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EMBARGOED UNTIL 10.00 AM MONDAY 8 MARCH 1999
AIC7TH ANNUAL NZ WATER SUMMIT
 WATER REFORM IMPERATIVES
AUCKLAND
8 MARCH 1999
ROGER KERR
EXECUTIVE DIRECTOR
NEW ZEALAND BUSINESS ROUNDTABLE

 WATER REFORM IMPERATIVES
 
 

Introduction

Water industry reform is one of many areas in which New Zealand has fallen
dramatically off the pace in recent years. The industry ranks with other
utilities like telecommunications, electricity, gas and roading in terms
of its contribution to the economy, to the living standards of New
Zealanders, and to the international competitiveness of the business
sector. The faltering progress in microeconomic reform since 1993 is
costing New Zealand dearly in terms of deteriorating growth rates and
rising unemployment.

The direction New Zealand must take in reforming the water industry is
clear. Political involvement in, and control of, the industry must be
replaced by greater reliance on market mechanisms. This approach has led
to impressive gains in other utility industries. Market-oriented reforms
have substantially improved the performance of overseas water industries
and there is the same potential for improvement in New Zealand.

A market-oriented reform package would include the following elements:

     …     introducing efficient pricing for water and wastewater
     services at least in most towns and cities;

     …     improving the incentives for performance of the local
     government-owned water and wastewater businesses     through
     corporatisation;

     …    privatising the water and wastewater businesses as a likely
     subsequent step to overcome the deficiencies          inherent in the
     corporatisation model;

     …     making greater use of franchising and contracting-out if
     there is a strong political preference to retain public ownership;

     …      removing the special restrictions in the Local Government Act
     which prevent Watercare Services Limited operating in a fully
     commercial and accountable manner; and

     …    addressing any market power problems through a light-handed
     regulatory regime relying on the Commerce Act and information
     disclosure requirements.
 
 

These recommendations were made in the report Reform of the Water Industry
prepared for the New Zealand Business Roundtable by CS First Boston in
1995. The fact that little has changed four years down the track, despite
a degree of acceptance of their general thrust, is a sorry reflection on
the inertia and entrenched ideologies in local government.

This paper reviews the minimal reform that has been achieved in New
Zealand in the water industry and contrasts this with the achievements of
other countries.

It then discusses why a more market-oriented approach, including changes
to governance and pricing arrangements, is likely to yield substantial
improvements. Although these arguments should be well understood by now,
the glacial speed with which councils are implementing change suggests
they need restating. The case for adopting a light-handed regulatory
regime as the best option for controlling the market power of water and
wastewater businesses is briefly recapitulated.

Finally, the case for rationalising the water industry is considered. The
current structure of the industry has been determined politically, based
on local authority boundaries. It is unlikely to be optimal. The difficult
issue is determining what a better arrangement might look like.

2 Reform of the water industry

2.1 'Reform' in New Zealand

A review of progress to date in New Zealand makes pathetic reading.
Although many councils appear to have considered reform options, few have
made substantial changes.

Auckland City Council is the only council to have formed its water
business into a Local Authority Trading Enterprise (LATE), having
established Metrowater in 1997. The Council had second thoughts about this
sensible change soon after. Metrowater has so far survived, but only just.
It is already delivering improvements in performance and cost savings. In
its first year of operation Metrowater reduced water losses from 17 to 13
percent; achieved an A grading for water supply across Auckland City for
the first time; and produced the first ever long-term management plan for
its assets. User charges have reduced the rate of increase in water
consumption compared with the rest of Auckland.1

Papakura franchised its water and wastewater operations to United Water in
1997 under a 30-year agreement, the first of its type in New Zealand.
Papakura's supply is managed by a company that is focused on water and
wastewater services and which can draw on the technical expertise of its
worldwide operations. The franchise arrangement has achieved net cost
savings of 10 percent, which have been passed on to ratepayers. Papakura's
record shows that, with political will and leadership, substantial
benefits can be delivered to ratepayers. Franchising has also been used,
or is being contemplated, for a few greenfields developments such as
Wellington's sewage treatment plant.

