Water Privatization I: Ownership And Operation

Arnold Kling recently commented on this Tech Central Station article on water privatization, a crucial issue. Water is one of the most inefficiently and abominably allocated resources that we have, which is appalling given its scarcity and its importance. In the American Southwest we are already starting to see some of the negative effects of the bureaucratic allocation of water and the utter lack of a price mechanism to signal to people when it is scarce. And, as Richard Tren notes in the TCS article, Africa’s economic well-being is similarly stifled by the lack of price and private ownership as investment and allocation mechanisms.

Both the TCS article and the comments that Arnold received on his post reflect the conflation of two different aspects of water: owning, building and operating the infrastructure, and pricing the flow of the commodity. These two issues are constantly conflated, to the detriment of the debate and to the detriment of good water policy. This post addresses the first of those issues, owning, building, and operating water systems.

The construction and ownership of water infrastructure and water sources first runs into an important economic issue: the potential natural monopoly characteristics of the infrastructure. Water infrastructure, like last-mile telephone and electricity wires, is a network with a characteristic feature of natural monopolies – subadditivity of costs. Subadditivity of costs means that relative to the size of the market, the profit-maximizing and cost-minimizing industry structure is to have one firm. Subadditivity suggests that if left to free entry and exit, competitive dynamics would take local water markets to the point where a municipality is served by a monopoly. So, the argument goes, we should treat it as a regulated utility, prohibit competitive entry, and regulate the rate of return it earns on its assets. That is, if we don’t have the local government itself provide the water itself.

Water is one of the most frequently municipalized of all network services, although the economic argument for it is weak. As Eric Krieg said in the comments to Arnold’s post, if cable doesn’t have to be owned municipally, why does water? In fact, the literature on municipal ownership of utilities offers a mixed bag, but generally finds that municipal utilities are more poorly managed than private utilities, and largely owe their survival to political fiat and to their tax-free status. In some cases, such as electricity, municipal utilities also benefit from getting preferential treatment in getting access to cheap federal hydropower from Bonneville and TVA. I prefer to save municipalization for a separate post, but I simply think that since the wave of municipalization in the early 20th century municipal control of utilities has become a political dynamic and not an economic one, and that the argument for preferential tax treatment of public utilities is weak when commercial incentives exist to establish such services through private markets.

I think it is true that local water infrastructure currently has subadditivity of costs, and therefore can be considered a natural monopoly. The other question, though, that we should ask is whether the ownership and management structure that we choose for the water infrastructure is adaptable to changes in economic and physical circumstances. On that count I think we have another reason to decide against municipal, and therefore politicized, ownership; we also have another reason to be very, very careful in the regulatory institutions we establish to control and manage private utilities that operate in dynamic, changing environments.

But it gets even more complicated than that. Suppose you are not persuaded by my argument that water utilities should be private companies and not municipal utilities. OK, but you could still contract out the management and operation of the water treatment and water delivery facilities to a private company that specializes in such services. Such a move could save taxpayers money and reduce operating costs, because the contractor has a comparative advantage in such services, more so than local governments. Such contracting out has delivered a lot of value in a lot of different countries over the past two decades. But wait, the skeptic says, how does the contractor have any incentives to deliver clean water to our residents? [c’mon, ask me a hard one!] Municipalities hold contractors to performance contracts, and establish independent monitoring of the quality of the water and other performance measures. Recall also that this is a repeated game, and that the contractor is likely to want its contract renewed, so it has incentives to please its customers, which will counter any incentives it has to cut costs by reducing quality. For those of you who are interested in the actual experience of water service contracting, I recommend that you check out the water privatization work of my former colleagues at Reason Public Policy Institute, who are the world’s foremost policy experts in this topic.

Another problem that arises in water is something that happens in any situation where you have multiple people extracting something from a common pool – if we don’t have well-defined property rights over specific shares of the pool of water in the aquifer, for example, each individual has an incentive to overuse the water. This is a typical manifestation of what Garrett Hardin called the “tragedy of the commons”, which I prefer to call the “tragedy of open access” for reasons that will become apparent. Treating water as a common pool, without establishing any rules to govern use of the common pool or means of excluding non-authorized users, is a recipe for overuse and exhaustion of the water source.

Note the precise way that I worded that previous thought – privatization of the ownership of the water source is one option, but there is an entire continuum of commons options between private ownership of the water source and open access, and its associated tragedy of overuse. Assigning proportionate share use rights that can adapt to changes in local population is one example of a set of rules that realistically incorporates the common pool aspect of the water source and the difficulty of defining and enforcing pure private property rights in such a context. Different communities in different contexts, different geographies, different economies will come up with innovative arrangements for governing the water commons, exploiting local knowledge. For more information on this subject I refer you to the seminal work of Elinor Ostrom, a political scientist at Indiana University who has been the pioneer in the theoretical work on governing the commons, and in publicizing the novel arrangements that people devise to manage irrigation rights and other common pool extraction issues. I also recommend the work of Gary Libecap, an economist at the University of Arizona, on the use of unitization in oil drilling to enable those with drilling rights to maintain sufficient pressure and not extract oil too quickly.

