3 cheers for a privatised water industry



The last time we saw a change of government in our green and pleasant land it was to the fanfare of “things can only get better”. How different now with our most recent change of government. The new Con-Dem fanfare is more like “things are bad and only going to get worse”. Its enough to bring out the Marvin in us all: “The first 5 years were the worst. The second 5 years were the worst too. The third 5 years I didn’t enjoy at all. After that, I went into a bit of a decline.”(1) And with an emergency budget brim to the full of changes in policy direction, we can’t help think Marvin might now be working behind the scenes at 11 Downing Street: “I have a million ideas, but they all point to certain death”.


But lets cheer ourselves up. While the new politics is not really that different because such fanfares come with the caveat “and please remember it wasn’t our fault”, the current doom and gloom about the impending “savage” (remember who said that?(2)) public sector cuts helps paint the 20 years of privatised water in England & Wales in a somewhat different and we think largely positive light. More than that, we suggest there might be (at least) three reasons to be cheerful about our privatised water industry. Readers from Scotland & Northern Ireland (and maybe elsewhere) might want to ponder on whether this is 3 reasons to think about having a privatised water industry.

(1) With apologies to Douglas Adams for such blatant paraphrasing. Some of us think a 5 year regulatory cycle can feel like 10 million years.


(2) Gold star if you answered the new deputy prime minister Mr. Clegg (uttered in his speech to his Party conference in 2009).


Reasons to be cheerful #1

Private water companies are masters of their own destiny (if they behave)


80:20 is the new golden rule for the management of the public purse(3). 80% of the effort to reduce the public sector deficit will be borne by reducing what Government spends. 20% will find its way into the taxes we pay.


Spending less is to be the new virtue. Ministers who want to survive the resurrected Star Chamber will have to show that what their departments do is more vital than that of their peers.

Difficult choices will need to be made(4). Knowing whether something is vital of course is irrelevant to making those choices. Everything in our interest group infested political system is apparently vital. It is the “more” bit that matters.


Take an example heard on the airwaves in the days preceding the recent budget as various public bodies made their pleas to be spared the Treasury knife. Public expenditure on flood defences is vital it was asserted and listeners were told that for £1 of public money spent on flood defences the public gets back £5 of benefit.


Spending a £1 on something worth £5 sounds a good deal. But that is not what matters or is relevant to our tough choices. What matters is whether it is the best deal. Suppose I currently spend £2: £1 on flood defences and £1 on free gym passes for people with BMIs above 30 (5) – and my difficult choice is that I can only in future spend £1. Which £1 do I cut?


Knowing my £1 on flood defence gets me a whopping £5 of less flood risk is not enough. I can only make the decision if I know how much benefit I get for my £1 spent on free gym passes. And if that £1 gives me £6 of benefits the decision becomes clear. Both flood defence and fat defence are vital, but on these numbers the latter is more vital (more valuable), hence to minimise my pain (loss of benefit) I give up the £1 I have been spending on flood defences(6).

So how does this make our private water companies masters of their own destiny (more on the “if they behave” bit in a moment)?


Private water companies in some ways have it easier than their public counterparts. They are only beholden to what customers need and want and what their owners/financiers want (which is usually no more than a stream of cash). And what their independent regulators will allow. Independent regulation is an important part of the privatised water industry story of course and the key part of that phrase is independent. Public water utilities in the UK find themselves facing systems of regulation inspired by the system created for England & Wales, but it remains less clear what independent regulation in the public case actually means when ownership and financing resides with the same set of interests that create the remit of the regulator.


In these cash strapped times for the public sector, for a publicly owned water business it would also matter what is happening with things like flood defence and fat defence. Public water is just another claim on the shrinking public purse and hence must compete for funds and budgets. Now grim civil servants have the potential to reap havoc with well thought out expenditure plans because other claims on public monies are more “vital” or have more political clout. And the double whammy for something like water is that when the business you run is asset-heavy then capital expenditure absorbs a lot of your precious cash-flow. Hence, deferring on capital projects is especially tempting if you are a public water business living at a time of pressure on public funds.


This is not to say that privatised water companies are immune to pressures to cut corners and defer much needed spending for short term gains. But the important point is that privatised water companies are judged by what they deliver for water customers and water investors. And that alone. They don’t have to worry about the Star Chamber beauty parade their counterparts in flood defence and fat defence (amongst others) will soon face.


