PRIVATISATION AND EFFICIENCY IN THE UK WATER INDUSTRY: AN EMPIRICAL ANALYSIS*

Date01 August 1995
AuthorLester C. Hunt,Edward L. Lynk
Published date01 August 1995
DOIhttp://doi.org/10.1111/j.1468-0084.1995.mp57003006.x
OXFORD BULLETIN OF ECONOMICS AND STATISTICS, 57,3(1995)
0305-904 9 S3.00
PRIVATISATION AND EFFICIENCY IN THE UK
WAlER INDUSTRY: AN EMPIRICAL ANALYSIS*
Lester C. Hunt and Edward L. Lynk
I. INTRODUCTION
Just over one hundred and fifty years ago Augustin Cournot developed a
simple model of oligopolistic interaction using, as a market example, spring
water produced at zero cost. However, whilst water used as an input or raw
material to the water industry can accurately be regarded as a free good, it is
clear that water as an output and used for consumption or as a further input
by industry is not. The processes of abstraction, distribution and treatment
impart sizeable value-added components which make water supply and its
related activities highly profitable. The present and potential profitability of
water partly explained its status as the third major public utility, following
telecommunications and gas, to be transferred to the private sector. The ten
Regional Water Authorities (RWAs) of England and Wales were privatised in
November 1989 establishing, alongside 28 privately-owned statutory water
companies, a water industry that is almost entirely privately owned.'
The privatisation of water was characterised by the separation of the
production and regulatory functions of the RWAs and the establishment of
the National Rivers Authority (NRA) to oversee water resource manage-
ment, controlling both pollution and abstraction. The separation of
production and regulation entailed the abandomnent of the principle of Inte-
grated River Basin Management (IRBM) whereby individual RWAs
controlled and planned all use of water in each river catchment area. The
separation was controversial sinëe proponents of IRBM maintained there
were substantial efficiency-enhancing features of IRBM; in particular the
presence of economies of scope between the environmental functions passed
authors are grateful to a referee and David Bevan for comments and to Mr. J. Panting of
Southern Water, Rita Morgan at the CIPFA Library and staff at the OFWAT Library, for
assistance. We are also grateful for discussion with members of the Drinking Water
Inspectorate, the NRA and Her Majesty's Pollution Inspectorate, concerning data availability,
and to Chris Bolt, Head of Economic Regulation at OFWAT. Naturally, any errors contained in
the paper are the authors' responsibility.
The newly established environmental body, the National Rivers Authority (NRA), carries out
functions previously conducted by the RWAs. Hence it would be wrong to conclude that the
industry is totally privately owned. 371
© Blackwell Publishers Ltd. 1995. Published by Blackwell Publishers, 108 Cowley Road, Oxford 0X4 1JF,
UK & 238 Main Street, Cambridge, MA 02142, USA.
372 BULLETIN
to the NRA, and the water and sewerage activities retained by the privatised
Water and Sewerage Companies.
The purpose of this paper is to assess the separation decision in the light of
the existence and the degree of scope economies which arguably existed
between the activities of the RWAs prior to privatisation. Although the water
industry was thought to be characterised by joint production, there has been
no empirical evidence on this issue or on the extent to which cost compte-
mentarities reduced annual operating costs. Using pooled cross-section,
time-series data drawn from the annual reports of the RWAs prior to privati-
sation, for the nine year period 1979/80-1987/88, and which incorporates
adjustments for variations in service quality, we find evidence of substantial
areas of cost complementarity between the water supply and environmental
activities of the RWAs. Irrespective of the drawbacks of the self-regulatory
system practised by the RWAs prior to privatisation (see later) it follows that
these scope economies are now unavailable under the present industiy
structure.
The plan of this paper is as follows. In Section II recent developments in
the UK water industry including the current regulatory structure are
discussed. Section III discusses the issue of joint production and the identifi-
cation of an appropriate methodological approach to the issue of water
industry divestiture. Section IV presents empirical estimates from a multi-
product cost function for the RWAs for the period prior to privatisation and
Section V presents a summary and conclusions.
II. RECENT DEVELOPMENTS IN WATER INDUSTRY STRUCTURE2
The pre-privatisation structure of the industry was established by the 1973
Water Act. Briefly this unified a highly fragmented industry structure where
water supply, sewerage and environmental services were distributed among
multifarious organisations at local level. The aim of reorganisation was to
achieve the scale and scope economies which were believed to be available
under a structure of larger integrated authorities. The philosophy was that
each of the ten RWAs would plan and control all uses of water in each river
catchment area - integrated river-basin management (IRBM) - though for
scale and scope economy reasons each authority was responsible for more
than one river basin. The RWAs became responsible for water supply,
sewerage, sewage disposal, water resource planning, pollution, fisheries,
flood protection and land drainage, water recreation and environmental
conservation. Operating alongside the RWAs were 28 statutory privately
owned water companies which collectively supplied around 23 percent of
household water. These were single-output organisations concerned solely
with water supply and distribution.
2 For a more comprehensive discussion and analysis of issues and developments in the water
industry, see Vickers and Yarrow (1988), chapter 11.
C Blackwell Publishers Ltd. 1995.

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