What are key market structure issues in the water sector?

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[Response by Sophie Trémolet and Diane Binder, October 2009]

Regulatory rules aim to promote the evolution of a market structure that yields efficient performance. Yet, the optimal configuration of market structure in the water sector is difficult to determine because of a number of issues, as described below.

 

  • Uncertainties about the optimal scale of operation1. The tendency of the past couple of decades has been towards increased decentralization, largely to respond to the fact that water is a local service by nature and that local politicians are responsive to local interests. However, decentralization of water service to the local level is not necessarily efficient due to limited economies of scale (i.e. high associated costs of service provision), restricted access to financial resources and limited local capacity. To overcome these issues, some water sectors have adopted various forms of aggregation2 models. Aggregation of services can provide opportunities for improved efficiency of service delivery, facilitated enhanced professional capacity, and enabled cost-sharing (Tynan, 2005). Additional benefits of aggregating service providers occur in the case of rural areas, where it is generally more difficult to attract private participation, and where clustering of services, or franchising”Franchising is a business methodology that focuses on the transfer of business know-how and practices, often accompanied by a specific training, in order to provide the necessary skills and expertise for a particular business. The seller of the business concept and know-how is the franchisor, while the purchaser of the license agreement to use the business know-how is the franchisee. The franchisee pays the franchisor for the business know-how that is provided and for the use of the franchisor’s business name (trademark) over a contractually defined period of time, and within a specific geographic territory”. (Van Ginneken et al., 2004). The payment is made through an initial upfront fee and an ongoing royalty, i.e. a percentage of the franchisee’s sales. , could lower the risks for private operators. The optimal scale of operation depends on a number of factors including topographical conditions (the existence of river basins serving an agglomeration of towns / cities), access to international markets (i.e. the possibility to access foreign markets for spare parts or international source of financing), local political context (i.e. the level at which regulatory decisions such as tariff setting, are made), existing regulatory mechanisms in place and the ability of policy makers and regulators to find innovative ways to regulate an aggregated service provider. Although benefits of economies of scale have been recognized, it has often been difficult to identify the optimal size of service provision, and at which point economies of scale would start to tail off. Governments may also decide to reduce the service areas of operators to facilitate comparative competition and provide a backup operator should an operator in another zone fail3.
  • Uncertainties about the optimal scope of operation4. Water services can be aggregated with other types of services (sanitation, electricity gas, etc.), as in the case of Gabon where the national utility, SEEG, provides water and electricity services. Grouping services or functions allows economies of scope in sharing overhead costs (management, billing, collection), reducing payment risks, and allowing for cross-subsidies. The choice of scope depends on a number of factors, including government policy and the regulatory framework in place (for instance, the existence of sectoral regulatory entities or multi-sector regulators).
  • Limited competition and high barriers to entry. Urban water and sanitation systems are notoriously capital intensive with large fixed costs for assets that have long lives. A high ratio of fixed to variable costs makes it demanding to set price that allow a small return on investment: as a result, water and sanitation have lower and riskier returns on investment than other infrastructure sectors. Therefore, the opening of water markets to competition has been quite recent and has experienced setbacks in many developing countries. A generally-held view is that the water sector has a high degree of natural monopoly and that introducing competition in the market would be inefficient, although some economists have made the case for competition in wholesale supply of water (Kessides 2004, Stern 2009). In actual fact, competition is widespread at the low-income end of the retail market, given that there are no inherent monopoly characteristics in reselling water by the bucket for example. In many developing countries, small-scale providers often account for a larger share of the market than incumbent utilities, yet they often have been ignored or regarded as a stopgap. Their growing recognition raises several market structure issues:
    • Because most small-scale providers are informal operators, there is a lack of available information to have a full picture of the market structure.
    • Most regulatory frameworks have been set up with one monopolistic provider in mind, and do not have the capacity to cope with a multitude of providers. It is therefore necessary to adapt regulation to take into account the existing competition between small-scale providers. It induces switching from a traditional approach of regulatory mechanisms (focusing on price caps and subsidy issues) to an approach in which competition, open entry and open sharing of information replace control mechanisms. Regulators should seek to level the playing field for incumbent utilities and entrepreneurs of all sizes.
    • The relationship between the utility and private entrepreneurs is a sensitive issue: too much competitiveness can create a difficult contractual environment (in which there is usually a large imbalance of power), while too close a relationship may open the door to corruption or the stagnation of the sector.

