Strategic Management Consultants                       smc




 Optimum Entity Size in the Water Industry of England and W...
Contents page

    April 2002................................................................................................
Page 3 of 74


 Terms of Reference for the project

 Ofwat commissioned this report to review whether an optimum size for ...
Page 4 of 74


Executive summary

The paper collects and reviews evidence from the literature on factors affecting firm si...
Page 5 of 74


Introduction

The paper is set out under thematic headings, and conclusions relevant to company size are
in...
Page 6 of 74


Can the size of (regulated) companies be objectively determined?
Appendix Four reviews the theoretical and ...
Page 7 of 74


Regulation and Comparative Competition

Regulation is a balancing act between opposing influences: there is...
Page 8 of 74


A surrogate for competition between spatially discrete monopolies is provided by comparative
competition – ...
Page 9 of 74


works in practice. Ofwat has itself progressively amalgamated data for companies in common
ownership in its...
Page 10 of 74


Ownership and the loss of comparators

Kay and Thompson16 refer to empirical studies which indicate that t...
Page 11 of 74



There is a trade-off between allowing takeovers to encourage productive efficiency and keeping
enough fir...
Page 12 of 74


industries. Baily, Hulten and Campbell27 conclude that the acquired plant’s efficiency increases
with the ...
Page 13 of 74


Table One            Changes in Industry structure from privatisation

   Date                      Compan...
Page 14 of 74


Are mergers beneficial?

The question here is to establish whether the advantage to customers of mergers i...
Page 15 of 74


Hence merger activity has still found a majority (60%) of higher cost companies absorbing lower
cost ones ...
Page 16 of 74


Making comparisons with ‘averaged’ data

Because of the size of the privatised WASCs there are significant...
Page 17 of 74


surviving public copies of these documents in several UK University libraries, but none are held
by the Br...
Page 18 of 74


Ofwat has published both values in its annual leakage reports9 for a number of years, and there is
further...
Page 19 of 74


Why are the companies the size they are now?

The history of water industry consolidation, central control...
Page 20 of 74


Big companies, big schemes and technocracy.

The culture of ‘biggest is best’ had been a feature of the 19...
Page 21 of 74


They had been able to respond to the crisis to make the best use of limited water resources. On
the other ...
Page 22 of 74


at the local level 49 there are recent concerns that big schemes will create incentives for
diversificatio...
Page 23 of 74


Can the size of (regulated) companies be objectively determined?

There is theoretical acknowledgement of ...
Page 24 of 74


Natural Monopoly as a justification for size

Adam Smith wrote in 177657 “Monopoly…is a great enemy to goo...
Page 25 of 74


Schmalensee61 has defined four main pre-requisites for efficient natural monopoly performance:
• prices ba...
Page 26 of 74


Economies of Scope and Scale

This section draws upon earlier work30 and augments it with more recent evid...
Page 27 of 74


characteristics of natural monopoly and assume that scale economies applied continuously across
the full r...
Page 28 of 74


Typically the water supply to a small town derived locally from a series of boreholes is likely to
be oper...
Page 29 of 74


Economies of Scope from Vertical and Horizontal Integration

Many authors have identified the cost advanta...
Page 30 of 74


Boundaries for Economies of Scale – Minimum Efficient Scale

There must by now be enough references in the...
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April 2002

