A General Economic Critique of Water Privatization

by Dr. William J. Weida

June 22, 2001

Privatization--definitions and theory

‘Classical’ Privatization

Privatization originally involved the sale of government enterprises in Europe and Japan, many of which had previously been nationalized. In the 1980’s, concern with balancing the budget led the Reagan administration to call for US privatization in which the US government followed the European model and divested itself of certain assets by selling them to private firms. Advocates of privatization felt many government activities could be performed more efficiently by private industry and they also hoped the sale of government assets would help balance the budget. Critics of privatization noted that private companies do not always act in the public interest and that many of the goods and services produced by the government are not amenable to private production.

The private sector is defined by independent ownership and control. It includes all decision-making units that are not part of the government. The hallmark of the private sector is its response to the signals contained in the prices it pays for the resources it uses and the prices it can charge for the goods it produces. This response is predicated on a critical assumption of viable competition in both the markets where resources are purchased and the markets where products are sold. Government organizations are not faced with this kind of price and information structure, so they are assumed to maximize their own utility (i.e., take those actions that enhance the existence of the government organization), not the utility of the goods or services they produce. For this reason, critics of government operations argue that no set of internal incentives or regulations can ever match the discipline of the market and thus, if the private sector can possibly provide a service, it is likely to do so more efficiently.

However, private producers do not find it in their best interest to produce everything members of society want. More specifically, there is a whole class of goods called public goods--things like roads, clean water, and public safety that will be under produced or not produced at all in a completely privatized market economy. Public goods bestow collective benefits on members of society because they are, in a sense, collectively consumed. The fact that no one can be excluded from enjoying their benefits creates two problems that prevent the private production of public goods:

1. You cannot exclude people from enjoying a public good whether or not they pay for it--the indigent who pays no taxes can still use the public sidewalk or drink clean water from a public fountain.

2. Goods that provide collective benefits are expensive to produce. Any one person’s input is unlikely to make much difference in what is produced. For example, any one person's efforts to control pollution is unlikely to make a major difference in the amount of pollution that enters water. This leads to a ‘tragedy of the commons’ where no single individual has a clear economic incentive to do things that would be good for the community as a whole. As a result, private enterprise is not motivated to provide necessary services/products and the government must provide them instead.

Thus, while privatization of water supplies has the potential to increase efficiency, it is not likely to be capable of providing the basic "public good" elements of a water supply—guaranteed service to all citizens of an area and guaranteed standards of cleanliness and quality. Further, privatization will only save money if one assumes significant efficiency gains because a private company must be compensated not only for the cost of providing the water--a cost any government or government-controlled entity would have also incurred--but also for the cost of capital borrowed to construct the project, a cost which is lower for government projects because the risk of lending to the government is lower.

Implications of privatizing water supplies

The differences between "privatizing" water supplies and the usual concept of privatizing government facilities or organizations create a number of difficulties when actual privatization of water supplies is implemented. To understand why this is so, it is important to remember that privatization--an economic concept—will not become a reality simply because some government policy mandates privatization. For privatization to work, there must be real competition between service providers. Real competition implies a sufficient number of service providers so that no one provider can unduly influence the water market.

Can this kind of competition be achieved in a water market? It is unlikely because history teaches that only two broad categories of privatization are likely to occur:

1. Monopolistic Privatization: A private company purchases all water resources at a fair market price determined by auction and then assumes all liability for future events while working within a market-based price system for both the factors of production and for the products the company produces. In this case, the resources can be correctly priced, but competition is absent and there is no incentive to provide the resources to the public at the lowest possible price.

2. Subsidized Privatization: A private company is granted public-owned water supplies (or the use thereof) at non-competitive or free prices. The company does not face a market-based price system for either its factors of production or its products, and it may or may not assume liability for future events associated with its operation. Here the resources are not correctly priced, there is no incentive to provide efficient service because there is no competition and, since risk subsidized, there is no incentive to run a well-managed organization. All of these factors will raise the price of the water supplied to consumers.

In neither likely case for water privatization, some or all of the benefits that accrue when a private company operates in a normal market--do not exist. The economic conditions that are supposed to create benefits from water supply privatization can only arise when a privatized organization is fully subject to the discipline of the market and when it receives the full amount of information contained in unsubsidized and uncontrolled costs and product prices.

Risk and privatization

Every economic enterprise faces some degree of risk in its operations. This risk has two functions: first, it tends to foster a conservative method of business operation and second, it provides the measure against which acceptable returns on investment are calculated. For example, a high-risk operation would be expected to generate a high return on investment or it would not be undertaken by a rational business.