Councils have increasingly used contracting-out options. Capital
construction and maintenance works are frequently contracted to the
private sector. Reticulation operation is also occasionally contracted
out. A number of councils have formed their construction and maintenance
operations into LATEs or business units, and require them to tender for
work in competition with the private sector. Savings of 10 to 20 percent
from contracting out are commonly cited. 2

Asset management is also improving, although at the end of 1997
considerably fewer than half the councils responding to an Internal
Affairs survey had asset management plans in place for their water and
wastewater assets3. Better monitoring of the condition of assets has
revealed that a large number of councils face major upgrading of their
water supply and wastewater infrastructure. The Auckland City Council
recently stated that rates would have to rise between 13 and 15 percent to
fund failing stormwater pipes. These figures seem dubious, but the fact
that action on run-down systems is only now being taken years after such
problems were recognised speaks volumes about the inadequacy of local
government control. Remedial works around the country are likely to have a
substantial impact on service charges.

Little progress has been made to introduce more efficient prices. Metering
has been extended only in a very limited way in some cities. Wellington,
for example, has adopted a voluntary metering regime. It also introduced a
fixed charge per household, which was a move towards more efficient
pricing, but contemplated reversing that decision a year later. The most
woeful case is Christchurch which has a wide base of installed water
meters but has never used them.

Many councils do not charge for the water used, or base their charges on
the cost of supplying the service. Over-consumption has harmful
environmental as well as economic effects, but environmental organisations
seldom support the most obvious solutions. Prices commonly do not include
the full opportunity cost of capital. Pricing is still strongly influenced
by politics. Garry Moore, the mayor of Christchurch, has vowed to fight
"like a mad dog" against plans to introduce a user pays system for water
and sewerage services4. One might ask why he is not also fighting "like a
mad dog" against user charges for electricity, telecommunications, food,
clothing and many other goods and services which are far more costly items
in household budgets. Perhaps he has been too exposed to the abundant
midday sun this summer. This resistance to efficient pricing principles
that would wisely ration scarce resources epitomises the blinkered
ideology of councils like Christchurch.

In the last four years no rationalisation of water businesses has occurred
despite the large number of local authorities involved in provision. Even
in Auckland and Wellington where expensive studies of rationalisation
options have been completed, nothing has been achieved.

The government has tinkered with Watercare, but only in an ineffectual
way. The 'club' ownership arrangement, in which local authorities are both
customers and shareholders, will prove problematic. Their interests as
shareholders and customers will conflict, pricing and investment are
likely to politicised, and the monitoring and performance disciplines
associated with political control will be weak. Legislative restrictions,
such as the restriction on local authorities selling their shares and the
constraint on Watercare paying a dividend, will continue to undermine its
ability to operate in a fully commercial and accountable manner.

The dismal saga is an indictment of local authority control. Local
government politicians have not been prepared to lead opinion and sell the
benefits of reform.

Instead they have generally chosen to pander to misinformed concerns about
change. In my view, central government must step in and direct reform, as
it has with roading. Its current review is welcome and provides an
opportunity for progress at last.
 
 

2.2 Reform overseas

The slow progress in New Zealand stands in stark and sorry contrast to the
achievements in other countries where commercialisation and private sector
involvement have become increasingly the norm.

In Australia, most of the water and wastewater industry has been
corporatised. The Hunter Water Board was corporatised in 1992. The Sydney
Water Board was corporatised in 1995. The largest Western Australian water
utility was corporatised in 1996. The major water utility in South
Australia, the South Australian Water Corporation, was corporatised in
1995. Melbourne Water was corporatised in 1991 and then restructured in
1995.