  1. 1. Strategic Management Consultants smc Optimum Entity Size in the Water Industry of England and Wales: a Review of Factors which Influence the Size of Companies. April 2002 Strategic Management Consultants Ofwat Rawgreen Centre City Tower Steel 7 Hill Street Hexham Birmingham Northumberland B5 4UA NE47 0HL
  2. 2. Contents page April 2002......................................................................................................................................1 Contents page ....................................................................................................................................2 Terms of Reference for the project....................................................................................................3 Executive summary...........................................................................................................................4 Introduction........................................................................................................................................5 Regulation and Comparative Competition........................................................................................7 Ownership and the loss of comparators...........................................................................................10 Are mergers beneficial? ..................................................................................................................14 ........................................................................................................................................................15 Making comparisons with ‘averaged’ data......................................................................................16 Why are the companies the size they are now?...............................................................................19 Big companies, big schemes and technocracy.................................................................................20 Can the size of (regulated) companies be objectively determined?................................................23 Natural Monopoly as a justification for size....................................................................................24 Economies of Scope and Scale........................................................................................................26 Economies of Scope from Vertical and Horizontal Integration......................................................29 Boundaries for Economies of Scale – Minimum Efficient Scale....................................................30 Boundaries for Economies of Scale – Integrated design.................................................................33 Capital Intensity...............................................................................................................................35 Conclusions......................................................................................................................................40 Appendix One ................................................................................................................................43 Organisational issues...................................................................................................................43 Appendix Two.................................................................................................................................46 Empirical and theoretical studies of mergers...............................................................................46 Appendix Three...............................................................................................................................49 Why are the companies the size they are now?...........................................................................49 Integrated River Basin Management (IRBM).............................................................................52 Privatisation.................................................................................................................................55 Appendix Four.................................................................................................................................56 Theoretical basis for firm size and industry structure.................................................................56 Differences in Managerial Ability. ............................................................................................61 Appendix Five.................................................................................................................................62 Example calculation of limits to economies of scale in the water industry.................................62 Appendix Six...................................................................................................................................64 Analysis of published data...........................................................................................................64 Assumptions................................................................................................................................64 Observations................................................................................................................................64 Final form of ‘models’.................................................................................................................65 References........................................................................................................................................68
  3. 3. Page 3 of 74 Terms of Reference for the project Ofwat commissioned this report to review whether an optimum size for water and sewerage companies in England and Wales can be determined, in particular to: • inform regulatory decisions on efficiency targets • inform judgement on the number and size range of companies required as comparators to sustain comparative competition. The study has been undertaken by Nick Curtis* and updates a review conducted as part of a broader Warwick University MBA thesis completed by him with Ofwat sponsorship in 1991. The study has two main elements: • review of the literature relating to firm size in regulated industries and ‘free’ markets? • analysis of data in the public domain to test water company size against criteria in the literature and to test for correlation between size and other operating and financial variables. * Nick Curtis BSc CEng MICE FCIWEM MBA is a Director of Utility Performance Consultants Ltd and a Consultant for Strategic Management Consultants Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  4. 4. Page 4 of 74 Executive summary The paper collects and reviews evidence from the literature on factors affecting firm size for regulated industries and free markets. The conclusions reached in the literature are tested where relevant against published information for the water industry of England and Wales, to review whether an optimum size for water and sewerage companies in England and Wales can be determined. Modelling of averages of published time-series data shows a rapid reduction in costs to customer with size (in terms of billed properties) which diminishes to a stable and slightly declining relationship once a scale of around 400,000 billed properties is reached. Although the two companies with the lowest cost to customers operate on either side of this size, they have relatively benign system characteristics, reflected in their lower capital intensity. The modelling shows that capital intensity (in terms of average total capital expenditure) is the most significant driver of cost to customers. All companies larger than the two lowest cost companies have significantly greater capital intensities, and thus significantly higher costs to customers. MES measures derived from other industries applied to the water industry plant sizes, and technical appraisal of idealised distribution systems show that technical scale economies in the water industry are exhausted at plant and distribution system sizes of 35000-45000 billed properties (equivalent to population in the region of 100,000). Following successive mergers of medium sized companies since privatisation, there are now insufficient comparative companies of similar sizes to test whether 400,000 billed properties represents an industry optimum size using published data. The slight continuing returns to scale beyond 400,000 billed properties suggests that there are some activities (e.g. call centres) whose optimum scale is larger than both the system technical optimum, and the potential company size optimum. However the largest companies benefit from lower unit costs obtained from their legacy of very large treatment works which are unavailable to smaller companies with the same capital intensity, and this may also partially explain the continuing apparent returns to scale for a given capital intensity. Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  5. 5. Page 5 of 74 Introduction The paper is set out under thematic headings, and conclusions relevant to company size are included within each section, and collected in a general conclusion section at the end of the main paper. The analysis of data in the public domain has been placed in Appendix Six. The text has been written and referenced to provide as far as possible a self-contained review of the issues. Some references have been included for the sake of completeness, and to streamline future work in this area. In each section the aim has been to establish whether size is important. The empirical references are to the water supply businesses of England and Wales, described in the paper as the ‘water industry’. Ofwat has published data used in econometric modelling to assess the relative efficiencies of companies in respect of operating expenditure and capital maintenance expenditure. In addition to that information this paper uses published information on total costs to customers and total capital and operating expenditure to explore the impact of company size on customers’ costs. Regulation and comparative competition This section contains a brief description of regulatory issues which the comparative competition approach seeks to address. Comparative competition (like yardstick competition) requires that companies’ differing characteristics are taken into account in the consideration of regulatory action. The number (and hence size) of independent companies impacts directly on the success of the comparative approach. Appendix One reviews the literature on organisational issues related to size of companies. Ownership and loss of comparators This section reviews briefly the literature on the impact of different forms of ownership (public, private and cooperative) on company efficiency. The efforts to retain independent comparators and the history of ownership in the water industry are described. Are mergers beneficial? The literature on empirical and theoretical studies of merged companies (chiefly in the US) is reviewed in Appendix Two. The section sets out the impact of ownership changes in the water industry on the original ranges of relative efficiency and cost to customers. Historical information is used to illustrate the diversity of characteristics of sub-systems within the larger companies, which is masked by the reporting of information at the company level. Why are the companies the size they are now? The history of the drought-driven pressure for concentration in the water industry is presented in Appendix Three. The justification for concentration rests largely on the assumption of constant returns to scale in a natural monopoly industry, and succeeding sections of the paper challenge that assumption with support from the literature and water industry experience. Big companies, big schemes and technocracy. The culture of the 1960’s provided the context for the creation of the new Water Authorities with technical specialists promoting pan-regional solutions to meet extrapolated growth in demand. Following the 1976 drought these forecasts were revised downwards and the emphasis of water management changed to financial controls. Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  6. 6. Page 6 of 74 Can the size of (regulated) companies be objectively determined? Appendix Four reviews the theoretical and empirical analysis of firm size, growth and industry structure. International experience shows that the size of public/private utility operators is determined by existing administrative structures, with only limited (geographical) subdivision. Natural monopoly as a justification for size By (economists’) definition there are economies of scale in natural monopoly, but also evidence from the literature and from the water industry itself that these can be exhausted at low levels of output, as described in the following section. Economies of Scope and Scale This section reviews the evidence from the literature and the water industry for economies of scale. The literature contains many references refuting the assumption of constant returns to scale. Measures of minimum efficient scale, and examples of integrated design from the water industry (Appendix Five) show that technically-based economies occur at a smaller scale than most water industry company sizes. Capital Intensity Return on capital is a major component of cost to customers in this capital-intensive industry, but there are significant differences between companies in the level of capital utilisation. Appendix Six contains the results of regression analysis using published data showing the relationship between size, capital utilisation and cost to customer. Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  7. 7. Page 7 of 74 Regulation and Comparative Competition Regulation is a balancing act between opposing influences: there is a need to preserve the benefits of innovation but not to insulate completely from competitive reaction; to balance economies of scale with the minimum numbers of firms necessary to preserve competitive behaviour. In its strictest form, regulation deliberately replaces the two chief requirements of free competition: freedom of entry, and independence of action. Government determines price, quality, and conditions of service, and imposes an obligation to serve1. The Regulator is also placed under a complex framework of duties and responsibilities. Strict prescription of company activities would inevitably stifle innovation. However, provided that the regulatory standards are minima, rather than absolutes, then there remains some scope for managerial activity in the regulated company. With tight regulatory controls, the company is protected from competition. Regulation is beset with Principal/Agent problems: there is asymmetric information, because the regulator (Principal) sees only the outputs, and the firm (Agent) knows all the inputs. There is hidden action and hidden information2 3 (see Appendix One Organisational Issues for an extended discussion). These problems are usually addressed in the formulation of regulatory rules. The company is not expected to provide details of its cost and demand functions. Only historical data can be assumed to be available to both parties.4 In imperfect markets (in the extreme case a monopoly) market power can assign high costs to other classes of patron (term used by Hansmann5 to describe collections of individuals or firms that transact with the subject firm). Unregulated monopoly is a worst case, but there are also costs which vary with the form of regulation. These include direct costs of regulation (regulator’s resources, costs of information provision, bidding and challenge), but may be eclipsed by other inefficiencies which stem from the regulatory structure. Examples of these inefficiencies include more intensive use of capital (the Averch-Johnson effect6 in Rate of Return regulation, and in larger companies generally), or the failure to pool technical knowledge or research (cooperatively, or through spillovers) leading to fewer cost-cutting opportunities in regulatory structures such as yardstick competition.7 Transaction and ownership costs vary with the assignment of ownership, and the most efficient arrangement will minimise the sum of these costs to the owner.5 Bonbright8 has said ‘the very nature of a monopolistic public utility is such as to preclude an attempt to make the emulation of competition very close’ i.e. if competition can’t exist, how can you imagine what it might have looked like? Kahn1 has offered guidance on regulatory choice when dealing with public monopolies: “the only analytical tool is judgement informed by economic theory and experience (provided that the experience is transferable)”. If an industry is so peculiar as to warrant removal from the market place then experience of unregulated or other industries must have less relevance. 1 Kahn, A. E., The Economics of Regulation: Principles and Institutions, Volumes I & II, Wiley, 1970 2 Arrow, K. J., The Economics of Agency, in Pratt, J. W. and Zeckhauser, R. J., (eds) Principals and Agents, Cambridge, Mass., Harvard Business, 1985 3 Rees, R., The Theory of Principal and Agent, Parts I and II, Bulletin of Economic Research, 37 4 Bos, D., Public Enterprise Economics, North-Holland Elsevier, 1986 5 Hansmann, H., Ownership of the Firm, Journal of Law, Economics and Organisation, 4 (2) 1988 6 Averch, H. and Johnson, L., Behaviour of the Firm under Regulatory Constraint, American Economic Review, 52, 1962 7 Sawkins, J., Yardstick Competition in the English and Welsh Water Industry, Utilities Policy 5(1) 1995. 8 Bonbright, reported in Nowotny, K., Economics of Public Utility Regulation: an Overview, in Nowotny, K., Smith, D. B. and Trebing, H. M., (Eds), Public Utility Regulation, Kluwer Academic Publishers, Lancaster, 1989 Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  8. 8. Page 8 of 74 A surrogate for competition between spatially discrete monopolies is provided by comparative competition – where companies are operating beyond the minimum efficient scale and there are sufficient comparators for statistically valid modelling comparative competition achieves greater cost efficiencies than other forms of regulation (such as simple price cap or cost-plus). Ofwat has used comparative information in price setting and publishes information on company performance to promote improvements in service9. The regulatory framework is simplified - the issue is what is to be compared and the appropriate number of comparators. In theory only one reliable low unit cost is needed to apply a yardstick, provided that cost functions are understood. A balance is needed between retaining numbers of comparators and the considerable effort which would be needed to replace comparative work with a detailed knowledge of the companies’ cost functions. There are four main regulatory issues which favour the use of inter-company comparisons over work on cost functions: • Regulators have limited resources compared to companies i.e. regulation must concentrate on a few core issues with clear theoretical approaches • Regulators have much less information than regulated companies – information must be collected on a standard basis • Regulators must operate in clear and consistent manner to provide reasonable planning horizon and avoid judicial review (a process of legal challenge of administrative processes in the UK). • Regulators must recognise differences in size and resources, whilst maintaining a consistent approach The regulator can overcome asymmetric information problems with comparative competition, provided he/she has enough information about companies’ different circumstances, and how these materially affect performance or service delivery. This enables the regulator to impose one company’s performance on others directly as a yardstick. More commonly, and with less information available to fully quantify differences in performance, the regulator stimulates a game of leapfrog amongst the regulated companies by publishing performance statistics. The companies themselves are left to identify the most cost-effective ways of improving performance, or simply keeping pace with the others. The regulator thus concentrates more on failure than success, but at the same time imposes a regime of steadily improving service delivery efficiency. From privatisation in 1989 the (then) Director General of Water Services, Ian Byatt, made it clear that he intended to publish comparisons between companies.10 In water there was a commitment against industrial concentration (with the consequent loss of comparators) from the start of the privatised regime. There have been difficulties tracking the financial performance of merged companies against price setting expectations, and analysts have had problems in trying to obtain ‘clean’ time-series data for the industry. The use of ‘shadow’ companies which are reported on as though free standing listed companies has been proposed to overcome this11, but there is little experience of how this 9 The Office of Water Services (Ofwat) publishes annual reports on performance and other information, and also publishes annual and price-setting information supplied by the appointed businesses. Annual reports are produced on Financial Performance and Capital Investment, Levels of Service, Leakage and the Efficient Use of Water, Water and Sewerage Service Unit Costs and Relative Efficiency and Tariff Structure and Charges. 10 Public statement by Director General Ian Byatt 8th August 1989 reported in The Water Share Offer, The Prospectus for the Offers for Sale by Schroders on behalf of The Secretary of State for the Environment and The Secretary of State for Wales, 22nd Nov. 1989 11 Powell, K. M., Yardstick Competition and the Actions of the Water Companies in England and Wales, Doctoral Thesis, Imperial College, London, Jan 1998 Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  9. 