Water infrastructure and source ownership and management is obviously a very complicated topic, and it’s important to realize that alternatives exist beyond just the public/private ownership decision. Even within public ownership there are lots of ways to align the incentives of the system users with long-run interests in sustaining the availability of water. Tomorrow I’ll talk about the most potent, and least used, method of doing that – dynamic pricing.

4 thoughts on “Water Privatization I: Ownership And Operation

  1. Lynne –
    When you discuss dynamic pricing, can you speak to the issue of the frequency of price change and communication latency, specifically in regard to the mass market?

    Within my work in electricity, I’ve constructed demand response systems that allow hourly spot prices (or alarms) to be communicated in near real-time to commercial customers to reduce next hour load – so I understand the concept, and agree that it provides the right incentives to drive efficiency.

    The trick is taking this to the residential mass market level – and whether it is practical, or even necessary to achieve the long term goals. I can certainly see the advantage of communicating a monthly weighted average (or seasonal on/off peak) price in utility bills, and how that would naturally drive more efficient use – or more efficient alternatives – on a long term basis.

    But monthly bills are necessarily retrospective – and monthly feedback of more dynamic pricing is too late to impact my consumption when it would have mattered. (I’m ignoring for the moment the pager-like devices that can be tied to major appliances.) Unless I’ve got a spot price indicator in my house next to my light switches and TV, I don’t have the information necessary at the time and place of ‘purchase’. Utilities seem somewhat unique in this regard – something that you continuously consume, without really knowing the price – or typically even the total quantity – until you get the bill at the end of the month.

    So back to the original concern – does the frequency of price change, coupled with the practical latency of communicating it to users prior to consumption, create limits to using dynamic pricing as an efficiency mechanism at the mass market level?

  2. I don’t mean to burden you further, Lynne, but in your forthcoming discussion of dynamic pricing I wish you would talk not only about payers but about payees. To whom is the price for water use to be paid?

    This to my untutored eye seems to be a less complicated subject in an arid state like Nevada, where most of the available water comes from a very small number of sources and is used by customers in a distinct area. Here in Georgia water comes from sources spread over a number of watersheds and aquifers. Efficient market use of the water from at least one of the watersheds would appear to lead to most of it being used in metro Atlanta, at the cost of wiping out coastal fisheries downstream in Florida. A related question is what economic value should be assigned to permits to use water for irrigation; does the grant of such a permit mean that its holder now owns the water he is permitted to use, and is it sound to confer on him the right to profit from the sale of the water?

    A year ago these were pressing issues here, because Georgia was in the midst of a drought that had lasted for four years. The drought has ended by this time, but metro Atlanta’s demand for water and the question of water ownership will be issues in the Legislature next year, and the dispute over water use between Georgia and Florida is headed for the courts after years of fruitless negotiation on an interstate compact. Hardly anyone really understands the economic principles involved in this, so any light you could throw on them would be appreciated.

  3. Thanks for your comments! I think I addressed them a little, but I also plan to cogitate on them for a future analysis. The reason I’m drawn to water is that I see the same potential business models and value propositions being useful in it as in electricity, including competing retailers. That means issues of vertical integration and disintegration, so the “to whom does it get paid” question relies on the ownership structure in the industry.

  4. I’ve been toying with an ideal/solution on the water/sewage problem for years. The initial cost would be huge, but it would open the door to added competition by lowering competition startup cost. This ideal would also includ cable, telephone, electric, gas, sewage and of course water.
    1)Start up a coporation that only residents can own the stock. Example The Houston Utility Delivery Corp.(This would keep non-residents from gaining control of the utilities like in England and Australia)
    2)Instead of putting in roads first on a new division of houses/buildins, install 2-3 utilities tunnels below the road site. Then build the road. When the existing roads fall into disrepair, you can dig them up and extend the system. (How often do you see the city dig up the same road 2-3 times in a year?)
    3)In these tunnels install the water pipes, sewage pipes, telephone lines, gas lines, cable TV. Maybe lay train tracks first to allow fast easy instilation.
    The Houston Utility Delivery Corp’s job would be a)maintenence of the road and utility lines, b) negotiable instalation of new lines, c)maybe coletion of fees from the end user.
    A nogotiated percentage or flat rate would be paid by the service provider of the utility companies.
    It would cost far less money to run a pipeline through a tunnel than to get the permits and dig new trenchs to run the underground lines. Thus this might increase competition.
    You would not have to worry about trees, lightning, car crashes etc.
    I think that underground power cables are safer for the people than the overhead power cables.
    Useing this system under/along side the Freeways would give you the “road” for the national power grid.
    The startup cost of this system would be “very” big but you would be able to “kill many birds with one stone”. Example, this would greatly enhance sewage recycling.
    Not only would you take control of the water system out of the hands of “Government”, you could also take control of the roads out of their hands too. This would lead to the lowering of taxes (only if the people DEMAND and Fight for it.)

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