 

 

Resources

Urban Water Reform: What We Know, What We Need to Know
Paper prepared for the annual meeting of the International Society for New Institutional Economics (ISNIE) in Boulder, Colorado, September 2006.
M. Shirley, The Ronald Coase Institute

Approaches to Private Participation in Water Services: A Toolkit
PPIAF, the World Bank Group, 2006.
PPIAF and The World Bank

Improving Water Services through Competition
Note no. 164 in Public Policy for the Private Sector. Washington, D.C.: World Bank Group, December 1998.
Webb, M., and Ehrhardt, D.

Competition in Water and Sanitation
Note no. 165 in Public Policy for the Private Sector. Washington, D.C.: World Bank Group, December 1998.
Solo, T. M.

Small Scale Private Water Providers: Perceptions and Perspectives
Building Partnerships for Development in Water and Sanitation, May 2008.
M. Paniagua

Independent Water and Sanitation Providers in African Cities: Full Report of a Ten-Country Study
UNDP-World Bank Water and Sanitation Program. Washington, D.C., World Bank, April 2000.
Collignon, Bernard, and Marc Vezina

Adapting regulation to the needs of the poor: Experience in 4 East African countries
BDP Research Series, May 2006.
S. Trémolet

Models of Aggregation for Water and Sanitation Provision
World Bank Water Supply and Sanitation Working Note No. 1, February 2005.
ERM, Stephen Myers & Hydroconseil

Optimal Size for Utilities: Return to Scale in Water, Evidence from Benchmarking
Note n° 283, Public Policy for the Private Sector, The World Bank Group, January 2005.
N.Tynan & B.Kingdom

The Clean Water Financing Program for Kazakhstan
Global Environment and Technology Foundation (GETF) & International Center for Environmental Finance (ICEF), 2007.
Global Environment and Technology Foundation (GETF) & International Center for Environmental Finance (ICEF)

Can the principles of franchising be used to improve water supply and sanitation services? A Preliminary Analysis
Water Supply and Sanitation Sector Board Discussion Paper Series n°2, January 2004, the World Bank Group.
M. van Ginneken, R. Tyler, D. Tagg

Sustainability of Water Service Delivery in Rural Environment: Past Approaches and the Way Forward
Review of Literature, Emerging Markets Group, February 2008.
Binder, Diane

The Design of Manila Concessions and Implications for the Poor
Washington, D.C.: The World Bank, 2002.
Rosenthal, Shane

Reforming Infrastructure: Privatization, Regulation and Competition
A World Bank Policy Research Report, 2004.
I. Kessides

Footnotes

  1. The scale of operation is the degree of decentralization of water supply services, i.e. the number of cities or towns included in service provision by the operator.
  2. Aggregation is defined as the grouping of several municipalities into a single administrative structure for the provision of a particulate service. Such aggregated structure can vary widely along at least two dimensions: scale (aggregated structures can group neighboring municipalities) and scope (aggregated structure can provide a single service, for example, bulk water, or all services, from raw water abstraction to sewerage treatment and even electricity. (ERM and al, 2005).
  3. See the question about “Promoting Competition” and the definition of yardstick regulation in Properties of Benchmarking and Yardstick Analyses of the BoKIR.
  4. The scope of operation refers to the aggregation of services (water production, whole water service, water and sanitation, water and energy and others – solid waste, heat, etc) and the aggregation of functions (operations, management, procurement, investment, financing, etc.). (ERM and al, 2005)