Around $5 billion worth of water, stormwater and wastewater projects has
been contracted to the private sector in Australia, with a further $10
billion likely to be offered for private tender over the next five to 10
years5. Following corporatisation, the South Australian Water Corporation
franchised all water supply and sewerage services in the Adelaide
metropolitan area to a private company, United Water, for 15 years. The
franchising arrangement achieved cost savings of around $10 million per
annum6. The ACT government has been endeavouring to secure support for
privatisation of its electricity and water utility.

Other reforms have also been implemented. The Hunter Water Board began a
process of demand management through user pays price reforms as early as
1982. The Sydney Water Board moved from property-based charges to usage
charges during 1995 and 1996. Rural councils have also moved towards
usage-based water pricing. The New South Wales government introduced
tradeable water permits in 19887. Similar moves have occurred in other
Australian states.

Some of the gains achieved in Victoria illustrate the benefits that New
Zealand is forgoing by its lack of action:

   * The metropolitan industry is on track to delivering cost savings of
     around $150 million over the five years since restructuring in 1995.
     At the same time, service standards have generally improved;

   * The non-metropolitan urban water authorities reduced their operating
     costs by 17 percent between 1994/95 and 1996/97 while substantially
     improving their technical and commercial performance; and

   * The annual gains from water trading have been estimated to reach $50
     million per annum by the year 2000. 8
 
 

Market-oriented reforms have been implemented in many other countries as
well. Scotland amalgamated its water and wastewater service supplies into
three entities which were corporatised in 1996. The reforms in England
involved corporatisation prior to privatisation.

Chile has established 13 corporatised water and sanitation utilities. The
largest utility, EMOS, serves a population of five million in the Santiago
metropolitan area. A World Bank study notes that EMOS performs well in
terms of standard indicators of utility performance. 9At the same time
that EMOS reduced tariffs by 26 percent it achieved improvements in
service levels.10 Chile is pushing ahead with plans to sell shares in its
water utilities.11

The increasing involvement of the private sector in the water industry,
particularly in third world countries, is also remarkable. A World Bank
report notes that before 1990 almost all developing countries relied on
government provision of water supply and sewerage services and that
private participation was rare12. Between 1984 and 1990 developing
countries awarded contracts to private companies for only eight water and
sewerage projects to a value of US$297 million.

Private participation has accelerated since 1990. Between 1990 and 1997, a
total of 97 projects were implemented in 35 developing countries, with
projects ranging from management contracts to leases, concessions,
divestitures and greenfield build-own-operate or build-operate-transfer
arrangements. Concessions were the dominant form of private sector
involvement, with divestiture being relatively rare. The total value of
the investment projects with private sector involvement in the period
1990-97 was nearly US$25 billion.

Penelope Brook Cowen, an infrastructure expert at the World Bank,
commented at last year's AIC water conference that "private sector
participation does appear to yield significant improvements in utility
performance; and the gains are more unambiguous the more responsibilities
are passed to the private sector Š ." 13

3 Key elements of a market-oriented approach

This section looks at some of the key elements of a market-oriented
approach to reform of the water industry. It considers governance,
pricing, and regulation of market power.

3.1 Changes to governance

Different governance arrangements impose different incentives and
constraints on individuals. Changes to the incentives and constraints that
individuals face will affect their performance. The aim should be to
encourage managers and staff in water businesses to act in ways that are
more consistent with the interests of consumers and ratepayer-owners.

Governance arrangements in the water industry range from council
departments, council business units, LATEs and contractual arrangements
with the private sector, to outright private ownership. They impose
different constraints and incentives on individuals, resulting in
systematic differences in performance.

Managers of council departments face conflicts because of the multiple
roles and objectives of councils. A council has an ownership role in
relation to its water and wastewater assets. It determines what services
are to be provided to customers, and usually provides the services. The
council has a role in representing customers, who usually do not have a
direct relationship with the service supplier. The council

effectively regulates the charges that are levied on customers. It also
has regulatory responsibilities under the Local Government, Resource
Management, Building and Health Acts. Even if these responsibilities are
separated from service provision within councils, conflicts arise at the
chief executive and council levels.