9. Page 9 of 74 works in practice. Ofwat has itself progressively amalgamated data for companies in common ownership in its annual publications. The heterogeneity of firms which has dogged the development of dynamic/stochastic models of firm growth and innovation is also a problem for comparative competition. Schleifer12 identified the need for ‘similarly situated’ firms for effective yardstick competition, and was also concerned about the effects of collusion between firms. He argued that simply making comparisons between data for different companies does not create any incentive for change, but in fact water industry experience has shown that it can. Monopoly companies can represent their positions as characteristic of their local circumstances, arguing that there are no direct comparisons which can be drawn. There are other pitfalls too. As Argenti13 has pointed out you might start out trying to measure what you need to know, but you end up knowing only what you can measure. It may be possible to bring about change where: • the monopoly businesses can be shown to be similar in the factors which govern a particular measure, • comparison can be limited to those components which are common to the businesses • factors which govern the measure can be modelled Each of these approaches has been used by Ofwat for different purposes. Kirsty Powell11 has demonstrated that “within the water industry of England and Wales comparative performance regulation is optimal and that yardstick competition only emerges as a special case. Where there are only two firms which intend to merge there are clear welfare arguments for forcing them to ring-fence their costs; however as long as two separate comparators exist, the first best outcome is always achieved”. Auriol and Laffont14 also show that regulating through nurturing a duopolistic or oligopolistic structure is beneficial due to the ‘yardstick effect’. It is clear that independence of the companies is an issue here, but common ownership cannot change the local operating circumstances in which companies find themselves. It can only offer opportunities for scale economies to be captured from labour-based for which the minimum efficient scale can be significantly higher than that for operational plant. In the water industry there was some evidence of independent action by companies in the first years after privatisation. “Company managers previously unaware and unaffected by competitive pressures were disturbed by the new rigours of yardstick competition. By setting performance targets with reference to comparative efficiency measurement the Regulator had, at a stroke, removed the incentive for collaboration.”7 After 1995 cooperation increased (through vehicles such as the water industry research group, UKWIR)15. Following increased merger activity, informational spillovers have also increased.11 Despite this change in the regulatory environment there remains support for comparative competition in principle, and thus it remains important to be able to characterise companies and assess what detriment the loss of a particular company might present for the preservation of independent and efficient comparators. 12 Schleifer, A., A Theory of Yardstick Competition, Rand Journal of Economics, 16, 1985 13 Argenti, J., Practical Corporate Planning, Unwin Paperbacks, 1989 14 Auriol, E. and Laffont, J-J., Regulation by duopoly, Journal of Economics and Management Strategy, 1 (3), 1993 15 Powell, K. M. and Szymanski, S., Regulation through Comparative Performance Evaluation, Utilities Policy, 5 (1), 1997 Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  10. 10. Page 10 of 74 Ownership and the loss of comparators Kay and Thompson16 refer to empirical studies which indicate that the form of ownership per se is not an important factor in determining how effectively services are supplied in utility industries. What does promote efficiency is the existence or threat of competition, whereas with no competitive challenges (the situation of the WA’s) overstaffing typically ensues. Nevertheless the WA’s reduced staffing by 30% in the five years 1979-84.17 Vickers and Yarrow18 reviewed empirical studies of performance differences between public and private utilities and concluded “the results of empirical studies are very mixed…. Substantial performance differences among utilities do nevertheless exist both within the industry and between countries. Consideration of relative efficiency gives no basis for the assignment of ownership”. It is difficult to draw a line between regulatory and public policy issues in considering the relative advantages of public and private ownership.19 It is also difficult to compare regulated private utilities with unregulated public utilities.20 The arguments for and against public/private ownership are not directly relevant to the aim of this paper, but the references cited by Vickers & Yarrow18 and Saal & Parker20 are included as an Appendix to the list of references. Holtham21 argued that the plc is unlikely to be the best form of organisation for certain utilities (in particular, water). He argues that there are powerful arguments for mutualisation of the water industry – the assignment of shares to the users of the service. He suggests that at the very least mutualisation of the service in Scotland would present a useful comparator with the rest of the UK. Further evidence of reduced costs associated with cooperatives is cited by Hansmann.5 There is no indication in these recent approaches of any consideration as to the optimum size for such enterprises. The sizes of existing companies (made larger by amalgamations) mean that what is measured is averaged over large areas. The balance of benign and adverse resource and supply circumstances (and thus the extent of averaging) is influenced by the topographical and/or geographical features of the areas of supply. Averaging of costs of service is inevitable in all sizes of companies but larger companies average across sometimes quite different supply systems. The averaging is beneficial to rural users as a cross-subsidy and detrimental to businesses taking large volumes at single locations. Even a cooperative might elect to apply price discrimination (such as deliberate subsidy of business or marginal costs of supply to rural areas). It is more difficult to obtain cost functions from larger amalgamated companies for efficiency measurements, but there is also risk-reduction opportunity in amalgamation which could lead to lower costs for customers (e.g. cost of capital). Ofwat has exacted the payment of customer premiums (in the form of price reductions) where the loss of comparators can be offset by benefits to customers. Unfortunately this is allocatively inefficient because the losers are the rest of the industry’s customers when a good comparator is lost, and the comparative impact of the new lower prices will only slowly influence the behaviour of other companies. 16 Kay, J. A. and Thompson, D. J., Privatisation: a Policy in Search of a Rationale, The Economic Journal, 96, 1986 17 Waterfacts (1984), Water Authorities Association, Jan 1985 18 Vickers, J. and Yarrow, G., Economic Perspectives on Privatisation, Journal of Economic Perspectives, 5 (2), 1991 19 McGowan, F., Utility Performance in the UK: The Role of Regulation and the Impact on Public Service, Annals of Public and Cooperative Economics, 66 (2) 1995 20 Saal, D. S. and Parker, D., Productivity and Price Performance in the Privatised Water and Sewerage Companies of England and Wales, Journal of Regulatory Economics, 20 (1), 2001 21 Holtham, G., Water, Our Mutual Friend, New Economy, 3(4), Winter 1996 Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  11. 11. Page 11 of 74 There is a trade-off between allowing takeovers to encourage productive efficiency and keeping enough firms in existence to permit cross-company comparisons.22 The Monopolies and Mergers Commission has supported strongly the retention of separate companies based on the concern over loss of comparators, and has turned down major merger applications on those grounds. The compulsory referral to the MMC for companies with a turnover in excess of £30m was said to inhibit Water and Sewerage Company (WASC) takeover in the water industry and initially only the smallest WASCs were taken over (Northumbrian, Southern, Wessex). Following the successful acquisition of Thames by the German company RWE in 2000, anything might happen. The MMC has ruled against amalgamation of larger companies (horizontal integration) chiefly on the grounds of preserving comparisons in the industry (Severn Trent and South West were both refused permission to take over Wessex and it ultimately went to Azurix, a paper-thin subsidiary of Enron). The Monopolies and Mergers Commission identified several negative effects of the loss of comparators in the industry23 24: • loss of a company at or near the frontier of efficiency and which is therefore potentially useful in setting a benchmark may have an impact on the effectiveness of regulation • loss may affect the confidence with which the regulator carries out his duties by changing the quality and the quantity of information • loss may affect the promotion of efficiency and better service in the industry by changing cost competition between companies • loss may change other aspects of the way in which the regulator uses comparators e.g. in ad hoc exercises undertaken in response to changing circumstances Good25 used the technique of Cumulative Abnormal Returns (CAR) to study the effect of mergers on the industry. He concluded “the detriment to the comparative regime caused by the loss of an independent comparator has not been offset by the creation of a more efficient company, as measured by total returns and regulatory accounts methodologies. Falling asset productivity and negative CARs support this statement.” Further evidence to support this concern (using Ofwat’s own information) is given in the next section of the paper. There is further support in a recent (unpublished) paper by John Ashton of the International Institute of Banking and Financial Services, Leeds, UK. Ashton argues that since the water industry is not in long-term equilibrium in terms of capital, both merger and acquisition amongst water companies are not justified in terms of cost efficiency. A substantive conclusion based on work on US manufacturing firms by Caves & Barton26 was the negative association between an industry’s efficiency and the extent of enterprise-level diversification, especially in the form of control of an industry’s plants by firms based in other 22 Waterson, M., Developing Utility Regulation in the UK, in Helm, D., (Ed), British Utility Regulation: Principles, Experience and Reform, Oxera Press, 1995 23 Monopolies and Mergers Commission, Wessex Water plc and South West Water plc: a Report on the Proposed Merger, London, HMSO, 1996 24 Monopolies and Mergers Commission, Wessex Water plc and Severn Trent Water plc: a Report on the Proposed Merger, London, HMSO, 1996 25 Good, A., Have Acquiring Water Company Shareholders Benefited, in Terms of Total Shareholder Returns, from Merger Activity in the Privatised Water Industry: How does this Impact on the Duties of the Director General of Water Services?, Dissertation for MBA, University of Aston, July 1997 26 Caves, R. E. and Barton, D. R., Efficiency in US Manufacturing Industries, Cambridge, Mass: MIT Press, 1990 Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  12. 12. Page 12 of 74 industries. Baily, Hulten and Campbell27 conclude that the acquired plant’s efficiency increases with the efficiency of whatever other manufacturing plants are operated by the same firm. This finding is consistent with the Federal Trade Commission’s Line of Business Data. Although this style of merger activity has been accepted for the water industry, it is rare for efficient companies to take over less efficient ones, and in the majority of cases the reverse is true for intra-industry mergers. In the water industry, internal mergers in general have seen larger inefficient companies absorbing smaller more efficient companies (see next section of this paper). Where there are common activities then some direct comparisons of efficiencies in different industries could be made at activity level (e.g. the parallels of network materials and design between the gas and water industries; billing operations; the operation of labour-based services such as customer call centres). Since privatisation the number of independent comparators in the water industry has reduced from 38 (excluding Cholderton which is a very small company) to just 22, as indicated in the table on the next page. The table also shows multi-utility mergers, and changes in parent company. 27 Baily, M. N., Hulten, C. and Campbell, D., Productivity Dynamics in Manufacturing Plants, Brookings Papers on Economic Activity: Microeconomics, 1992 Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  13. 