to the question of whether Britain was right to privatise water. All depends on the skill with which any chosen regime is applied in practice, as the benefits and pitfalls apply, in some combination, to all of the possible regimes. On balance, the water regulator in the UK has so far done a difficult job rather well.

Over the long term, though, the difficulties will increase as prices rise to cover the replacement, expansion and improvement of the system. Historic subsidies will diminish, yet investors will continue to need a return for their growing asset base. The danger is that we will respond to this by ever more complex and contradictory rules, thus bringing privatisation into disrepute - in the same way that the public provision of utility services fell into disrepute a decade ago.

Nick Morris is chief executive of London Economics and a visiting professor at the City University Business School