The roles and objectives of councils translate into multiple roles for the
managers of council departments. With multiple objectives, managers must
make trade-offs between them, often without guidance as to their relative
importance. Monitoring of performance is more difficult. And because
performance is more difficult to measure, the incentives for performance
are weakened.

Without a direct relationship between a council department and its
customers, the service supplier has limited information on consumers'
preferences. The lack of contact reduces the incentive of the supplier to
be responsive to customers' interests. Council involvement politicises
price setting, with the result that prices are often set too low, leading
to excessive demand for water.

Council business units have a greater commercial focus but are rarely
given a single commercial objective. The problem of multiple objectives
remains. Political and commercial roles are not separated since business
units remain divisions of councils. Often business units do not have their
own balance sheet or accounts. Price setting is still strongly influenced
by political considerations.

The problems associated with council departments and business units can be
ameliorated by extensive contracting out of services. Competitive
tendering of contracts to the private sector for capital expenditure
projects, maintenance and operation of assets is a powerful way of
minimising the costs of providing water and wastewater services. However,
contracting out does not ensure that the council department or unit makes
investment decisions at the right time and chooses the right level of
capital expenditure or maintenance - it only increases the likelihood that
the level chosen will be delivered relatively efficiently.

Corporatisation gives managers the primary objective of profit
maximisation, subject to regulatory constraints on monopoly power. A
profit-maximisation objective provides a clear focus for managers. It
facilitates monitoring of management performance by owners and customers
and motivates the business to strive for efficiency. Consumers benefit
because corporatised firms have strong incentives to determine customer
preferences and to satisfy them at minimum cost.

The main problem with the corporatisation model is that, over time,
governments find it difficult to maintain an arm's length relationship
with the organisation. Interference by politicians in decision-making
weakens incentives for good performance. This is one of the main reasons
why privatisation is ultimately the preferred option. Privatisation can
cement in the gains from corporatisation while strengthening incentives
for performance by exposing managers to capital market constraints.

If there is a strong political preference for retaining public ownership,
greater use of contracting out and franchising may achieve improvements in
efficiency, particularly in the short term. However, franchising requires
detailed input from a buyer in contract design and performance monitoring.
It does not therefore necessarily overcome incentive problems associated
with government involvement.

In my view corporatisation of major urban water and wastewater businesses
would deliver substantial benefits. Metrowater's experience as a
corporatised entity confirms this, as does overseas experience.
Privatisation would maintain these benefits and yield additional gains.

For smaller water and wastewater operations the overheads associated with
LATEs may outweigh the benefits of an increased commercial focus. One
solution would be for smaller operations to amalgamate into larger
entities to economise on the overhead costs of establishing LATEs. Another
option would be for them to remain (or become) business units but to
contract out all of their capital and maintenance work, as well as
operating services. The business units would then have primary
responsibility for managing contracts with private providers.
 
 

3.2 Reform of pricing

Reform of governance arrangements goes hand-in-hand with improvements to
pricing arrangements.

Water utilities must move towards use-related charges. Prices should be
based on the opportunity costs of supply to ensure that users take proper
account of the true economic costs of water and sewerage services.
Efficient prices for water and sewerage services should include the value
of water in alternative uses, the costs of any environmental damage, the
cost of operating and maintaining the system, the opportunity cost of
capital and the capital costs brought forward by demand. Fixed charges
should be used to cover fixed costs if marginal-cost pricing does not
generate enough revenue to cover total costs.

Efficient pricing requires metering of usage or the adoption of a proxy
for usage. It is possible that the benefits of user charges will currently
be outweighed in some supply areas by the costs of installing and
monitoring meters for some customers. However, these situations are likely
to become more limited as demand for water grows, and supply can only be
increased at an increasing cost.