13. Page 13 of 74 Table One Changes in Industry structure from privatisation Date Companies Trading in water as Owner No Cos 1988 East Worcester, Bournemouth and Continued separate Biwater Supply, Biwater 38 West Hants reporting Group 1990 Colne Valley, Lee Valley, Three Valleys Compagnies Generales 36 Rickmansworth des Eaux (later Vivendi) 1990 Newcastle & Gateshead, North East Water Lyonnaise des Eaux 35 Sunderland & South Shields (later Suez Lyonnaise des Eaux) 1990 Mid-Sussex, Eastbourne, West South East Water Saur group (Bouygues) 33 Kent 1991 Bournemouth, West Hants Bournemouth and West Biwater Supply, Biwater 32 Hants Group 1992 Essex, Suffolk (East Anglian) Essex & Suffolk Lyonnaise des Eaux 31 (later Suez Lyonnaise des Eaux) Sept 93 Severn Trent, East Worcester Severn Trent Severn Trent plc 30 Oct 95 East Surrey, Sutton Sutton & East Surrey Sutton & East Surrey 29 Nov 95 North West & Norweb United Utilities United Utilities plc Dec 95 Northumbrian, North East Northumbrian Lyonnaise des Eaux 28 (later Suez Lyonnaise des Eaux) Jan 96 Dwr Cymru, Swalec Hyder Hyder July 96 Southern, Scottish Power Southern Scottish Power May 97 Chester, Wrexham Dee Valley Dee Valley 27 1997 Mid-Southern, South East South East, but some Saur group (Bouygues) 26 separate reporting 1997-8 July 97 Anglian, Hartlepool (HPL) Anglian, but HPL Anglian 25 continued separate reporting to 2000 Aug 98 South West South West Pennon Sept 98 Wessex, Azurix Wessex Enron Mar 99 Yorkshire, York Yorkshire 24 Jan 00 Cambridge, Union Fenosa SA Cambridge Union Fenosa SA Dec 00 Thames, RWE Thames RWE Dec 00 Hyder Glas Cymru Glas Cymru 2000 Yorkshire Yorkshire Kelda 2000 Northumbrian, Essex & Suffolk Northumbrian but ESK Suez Lyonnaise des Eaux 23 separate 2000 2000 North Surrey, Three Valleys Three Valleys Vivendi 22 Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  14. 14. Page 14 of 74 Are mergers beneficial? The question here is to establish whether the advantage to customers of mergers in ‘free’ markets is at a level which suggests that they should be allowed in a regulated industry. Appendix Two sets out empirical and theoretical evidence (chiefly from work in the US). The conclusion can be drawn from the empirical work that productivity gains following merger are more about restoring the performance of the target company, whose decline had prompted the merger. Within the water industry the pattern is most often the reverse of the free market models described in Appendix Two. In general the smaller companies have been more efficient than their new parent. The residuals from Ofwat’s combined water service model published in 1994 (Table 7)28 show that with only two exceptions (Severn Trent & East Worcester, East Surrey & Sutton, shaded grey below) the larger company has been less ‘efficient’, as shown in the chronological merger table below (lowest residual = most efficient). Table Two Merged water companies and their efficiencies Larger company Residuals Smaller Company Essex 0 0 Suffolk Severn Trent -11 +8 East Worcester East Surrey -14 +5 Sutton Northumbrian +9 -13 North East Wrexham -5 -11 Chester South East 11 -8 Mid Southern Anglian -5 -7 Hartlepool Yorkshire -11 -26 York Northumbrian (NNE) 0 0 Essex & Suffolk Three Valleys -3 -8 North Surrey Thus it can be seen that the majority (80%) of merger activity within the water industry has served to remove comparators useful for Ofwat’s efficiency studies. In several of these situations, the merger has been brought about by common ownership of previously separate companies, and the Regulator has not been able to intervene on behalf of customers. The picture is more mixed if the cost to customers is examined as in the Table below (costs from 1991-2 are shown, preceding mergers, company water delivered estimates, Table 1). Table Three Merged companies and their unit costs Larger company p/m3 Smaller Company Essex 50 61 Suffolk Severn Trent 48 57 East Worcester East Surrey 62 53 Sutton Northumbrian 42 52 North East Wrexham 63 57 Chester South East 86 52 Mid Southern Anglian 59 39 Hartlepool Yorkshire 53 48 York Northumbrian (NNE) 46 53 Essex & Suffolk Three Valleys 48 46 North Surrey 28 Ofwat, 1993-94 Report on the Cost of Water Delivered and Sewage Collected, Ofwat, Birmingham, Dec 1994 Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  15. 15. Page 15 of 74 Hence merger activity has still found a majority (60%) of higher cost companies absorbing lower cost ones (except for the four mergers indicated by shading). In the case of South East and Mid Southern, the companies have been of approximately the same size, but the management of the less efficient one has fulfilled a dominant role in the combined company. Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  16. 16. Page 16 of 74 Making comparisons with ‘averaged’ data Because of the size of the privatised WASCs there are significant differences of environment and network characteristics within individual company areas, and averaging of data across the whole supply areas impinges on the success of modelling. As indicated in the section above, mergers have most frequently combined and submerged better comparators in worse-performing larger companies. In 1991/2 Ofwat sponsored an explanatory factors group which sought to develop a range of measures to capture drivers of operating cost differences between companies for the water service, which had sufficient separate data points available at the company level. Ofwat reviewed a variety of techniques for data management and analysis, and sponsored econometric and data envelope analysis of the additional data provided by the companies. The aim was to establish robust models of costs which would allow judgements to be made of the relative efficiency of companies, once the explanatory factors had been taken into account. Somewhat later Ofwat sought subdivision of sewerage service data by areas and individual large plants to enable similar modelling to be carried out. Further details of Ofwat’s approach are given by Curtis.29 The working group considered a range of measures including direct measures of sparsity of population (the geographical technique of nearest-neighbour analysis was suggested). Ultimately the network measure of total length of main proved to be a cost driver in the econometric analysis for the water service. However, as described by the author in 199130 based on work published in 198431 there are significant differences between the average population density and the unit length of main within the suppliers’ areas. These differences reflect varied nucleation of settlements and can have a bearing on both capital and operating costs. The effects are largely masked by the averaging within the large regional companies. The comparison problem is multi-factorial – even if the obvious issue of dispersion of population can be characterised by a suitable measure there are regional differences in water quality and effluent strength to be taken into account. An index of rurality has been developed for other purposes.32 Because the data has been assembled at the level of rural districts this appears to offer a good chance of accounting for the differences in population distribution, and further work on the suitability of the technique could be worthwhile to test the application of the approach to water industry boundaries. The extent of variation within companies in relation to leakage is illustrated in Table 5 below. This uses the example of Severn Trent WA and a few other combined areas using data published in the 1980’s in Water Services Yearbook,33 and by the MMC in its 1981 Report34 on the company. This type of data is available for all company areas, for a series of years within the Water Services Yearbook. Prior to this similar and much more extensive data was compiled in the British Waterworks Association Yearbooks, going back to the 1920’s. The author has located 29 Curtis, N. J., La revision de precios del Ofwat (Periodic Review). Un ejemplo practico de evaluacion de abastecimientos mediante indicadores de gestion, paper (in English) presented to workshop on benchmarking for MSc students, University of Valencia, Spain, 25 June 1999 30 Curtis, N. J., Independent Comparators in the Water Industry of England and Wales, Dissertation for MBA, University of Warwick, June 1991 31 Curtis, N. J., Design Philosophy and Principles, in Brandon, T. W., (Ed), Water Distribution Systems, Water Practice Manual 4, Institution of Water Engineers and Scientists, 1984 32 Cloke, P. J., An Index of Rurality for England and Wales, Regional Studies, Vol 11, 1977 33 Water Services Yearbook was published annually by Fuel and Metallurgical Journals, Redhill, England and contained water company information at sub-divisional level. 34 Monopolies and Mergers Commission, Severn-Trent water Authority, East Worcestershire Waterworks Company and The South Staffordshire Waterworks Company: A Report on the Water Services Supplied by the Authority and the Companies, London, HMSO, 1981 Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  17. 17. Page 17 of 74 surviving public copies of these documents in several UK University libraries, but none are held by the British Library – no single library with public access appears to have retained a full set. From the table (based on these simple measures) it can be seen that the Upper Severn Division (which includes the supply area up to the Elan Valley in mid Wales) has much more in common with the Welsh Gwynedd area than with the rest of Severn Trent. Similarly Chester has more in common with the dense urban areas of South Staffs and Severn Trent than it has with Wrexham, which in turn is closer to Upper Severn and Gwynedd areas, judged by these simple measures. By implication comparisons would be enhanced if the Severn Trent reported separately for its separate divisions. In fact most companies (from Water Authority days) have progressively reduced the number of operating or management units, with some later expanding numbers again. The divisional management within Severn Trent now has a different structure, but as expected the network characteristics are broadly the same. Larger water-only companies have also reduced the number of separate operational management areas. Table Five. Comparison of divisional data for Severn Trent with other example areas. Severn-Trent Divisions Population Mains per Unaccounted Marginal Leakage Service reservoir and some other density capita for water cost of water revenue storage (days of company areas (persons/ (metres/ (leakage) p/m3 expend’re average demand) square km) head) m3/km/d (1980/81) £000/Ml/d (1980/81) (1980/81) (1980/81) (1980/81) (1980/81) Avon (Coventry) 416 5.1 14.9 4.0 0.74 2.1 Derwent (Derby) 366 5.5 11.6 3.0 0.76 1.9 Lower Severn 298 7.1 14.9 2.9 0.68 1.7 (Tewkesbury) Lower Trent 569 4.6 17 3.0 0.63 1.45 (Nottingham) Soar (Leicester) 338 5.5 13.1 4.1 0.70 1.0 Tame (Birmingham 1705 3.8 17.1 1.0 0.26 1.03 and Wolverhampton) Upper Severn 73 10.6 5.9 2.9 1.02 2 (Shrewsbury) (S-T o’all now 7.9) Upper Trent (Potteries) 376 5.5 20 2.2 0.78 1.8 South Staffs Water 808 4.2 17 3 (author’s 1.0+ 1.1 Company (now 12.5) estimate) Thames Metro 3793 2.9 (now 33) 0.93 (Metro only) (but large bankside) Welsh Gwynedd 73 9.5 (now 9) 1.4 Chester 850 4.4 (now 8.2) 4 (incl bankside) Wrexham 213 8.8 (now 4.9) 0.9 The measure of leakage used here is m3/km/d, which tends to show lower leakage in rural areas, and higher leakage in urban areas, the reverse of the per-capita measure (l/h/d). This favours the companies with large rural areas and dense urban populations such as Anglian, Welsh, South West and Wessex (the latter has very old networks in its urban areas (e.g. Bath) and thus has a relatively high leakage level by this measure). It is worth observing, because the figures above support the conclusion (showing a non-linear increase in leakage with reduction in mains/head) that leakage is more of an urban problem. Judgements on leakage as a measure of relative company performance should take into account both the losses per length of main and per capita. Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  18. 18. Page 18 of 74 Ofwat has published both values in its annual leakage reports9 for a number of years, and there is further support for this in the author’s work on international comparisons for Ofwat.35 The figures above show that averaging across companies can make a significant difference to an otherwise extreme performance. Thames currently reports the worst rate of industry leakage on the per- kilometre measure, but the figure for the Metropolitan area is very much greater than for the whole company area. This is because of the inclusion in the gross supply area of the rural areas of the Cotswolds, Oxfordshire and the Home Counties – other water companies feed the densest urban areas of the Home Counties. In an ideal situation, comparator companies would exhibit characteristics which cover the whole range of cost or performance-driving variables. When looking at total costs to customer (see Appendix Six) the problem with the existing industry structure appears to be that both size and capital intensity are polarised because of the loss by amalgamation of medium sized companies. This polarisation can give rise to spurious accuracy from regression analysis – eg. for leakage, where the Thames Metropolitan area leakage level is double that in other companies. 35 Curtis, N. J., A benchmarking study of the England and Wales Water Companies and Sydney Water Corporation Ltd for 1996-97, Ofwat, April 1998 Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  19. 19. Page 19 of 74 Why are the companies the size they are now? The history of water industry consolidation, central control and ultimately privatisation has been well documented in the literature. Appendix Three contains a brief history of how the evolution of the industry structure has impacted upon the current size of firms in the water industry of England and Wales. If any change is to be sought in the structure of the industry it is useful to understand how it came to be arranged as it is at present. In summary, over time the industry has been styled as: • a service essential to human life restored to public control to deliver water for all (growth in size) • a service vital to the public health and development of rural areas (growth in size) • a target for nationalisation (central control of larger management units) • a fragmented industry operating at too small a scale to secure adequate resources (pressure to merge and consolidate) • an integrated environmental champion (integrated river basin management) • the most natural of monopolies (biggest is best) • an arm of the regional state (regional scale operations) • a drain on public funds (reduction of capital spending) • poacher and gamekeeper at the same time (an environmental disaster) • the dirty man of Europe • new flexible and efficient private companies (the same people, the same problems, the same size) • a tax on industry (massive increases in charges to restore the environment and water quality) • a market success (massive increases in dividends) • a mutual cooperative Throughout all of these incarnations there has been an unswerving public and private belief in the existence of universal returns to scale over the full range of water industry activities. This has been despite a developing body of empirical literature from the 1950’s which refutes that premise for geographically dispersed oligopolistic or monopolistic markets. The succeeding sections of this paper describe empirical and theoretical research which can inform judgement on whether an optimum size of utility entity can be determined, and provide the background to the summary statements above. Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  20. 20. Page 20 of 74 Big companies, big schemes and technocracy. The culture of ‘biggest is best’ had been a feature of the 1960’s.36 By 1963 the respected water engineer A C Twort could write37 “ We are in an era of gigantism, where nationwide economic survival depends on gigantic organisations for mass production. We no longer irrigate our own small-holdings and water our cattle from the village pump; we mass together for work, we mass produce in mammoth factories …. and therefore we must mass-produce our water.” Saunders38 saw the new large WA’s as a component of the regional state, in which decision- making placed a premium on expertise and substituted professional ethics for other forms of accountability. This situation changed “as the real issues facing the industry are not so much physical and technical as economic and social.” Nevertheless the technically based structure remained. Fischer39 defines technocracy as decision making power and criteria based on technical expertise, and suggests that technocrats are the most successful interest groups in US and UK politics. In particular, the technocracy was rooted firmly in the engineering of large capital works rather than network management.40 Appraisal of the real economies of scale available in construction and operation of above-ground assets almost always ignored the infrastructure costs to deliver/collect the output or input for the customer. In an industry where between 60% and 80% of the asset value is in infrastructure this was a woeful oversight. Disappointingly, some of the claimed success of the new larger Authorities has been ascribed to their size – one writer claims that the rationalisation of the Black Country Sewage Treatment Scheme (the reduction of 9 proposed new works to 2) was achieved because of the creation of Severn Trent WA. Having been in the same engineering design office at Tame Division of Severn Trent at the time the author can record this as one of the very few triumphs of the network specialists over the big-scheme technocrats. A sewerage specialist (Bill Laight) had initially flippantly observed that there was the available fall in level to transfer Black Country sewage downstream to treat it at the very much larger and lower unit cost Minworth works. When he looked at the idea in more detail, the economic case became overwhelming, even disregarding the environmental advantages to the river in the upper reaches of the River Tame (where more than 80% of the base flow was effluent). The two works retained in the Black Country had already incurred significant expenditure before the rationalisation was proposed, hence remained in the final scheme. The 1970’s saw the emergence of an environmental lobby opposed to the destruction of scenery and habitats by large construction works and in the absence of a clear institutional framework resource development had to proceed more cautiously. Once again (refer to Appendix Three for discussion of the impact of earlier droughts) a drought had a major influence on the course of events. The drought of 1976, only two years into the new regime is important in two respects. On the one hand it is cited41 as the definitive example of the success of the new multi-purpose Authorities. 36 Schumacher, E. F., Small is Beautiful, Abacus, 1974 37 Twort, A. C., A Textbook of Water Supply, London, Edward Arnold, 1963 38 Saunders, P., The ‘Regional State’: a Review of the Literature and Agenda for Research, Working Paper 35, Sussex, University of Sussex Department of Urban and Regional Studies, 1983 39 Fischer, F., Technocracy and the Politics of Expertise, California, Sage, 1990 40 Booker, G. A., Water Distribution Systems – Introduction, in Brandon, T. W., (Ed), Water Distribution Systems, Water Practice Manual 4, Institution of Water Engineers and Scientists, 1984 41 Taylor, L. E., Policies and Objectives, in Brandon, T. W., (Ed), Water Services Planning, Water Practice Manual 6, Institution of Water Engineers and Scientists, 1986 Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  21. 21. Page 21 of 74 They had been able to respond to the crisis to make the best use of limited water resources. On the other hand it became clear that people could manage with less water (total demand was significantly lower in 1977, the first reduction in demand since the War), and that there was considerable scope for more efficient use of the existing sources. Reporting42 on the 1976 drought, the National Water Council (NWC) concluded that there appeared “to be only a very limited need for major new reservoir storage in the period up to the end of the century.” There was a shift in emphasis away from trend forecasting of total demands (which had justified the massive but largely redundant Kielder scheme, opened in 1982) and towards more detailed analysis of the components of demand.43 This led to a scaling back of demand forecasts, and more emphasis on managing the synergies of mixes of resource types which could enhance overall drought yields (e.g. conjunctive use of ground and surface sources – mutual hedging). Fred Pearce44 was critical of the new large organisations and their resource planning: “Most of the ‘new men’ occupying larger desks and drawing larger salaries inside the new regional authorities were the bigger fish from the old Council Sewerage Boards and River Authorities. They had brought their big project ideas with them. But almost as soon as they had collected their keys for the executive washrooms, they found that long-cherished projects might fall victim to lower demand forecasts. Many simply refused to believe the predictions. Some saw them as an extension of the conservationists’ campaign against the new reservoirs. In the confusion a lot of things got built which should have been prevented.” As Ward45 comments, naturally the first act of any huge new public body is to build itself a new headquarters on a scale commensurate with its status and its responsibilities, and every one of the WA’s and some of the merged WOCs did exactly that. The central office was in many respects the symbol of central control and corporate planning, implying faith in continuous returns to scale. By 1983 Twort’s vision was a pale shadow and engineers were confronting issues of social needs.40 The government was allowing capital spending at only 50% of the level in 1974.46 Following recommendations from the MMC in its report34 on Severn Trent and its agent Water Companies in 1981, the Water Act 1983 changed the constitution of the WA Boards to make them more business-like, and the National Water Council was abolished. This removed the forum for discussion between WA’s of matters of common interest and the vacuum was filled by the formation of the Water Authorities Association, operating from the same premises. The Water Act 1983 signalled the end of technocrat control and the rise of financial control.47 The UK has not been alone in committing to capital construction of works which customers do not or cannot economically access. Ward45 describes experiences in Spain where until government constructed the distribution channels from principal canals in 1952, the water from the dam on the Guadalete Valley (Cadiz) had been largely unused since the dam’s construction in 1910.48 Despite a long tradition of resolution of water rights issues for the traditional seri-culture 42 National Water Council, NWC Water Industry Review, NWC, London, 1978 43 Archibald, G. G., Forecasting Water Demand – a Disaggregated Approach, Journal of Forecasting, 2, 1983 44 Pearce, F., Watershed: the Water Crisis in Britain, London, New Junction Books, 1982 45 Ward, C., Reflected in Water: a Crisis of Social Responsibility, London, Cassell, 1997 46 Thackray, J. E., Future Perspectives, in Brandon, T. W., (Ed), Water Services Planning, Water Practice Manual 6, Institution of Water Engineers and Scientists, 1986 47 Maloney, W. A. and Richardson, J., Managing Policy Change in Britain: the Politics of Water, Edinburgh University Press, 1995 48 Malefakis, E. E., Agrarian Reform and Peasant Revolution in Spain: Origins of the Civil War, New York, Yale University Press, 1970. Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  22. 22. Page 22 of 74 at the local level 49 there are recent concerns that big schemes will create incentives for diversification of agricultural production into water-hungry crops. Spain now has a per-capita demand for water exceeded only by US, Canada and Russia. Hooper50 quotes Juan Lopez de Urralde “The Ministry has an engineers’ lobby which has acquired a momentum of its own and is continuing to apply a policy that goes back to the days of Franco, consisting essentially of huge construction projects.” Ward45 suggests that large-scale water management schemes acquired a misplaced legitimacy from the apparent successes of the Tennessee Valley Authority, and the massive water management projects of California. He suggests that in fact the TVA survived more through the location of nuclear research there for the making of the atom bomb during the Second World War, than from the economic advantage of large scale water management. Davidson and Myers51 blame a wider range of international development failures on the export of large-scale projects: “Modern large-scale water management began in countries with ample rainfall and a temperate climate where regard had to be paid to the interests of the population. It has been exported worldwide with results of deforestation, intensive land use, centralised planning and inequitable land distribution.” The evidence argues for a balance between the cost advantages of large source and treatment works with the increasing costs of transmission to demand centres. Appendix Five provides an analysis of the exhaustion of scale economies in water distribution at a low scale of operations. Refer also to the later section of this report entitled ‘Boundaries for economies of scale – integrated design’. 49 Fairen-Guillen, V., El Tribunal de las Aguas de Valencia y su Processo, Valencia, Caja de Aborros, 1988 50 Hooper, J., The Drain on Spain, Guardian, 14 June 1995. 51 Davidson, J. and Myers, D., No Time to Waste: Poverty and the Global Environment, Oxford, Oxfam, 1992 Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  23. 23. Page 23 of 74 Can the size of (regulated) companies be objectively determined? There is theoretical acknowledgement of the virtue of objective privatisation process – “Each act of privatisation must be part of a whole scheme tailored to the particular conditions of each industry.”52 53 However in practice it appears that all of the UK privatisations have proceeded in rather a rush, and although there have been proposals to determine the size of regulated companies, in general they have been privatised as they stood. Chiefly the reasons stem from a concern not to unsettle investors (the City). David Young as Secretary of State wanted BT broken up in the fashion of the regional ‘Baby Bells’ in the US telecoms industry structure, but concerns over possible delays to the privatisation prevented this. The BT model was followed for the Gas privatisation with strong lobbying from Sir Denis Rooke (Head of BG) against break-up.54 Advice on the flotation of the electricity producers suggested that there should be 5 or more generating companies, but because of City doubts about competition a “lop-sided duopoly” was set up which was ultimately corrected by the removal of the nuclear sites from National Power. Parker has described this as a “triumph of market structure over market forces.”55 BG was split into Centrica and Transco in 1997 by the separation of supply from delivery (a reversal of the vertical integration). In electricity the separation of production from supply was maintained by barring the generators from acquiring the distribution companies after the expiry of the government’s ‘golden shares’ in 1995. However from 1997, the generators have all sought vertical integration – Powergen/East Midlands, National Power/Midland, and British Energy/ Swalec (bought from Hyder, Welsh Water). Takeover activity has been strong in the electricity industry with 10 out of 12 Regional companies being taken over by 1997 (7 by US companies, 2 by Water Companies until Hyder sold Swalec back to the industry, and Hanson bought Eastern). Internationally no pattern appears in the size of units proposed for private sector participation. In the US the Baby Bells have a distinct regional structure, but the stimulus for restructuring has been a reduction in concentration rather than an attempt to create optimum sizes of utilities. Stephen Myers’ comprehensive review56 of proposed public-private partnerships in water services internationally shows proposals for water supply units ranging from 48000 population (Fafe, Portugal) to several million (Berlin). The factor which most appears to dictate the size of the undertaking is the existing administrative structure. In only a few cases have there been positive attempts to introduce competition (or its regulatory surrogate, performance comparison) by subdividing existing areas (e.g. Karachi, Manila, and also Ghana which postdates the paper’s publication). In each case the populations of the separate units remain very large compared with any reasonable estimate of MES for the industry. For example Manila is split into two units of 5m and 6m respectively, Ghana into areas of 4.2m and 3.7m. The theoretical and empirical analysis of firm size, growth and industry structure is described in Appendix Four. The extensive modelling which is reported in the literature still fails to explain in depth the heterogeneity of successful firms within industries, even within free markets. 52 Beesley, M. and Littlechild, S., Privatisation: Principles, Problems and Priorities, Lloyds Bank Review, July 1983 53 Beesley, M., The Regulation of Privatised Monopolies in the UK, Rand Journal of Economics, 20 (3), 1989 54 Young, A., The Politics of Privatisation: Privatised Utilities in Britain, Palgrave, 2001 55 Parker, M., Coal Privatisation, Competition and Integrated Energy Policy – Free or Managed Market?, in Gilland, T., (Ed), Regulatory Policy and the Energy Sector, Centre for Regulated Industries (CRI), 1993 56 Myers, S., Water Services Management: A Public-Private Partnership, Financial Times Energy, FT Business Limited, 1998 Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  24. 24. Page 24 of 74 Natural Monopoly as a justification for size Adam Smith wrote in 177657 “Monopoly…is a great enemy to good management, which can never be universally established but in consequence of the free and universal competition which forces everybody to have recourse to it for the sake of self defence.” Natural monopoly is defined variously in the literature: • an inherent tendency for decreasing unit costs over the entire extent of the market, where the economies achievable are internal to the individual firm1 • having a stable sustainable set of prices (usually guaranteed by fixed costs of sufficient magnitude) and which cannot be controlled by the threat of market entry58 • the situation where it is less expensive for market demand to be met by one firm rather than by more than one firm59 • natural monopoly has a number of characteristics, most importantly economies of scale but also having capital intensity, non-storability with fluctuating demand, locational specificity, producing necessities for the community and involving connections to customers60 • there is a fixed and unmovable connection with the customer, an obligation to supply on demand and demand fluctuates widely, a pipe’s capacity is roughly proportional to cross- sectional area, while cost is proportional to circumference and pumping costs are non- decreasing in volume61 • a multi-product activity is a (static) natural monopoly if and only if the cost function defined over the relevant outputs is globally subadditive62 and a practical corollary: • Baumol et al58 showed that the simultaneous existence of scale and scope economies between a set of outputs is sufficient to ensure local sub-additivity of the cost function. By any of these definitions, the water industry is a natural monopoly. Water has “arguably the strongest case for being classified as a natural monopoly.”63 Sharkey64 differentiates two kinds of subadditivity, on the plant and on the firm. At the plant level, two firms can share a larger works and both benefit from economies of scale in construction and operation. There are many instances of just this form of shared asset in the industry, but there are negative aspects of the agreements which govern sharing of outputs or transfers, and one partner is inevitably aggrieved about subsidising the other(s). Alternatively Bos4 found that for the majority of water industry expenditure, the returns to scale are stable (on total cost) at a relatively low output. 57 Reported in Ref 11 58 Baumol, W. J., Panzer, J. and Willig, R. D., Contestable Markets and the Theory of Industry Structure, New York, Harcourt Brace Jovanovich, 1982 59 Train, K. E., Optimal Regulation: The Economic Theory of Natural Monopoly, Cambridge, Mass., MIT Press, 1991 60 Newbery, D. M., Privatisation, Restructuring and Regulation of Network Industries, MIT Press, 2000 61 Schmalensee, R., A Note on Economies of Scale and Natural Monopoly in the Distribution of Public Utility Services, Bell Journal of Economics, 9, 1978 62 Hunt, L. C. and Lynk, E. L., Privatisation and Efficiency in the UK Water Industry: an Empirical Analysis, Oxford Bulletin of Economics and Statistics, 57 (3) 1995, originally published as Discussion Paper 90-01 by University of Swansea Department of Economics, Jan 1990 63 Crew, M. A. and Rowley, C. K., Feasibility of Deregulation: a Public Choice Analysis, in Crew, M. A., (Ed), Proceedings of Seminars at Rutgers University in Oct1987/May 1988 published as Deregulation and Diversification of Utilities, Kluwer Academic Publishers, Lancaster, 1989 64 Sharkey, W. W., The Theory of Natural Monopoly, Cambridge University Press, 1982 Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  25. 25. Page 25 of 74 Schmalensee61 has defined four main pre-requisites for efficient natural monopoly performance: • prices based on marginal costs • appropriate product selection • efficient production • zero economic profits on average All four of these conditions have to be satisfied to be fully efficient. None of these is satisfied for the water industry, although efficiency and service delivery have improved since privatisation. Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  26. 