Risk exists because of the nature of the work performed or service provided. Assuming prudently designed water production and supply systems, a privatized water supply company cannot further reduce its risk, it can only shift the costs of risk away from the its operation and onto someone else. Shifting the costs of risk can only be accomplished with active or tacit government approval. For example, it is not surprising to learn that failure to allow privatized institutions to fully face the reality of the market has been a common problem in Eastern Europe as Socialism has been replaced with Capitalism. These governments have little experience with capitalism and thus, little understanding of Capitalism's requirements. What is surprising is that the same problems have also occurred in privatization efforts in Capitalist countries.

The Hungarian economist Janos Kornai has noted that Capitalist enterprise is motivated to maximize profits and as a result, it has little incentive to over demand resources. If it employs more resources than required, profits suffer.

If the budget constraint is hard, the firm has no other option but to adjust to unfavorable circumstances by improving quality, cutting costs, introducing new products or processes. If the budget constraint is soft, the firm can ask for compensation for unfavorable external circumstances and the government is acting like an insurer, taking over all moral hazards. The soft budget constraint protects the old production line, the inefficient firm and thus impedes innovation and development.

Because of the health and social issues involved, a soft budget constraint (i.e., government subsidation of the costs associated with the risk faced by the water supplier) is likely when privatization of water supplies occurs. This could shift most costs of insuring the success of the operation to the government and, in the process, create a moral hazard. A moral hazard exists when one party to a contract passes the cost of their behavior on to another party. Such contracts lead to inefficient behavior because if a contract absolves one party of the consequences of his or her actions, and if people act in their own self-interest, the result is inefficient operations.

Return on investment for the privatized water supplier

Privatized water supplies are claimed to provide a cheaper solution to water distribution problems than those already in place. However, there must be a potential economic gain for both parties in any successful business arrangement. Normally, companies seek an industry-accepted return on investment and this return is determined by the price competition that takes place when the product or service is provided. In a case where much of the risk has been assumed by the government and where the number of competing water providers is limited, the return on investment may be artificially high. When return on investment is artificially high, the company lacks the incentive to use efficient production techniques. In addition, firms may actually have an incentive to over invest if the allowed return exceeds the cost of capital.

In addition, the operator of a privatized facility must experience a greater return on the investment of its own capital than would be earned from alternative uses of the money or there would be no incentive to undertake the privatization in the first place. The return on investment must also take into account the risks inherent in the production and supply of water. One of these risks occurs if the water supplier loses its customers because there is no alternative use for the facilities that the supplier has built (as opposed to an individual who builds a factory that could be used for a variety of production processes should the initial product fail.)

Because of the specialized nature of water supply and distribution facilities, economists recognize that this situation may create a ‘holdup problem.’ A ‘holdup problem’ occurs when one party in a contract can exploit another party’s vulnerability because alternative uses for the asset built to supply the product (water) are limited or non-existent (i.e., a water purification plant cannot be used for other purposes.) ‘Holdup problems’ often lead to distrust and to reduced investments, and these conditions lead, in turn, to reduced efficiency of production. To solve this problem, government is often asked to assume costs and risks—in this case, the risk of building a single-use water treatment facility--that would normally be borne by a truly privatized concern. The need to shift risks to the government arises in this situation because the project is fundamentally unsuited to privatization. The shifted risks will be a subsidy to the water supplier paid for by the government and ultimately, by the taxpayer.

Conclusion

Privatization implies an absence of government intervention and control. But liability for public safety and health issues implies government intervention and control. This creates an inherent conflict that has the potential to reduce profit.

Information about health and safety issues is a public good. In many cases, the government has set up agencies to insure that information reaches the public. In the past, the assignment of liability to private concerns has often been directly related to the information released about the operations of those firms. An attempt by water suppliers to decrease liability in these situations may lead directly to efforts to decrease information flows about the water supply process and the quality of the product.

In sum, real privatization of water supplies is, for good and obvious reasons, unlikely to occur. Instead, water privatization efforts are likely to cost much more in the long run, and losses to communities dependant on privatized water are likely to be much greater than simple dollar costs can indicate. If water suppliers use the cover provided by privatization to avoid public scrutiny and to nullify existing public oversight of water supplies, the results are likely to be scandals and pollution problems that will cost the public far more than any gains in efficiency could offset.

Dr. William J. Weida([email protected])