3.3 Regulation of market power

The regulatory environment needs to be considered when businesses are
corporatised and a commercial approach to pricing is adopted. A
profit-maximising objective gives corporatised entities incentives to
exploit any market power they may have.

The Business Roundtable remains of the view that a light-handed regulatory
regime involving information disclosure and the provisions of the Commerce
Act offers the best option for regulating corporatised and privately owned
water and wastewater businesses. It imposes constraints on market power
while retaining incentives for managers to optimise the efficiency of
their organisations and minimise costs. The regime is not perfect - there
may still be some abuses of market power - but the alternatives are worse.
While a heavier-handed regime may impose stronger constraints on the
exploitation of market power, it simultaneously undermines the incentives
to minimise costs and optimise investment. The costs of the distortions to
productive efficiency are likely to far outweigh the costs of any monopoly
pricing.

Concerns about monopoly are not an obstacle to privatisation. The same
issues arise with corporatisation, and indeed with other forms of public
ownership. Research suggests that public ownership is an inferior strategy
for controlling monopoly compared with light-handed regulation that relies
on sound competition statutes, especially given the other disadvantages of
public ownership.14

4 Industry structure

The structure of the water industry has largely been determined by
political considerations (the boundaries of the local authorities) rather
than commercial forces. This suggests that the current structure is
unlikely to be optimal. This conclusion is reinforced by the observation
that there are a large number of entities serving a relatively small
population. Seventy-three local authorities, Watercare and the Wellington
Regional Council provide water and wastewater services, with around a
third serving populations of fewer than 20,000 people. The World Bank has
suggested that the minimum efficient scale of water industry firms may
involve a population base of around 500,000.

Although it is likely that there would be efficiency benefits from
rationalisation there is no straightforward way of determining what form
rationalisation should take, what entities should be rationalised, and how
rationalisation should be initiated.

It is nearly impossible to centrally plan an industry efficiently - to
determine the optimal number of entities, and preferred contractual
arrangements. The problem could be solved by privatising the water and
wastewater businesses and allowing private operators to seek out
rationalisation opportunities within the constraints imposed by the
Commerce Act. Alternatively, councils could be required to franchise their
operations at the same time, which would allow private firms to bid for
groups of contracts, subject to the same constraints. A further major
potential advantage of privatisation options is that it would allow the
development of multi-utility businesses where synergies between the supply
of water and sewerage services and electricity, gas, telecommunications or
roading services may exist.

Corporatisation could also improve the incentives of water and wastewater
businesses to search out rationalisation opportunities. However,
compromised versions of the corporatisation model and the desire of
councils to retain control of local businesses may undermine these
incentives.

Corporatisation may also not be a feasible option for some of the smaller
entities - for such entities amalgamation or other contracting options
would need to occur before consideration was given to corporatisation.
However, the studies undertaken in Auckland and Wellington found that
substantial efficiency gains could be achieved through amalgamation in
these centres. Many of the benefits could potentially also be achieved
through contractual arrangements. In France, for example, the water and
wastewater assets owned by 36,000 communes are for the most part operated
by three private companies through franchise arrangements.

I strongly doubt that local authorities will achieve any significant
rationalisation of their businesses unless they are required to do so by
central government. The government needs to devise a process to require
councils to consider options for rationalisation and to implement them if
potential efficiency gains are demonstrated.

Given the likely gains from corporatisation of relatively large water and
wastewater businesses, the government could mandate the formation of LATEs
in major urban areas. It could require that, during the establishment
phase, establishment boards consider the scope for realising efficiency
gains through amalgamations or other contractual arrangements.
Establishment boards could be required to report on the options considered
and the reasons why a particular course of action was chosen.

Smaller utilities could be given the choice of amalgamating with other
utilities to form LATEs, or contracting out most or all of their
operations.