So if you sit in a private water company and find yourself reliving the trials and tribulations of a regulatory price control, take some small comfort from this first reason to be cheerful. It could be worse. If you were a public sector water services provider, you would also now be sweating over what lies ahead with the comprehensive spending review.


(3) Nothing is new of course. Just ask Vilfredo Pareto – an Italian civil engineer turned economist and cat lover - who inspired the 80:20 rule in 1906.


(4) Difficult choices is of course a tautology. Choices are difficult because choices are bad and choices are bad because with any choice you have to give something up to enjoy something else. Just ask any standing economist (see www.standupeconomist.com)


(5) BMI is the Body Mass Index (your weight in kg divided by the square of your height in metres). If yours is above 30 you are clinically obese or a mountain of muscle (which is actually one of the reasons it is a flawed measure). Simple waist size is better apparently.


(6) If you are Canadian (the Canadian prescription for deficit reduction in the 1990s was a flat 20% cut in all areas of spend) you might remind us that this misses the option to reduce spending on both by 50 pence. But any economist would tell you that is wrong (a.k.a inefficient) as long as her assumptions are correct. So assume that halving spending means halving benefits. For my new spend of £1 I reduce my flood defence benefit by £2.50 and my fat defence benefit by £3. So my total benefit reduction is £5.50 which is more than the £5 reduction I experience if I choose to not spend anything on flood defence. Efficient choices as any economist will tell you depend on the marginal rate of substitution (and this is less than my cost of 1 for fat defence and more than my cost of 1 for flood defence), hence I should allocate my £1 in the direction of fat defence.


Reasons to be cheerful #2


Private water companies are serving the public good


Part of the new direction is really about what should the public sector actually do – and remember in the UK 8 million or so people get their water service from the public sector.7 In other words can we reduce the size of the public sector by making it do less of the things that it shouldn’t really do anyway.


Telecoms, energy, air travel and of course water and sewerage in England & Wales all said goodbye to direct Whitehall control back in the 80s, the railways said goodbye in the 90s and then effectively said hello again in the teenies. And it now seems some parents (how would they find the time?) might be encouraged to wrestle the education of their children from the control of our local Town halls.8


Another, and perhaps bigger, strand to this direction is about asking whether it might be better to get the private sector to deliver public services. In truth this is nothing new. Just ask the tiers of procurement officials who have the job of getting best value for the public purse out of private sector contractors.


It is also nothing new to the water industry in England & Wales. For 20 years the privatised water industry has pretty successfully – within the legal and regulatory framework - pursued the delivery of the rather important public good that is public water supply and sanitation.


So our new Con-Dem government might like to remind itself of the rather important example provided by our privatised water industry. Given some sensible parameters and constraints to work within privately owned water businesses can be made to work for the enhancement of the social good.


Incentives of course help with this. But attitudes and mindsets also drive behaviours. We would speculate that the sewage plant operative in Belfast feels no less a commitment to the public good than his counterpart in Glasgow and both have no more a commitment than their equivalent in Manchester. Whether private or public owned, the desire to deliver social goals can be observed throughout the UK water sector.


(7) You could add to that most of the Welsh but their not for profit enterprise is not on the public books and hence not a burden on the public finances and so is excluded. But it does highlight that private water maybe has the Anglo-Saxon gene.


(8) A strange example of the public sector expanding into areas already served by the market.


Reasons to be cheerful #3


Private businesses generally outperform Governments (& Regulators) when it comes to how to organise service delivery


Getting more from less will have an even greater pre-eminence in the minds of the policy architects who spend their time drawing up new strategic directions for the delivery of public services. Talk to a friend, a neighbour or maybe even a partner employed in one of our great public services and you will detect very quickly the symptoms of restructuring fatigue. New plans, new structures and new ways of doing things are a massive cottage industry in the public sector. Managers in our private water companies who grumble about micro-management by their regulators would probably do well to spend a day with some of their public sector peers.


In the private world acquisition is a pretty common way to “grow the business”. Getting bigger certainly grows the revenue line, but less often does it actually grow the bottom line. Promised cost savings don’t materialise, work-forces just don’t gel or mind-sets just will not budge.


But in the private world there are some disciplines around that mean getting restructuring wrong has a cost for the proponents of restructuring. The moving on of Chief Execs being one.