5 Conclusions

The fact that so little progress has been made on reform of the water
industry in New Zealand in recent years reflects deep-seated problems in
local government. These include weak incentives and accountability,
vulnerability to special-interest lobbying, the poor quality of analysis
by many council managements, councillors with a poor understanding of
public policy issues, and overly-politicised, factionalised councils. In a
highly politicised climate it is not surprising that inertia and
resistance to change win the day so frequently. But paralysis is neither
good enough nor inevitable. The general lack of progress made by most
local authorities over the past four or so years contrasts with the
changes achieved in Papakura, most Australian states and many other
countries.

The introduction of a market-oriented approach to reform would yield
substantial improvements in efficiency. Corporatisation and greater use of
franchising and contracting out would improve the incentives for
performance of the local government-owned water and wastewater businesses.
Privatisation would overcome the problems inherent in continuing
government ownership.

The adoption of more efficient pricing arrangements must be part of a more
commercial approach.

Regulation of market power in the water industry should be by way of a
light-handed regime. This approach has been outstandingly successful in
New Zealand, bringing benefits that far outweigh any detriments.
Heavier-handed regulation would impose substantial costs in the water
industry and other utilities.

Rationalisation of the water industry is likely to yield efficiency gains.
However, determining what form rationalisation should take, what entities
should be rationalised, and how rationalisation should be initiated is
problematic. Essentially a market-based approach through privatisation or
a government-directed approach are the only feasible alternatives.

Local Government New Zealand keeps telling the business sector that
councils are addressing the problems and understand the need for change.
They maintain that councils should be allowed to make decisions at their
own time and speed. This case is wearing thin. I remain highly sceptical
that most councils will implement any significant change unless they are
firmly directed by central government. The prospective roading reforms
would never have happened if they had been left to local government. It is
perfectly appropriate for central government, which has the responsibility
for determining the framework in which local government operates, to
require similar changes to the water industry.

Too much is at stake. The New Zealand economy is seriously
under-performing relative to its potential, and the gap between average
incomes here and in more successful countries is wide. Inefficiencies in
the water industry are holding the whole economy back. Those who profess
to be concerned about problems of low incomes and unemployment should be
calling the loudest for reforms. Unless central government insists on
changes, my fear is that in another four years we will still be discussing
the same problems and issues, and that the industry's performance will be
lagging even further behind international best practice.
 
 
 
 

End Notes

1A press release of 10 September 1998 noted these and other gains achieved
by Metrowater in its first year of operation.

2See, for example, CS First Boston (1995), Reform of the Water Industry,
report prepared for the New Zealand Business Roundtable, p 126.

3"Review of the Powers and Responsibilities of Local Authorities to
Provide Water and Wastewater Services: Overview of Analysis of Returns
from a Survey of Local Authorities", Bridgeport Group, April 1988, pp 8
and 13.

4City Weekly, 25 January 1999, p 3.

5Australian Financial Review, 18 August 1998, p 33.

6Ibid, p 37.

7Australian Industry Commission, Microeconomic Reforms in Australia: A
Compendium from the 1970s to 1997, Research Paper, AGPS, Canberra, January
1998, pp 75-76.

8Clarke, R, Implementation of COAG Reforms: Approaches and Issues, paper
presented to AIC Australian water conference, 23-24 June 1998, p 6.

9Scott, G and Brook Cowen, P, "Some Issues in Institutional Reform for
Improved Performance in Government-Owned Water Utilities", draft report
for the World Bank, 1996, p 29.

10Brook Cowen, P J, Utility Reform and Private Sector Participation in the
Water and Wastewater Sector: An International Perspective, AIC 6th Annual
NZ Water Summit, 26 February, 1998, p 7.

11The Press, 26 August 1998.

12Silva, G, Tynan, N and Yilmaz, Y, "Private Participation in the Water
and Sewerage Sector - Recent Trends", Viewpoint, World Bank Group, August
1998.

13Brook Cowen, P J, op cit, p 6.

14See Willig, Robert D, "Public versus regulated private enterprise",
World Bank Research Observer (Annual Conference on Development Economics
Supplement), 1993, pp 155-180.

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