This might be worth bearing in mind in the current climate. Trying to find the best means of organising an economic activity – whether it is private or public – is an important objective in any sector and all the more important when budget constraints are getting harder not softer. But too often the easy prescription of merging hospitals, police forces and even schools – “growing the business” - seems to prevail in the minds of the public sector policy gurus. And maybe it happens too often, because private sector disciplines do not prevail and are not available to put checks on blanket restructurings of service delivery. The result is a tendency to want to transform how things are done without first asking if things need to be transformed in the first place.


In water there is a reasonably settled position on what the economists would term horizontal integration – water company mergers. In large part, of course, this has been about Ofwat’s desire to literally preserve its degrees of freedom. But, save a few voices who dream of national champions, there hasn’t either been any strong push from the industry’s executives for any significant consolidation of the water sector. This is because both history and the available evidence are against it.


The post-war (that is the second world war) history of the water industry is actually one of significant consolidation. Pre-1970s water undertakings were numbered in three digits. We are now down to about 20 or so independently managed companies. In short, the sector has done its consolidation and the available economies of scale have been mostly reaped. The only available evidence – Stone & Webster Consultants (2004) (9)– would suggest that while the current configuration might be less than optimal – some big guys being too big and some very small guys being too small – there is no strong case for reducing the current number of source to tap water businesses. And on this there appears to be broad consensus between companies and regulators.


Ask the question in a different way and this consensus in the water industry seems to be less in evidence. Restructuring of a different sort is on the agenda in the water sector. And it is being pushed not by the company executives who we presume think about the incentive of the bottom line but by the sector’s regulator. Upstream markets, retail markets, accounting separation are all different ways of expressing the same underlying view. The current organisation of source to tap and source to drain monopoly businesses is missing something. Market competition.

Again the lessons of history and the available evidence should force us to take stock of this push for restructuring in water. Previous re-organisation in the water sector in England & Wales has emphasised the benefits of co-ordination and planning. Hence, the 1973 creation of the ten river basin authorities. The same work by Stone & Webster Consultants (2004) also painted a picture of what the economists would call scope economies from the vertical integration of the production and distribution functions. And maybe this all serves to highlight that simple things like coordination and planning – resulting in more control of service risks and essential for efficient delivery – are pretty important in water. What else would explain the recent reversal by Glas Cymru of its out-sourcing model?(10)


Two other examples are worth noting. While the Whitehall mandarins are not yet convinced (maybe because they enjoy running the trains), speak to the managers that run the train operating companies and you will hear the case for going back to a vertically integrated railway. And in the energy sector, serious questions are now being asked about whether vertical separation in that sector is up to the job of keeping the lights on. More than that, does not the evidence of privately owned supply companies who have steadily re-acquired upstream capacity suggest that company executives in that sector think the same?


Reason to be cheerful #3 might then only have a temporary feel about it. The private water industry might be immune or protected from the numerous restructuring crusades that abound already in the public sector and will no doubt be re-fashioned and re-invigorated by the new austerity. But is there….


(9) Stone & Webster Consultants (2004) Investigation into evidence for economies of scale in the water and sewerage industry in England and Wales.

http://www.ofwat.gov.uk/pricereview/pr04/pr04phase1/rpt_com_econofscale.pdf


(10) Operating contracts for water supply and waste having been previously been out-sourced are now back in-house.


One reason to be fearful?


The executives of our private water companies might feel better equipped to know what will work and what will not work in terms of industry restructuring and history might be on their side. In the end, however, the same legal and regulatory framework that helped cement the first two reasons to be cheerful might be the un-doing of our third. Maybe Marvin was really a regulator of the vertically integrated water business supplying the restaurant at the end of the universe when he said: “I’ve calculated your chance of survival, but I don’t think you’ll like it”.


Believing the water industry needs to transform itself through restructuring of its value chain is easy to promote and a valid view to hold. But the questionable track-record of policy-makers, gurus and regulators when it comes to the big questions about how we best organise service delivery should offer some pause for reflection. That pause would also provide some time to think about the question that restructuring / competition is supposedly the answer to.


Twenty years of privatised water in England & Wales has delivered a lot and arguably more than it was believed continuing with public water would. Thus far, water has been immune from the desire to lay on top of the private ownership structure a radically different market structure. If Marvin is about right on the regulatory calculation, it is incumbent on the proponents of change to (better) explain the basis of that calculation.


Got a view on this perspective, share it with:

Scott Reid, Director (ICS Consulting)


Phone: 07900 812235

Email: scott@icsconsulting.co.uk

Skype: scott-icsconsulting


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