26. Page 26 of 74 Economies of Scope and Scale This section draws upon earlier work30 and augments it with more recent evidence. As indicated in the brief description of monopoly characteristics above, there is the expectation of economies of both scope and scale in natural monopoly. There is a social value in ensuring that organisations are of a sufficient size to conduct activities efficiently. On the other hand there is evidence that very large firms suffer from loss of co-ordination, and that scale economies are exhausted at low levels of output relative to firm sizes (see below). In practice there will be separate scale economies for each of a firm’s activities, and it would be unreasonable to suppose that these will coincide at a given level of output. For example Hunt and Lynk62 concluded that water and sewerage were individual natural monopolies and that it was not clear that there would be scope economies from joint operation. After all, they had operated independently in many locations for more than a hundred years prior to 1973. It can be concluded from the earlier history of the industry that the primary reason for the creation of the Water Authorities was a political development of policy appropriate for the regional management of resources and discharges to the environment. This does not mean that the size of region necessary to ensure the appropriate level of staffing for an environmental regulator (first the WA’s, then the NRA, now the Environment Agency) was at all appropriate for the operation of water supply and sewerage systems. Equally once the NRA functions had been separated in 1989, with higher total costs because of the loss of economies of scope according to Hunt and Lynk,62 there. Nevertheless there was no question that there were significant economies of scale and scope captured by the larger organisations in the supply of water to distribution systems, and in the joint treatment of large volumes of effluent. A primary reason why the economies of scale could be demonstrated when Deloitte Haskins & Sells carried out the pre-privatisation efficiency studies65 is that the very large-scale treatment works already existed, constructed at a time when network costs were regarded as sunk before they were expended. Deloitte Haskins & Sells and most other commentators on the industry restricted their analysis to the visible assets, and not the network assets delivering or collecting the outputs for customers. They did not confront the “if I was you I wouldn’t start from here” question of whether a least total cost analysis would reconstruct the same large works. Experience within the industry shows that stranded assets dictate the form of the system adopted (see the later section on integrated design for some examples). Thames Water could never have expected cost-savings from the Ring Main construction if it had not already got the very large treatment works and abstraction licences which geographically dictated its source to distribution policy. There were economies within the project arising from the strategic selection of the route, in picking up output from other strategic treatment works, but the scale of the cost was accepted as necessary given the existing location of sources. The recent development of groundwater recovery in North London, if it had been considered in the original design, would have had a significant impact on the capacity of the ring main, but not the cost. This is because the marginal cost of additional hydraulic capacity on such a difficult route would have been very small compared to the cost of creating the route in any significant size. Throughout the consultation which led to the formation of the WA’s the virtue of scale was proclaimed as a catechism, but the literature contains little evidence to support those claims for the industry in terms of total cost. Unfortunately there was a tendency to adopt the defined 65 Deloitte, Haskins & Sells, Water Industry: Comparative Efficiency Review for Department of the Environment and Welsh Office, March 1990 Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  27. 27. Page 27 of 74 characteristics of natural monopoly and assume that scale economies applied continuously across the full range of WA activities – the logical outcome would thus surely be a single national supplier. This ideal was not pursued except for consideration of national resource management, which tends to reinforce the view that the structure for water cycle management could be different from that which would be appropriate for service delivery. There is no evidence from within the water industry or in similar spatially discrete oligopolies that the largest works are more efficient in total cost terms than a set of smaller works in the right place – evidence that contradicts the catechism has been ignored by government and companies themselves. The returns to scale might be expected to be continuous up to a given size for each activity, and thereafter costs may rise again. In reality of course, resources and discharge points are not always situated conveniently close to demand, and some companies have to incur higher costs to provide services. Those that have benign situations (or the advantages of some Victorian foresight – which could now be viewed as uneconomic over-design) come closer to the theoretical ideal, and this is probably the key to the real variation in costs across the industry. It appears that the variation in costs due to the nature of sources and networks and access to discharge points is greater than the variation in costs achieved from economies of scale. Unfortunately (as revealed by modelling within this project – Appendix Six) there are no longer sufficient companies in the industry to be able to determine how these effects interact to drive total Cost to Customer (which is only one of the measures on which a customer might make a choice). There are in fact scale diseconomies in the expansion of systems to serve more remote rural areas: the output is being increased but so is the average length of pipe per property (what Kahn1 terms the place utility). In these cases the marginal cost can exceed the average cost, but the service is still traditionally regarded as a natural monopoly because of the tendency to long-run decreasing costs internal to the company as a whole. Some researchers have been able to identify economies of operation at the company level, but they are also guilty of assuming that the economies are self-contained and wholly recoverable within an asset group or activity. For example Parker and Sewell66 and Lynk67 report that the WA’s achieved economies of scale in water supply, sewage treatment, administration and research and training. Undoubtedly the savings are real for organisational level labour-based activities such as research and training. However savings on supply and treatment looked at in isolation ignore distribution network costs and network diseconomies, largely because wholesale expansion of these networks has been avoided by time-expired (80-year old) strategic decisions on the provision of spare capacity in local distribution systems.31 The networks remain adequate in the older urban areas on historical design criteria also because: • the urban population density has massively reduced (household occupancy rates have fallen from more than 5 per household in 1935 to 3.2 in 1975 and around 2.4 in 2000). • the reduction in industrial output (particularly of primary industries such as coal and steel) has released capacity in large distribution mains • there has been net out–migration from urban areas in addition to the reduction in occupancy (for example, the Metropolitan Water Board supplied 7.7m people in 1934, but by 1981 only 5.5m, despite massive post-war housing development within the supply area). 66 Parker, D. J. and Derrick Sewell, W. R., Water Institutions in England and Wales: an Assessment of Two Decades of Experience, Natural Resources Journal, 28 (4), 1988 67 Lynk, E. L., Privatisation, Joint Production and the Comparative Efficiencies of Private and Public Ownership: the UK Water Industry, Fiscal Studies, 14 (2), 1993 Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  28. 28. Page 28 of 74 Typically the water supply to a small town derived locally from a series of boreholes is likely to be operating efficiently at low cost. Conversely, for certain sewage treatment processes (e.g.the improvement of sewage sludge by digestion) there are much larger minimum efficient scales (MES). It is likely that an area with a relatively dispersed but growing population such as East Anglia will have fewer opportunities to take advantage of scale economies in processes with larger MES than a densely populated urban area such as the Thames basin with stranded large assets, but spare capacity. Because of the size of the privatised WASCs there are significant differences within individual company areas. Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  29. 29. Page 29 of 74 Economies of Scope from Vertical and Horizontal Integration Many authors have identified the cost advantages of vertical integration, but this need not include labour-based services, even many of those concerned with the operation and maintenance of the primary assets. Williamson68 identified the benefits of vertical integration as ownership’s right of control allowing adaptation to changing conditions without having to re-contract or consult the asset owner. These gains are traded off against the bureaucratic costs of managing the asset within the firm, with the trade-off increasing with the depth of asset specificity.69 The trade-off may be difficult to assess because the benefits may be different in kind (and location) from the costs of vertical integration.70 Morse71 concluded that water industry assets are very specific and complementary and would trade exclusively with one another, hence he concluded that collection, treatment and distribution should be controlled together. He suggested that the sewerage service could be operated separately, in agreement with Hunt and Lynk.62 Kelly72 reports research into electricity distribution utilities which shows that there are no economies arising from mergers or expansion of supply geographically, in total cost terms. Tracking of merged companies in the water industry of England & Wales shows a similar picture – often the only savings obtained have been those imposed as price cuts by the Regulator. An illustration of this is provided in the earlier Section on mergers. Detailed data to support the premise has not been included in the information attached to this report, but there are many examples in the literature to support it in free and regulated markets.73 74 75 68 Williamson, O. E., Transactions-Cost Economics: The Governance of Contractual Relations, Journal of Law and Economics, 23 (2), 1979 69 Williamson, O. E., The Logic of Economic Organisation, Journal of Law, Economics and Organisation, 4 (1), 1988 70 Moore, J., The Firm as a Collection of Assets, European Economic Review, 36, 1992 71 Morse, L. B., Water: The Case for Cooperatives, IPPR Working Paper by Dept. of Economics, N Carolina, Arkansas & Tennessee State University, 1997 72 Kelly, J., Scale Economies in Electric Distribution, presented to 14th Annual Conference of Center for Research in Regulated Industries, San Diego, June 29 2001, American Power Producers Association, 2001. 73 Audretsch, D. B., & Klepper, S., Eds, Innovation, Evolution of Industry and Economic Growth, Vols I-III, Edward Elgar Publishing Ltd, 2000 74 Lichtenberg, F.R. and Siegel, D, Productivity and Changes in Ownership of Manufacturing Plants, Brookings Papers on Economic Activity: Microeconomics, 3, 1987 75 Gort, M., An Economic Disturbance Theory of Mergers, Quarterly Journal of Economics, 83, 1969 Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size
  30. 30. Page 30 of 74 Boundaries for Economies of Scale – Minimum Efficient Scale There must by now be enough references in the literature attesting to the exhaustion of scale economies at low levels of output to deter further industrial concentration on technical process grounds. Beyond a certain scale expansion should be by increase in the number of efficiently sized plants, not construction of larger plants. As long ago as 1938 it was reported76 that the minimum efficient scale (MES) of the US automobile tyre industry was small relative to the market size. In 1954 Bain77 found that long-run average cost decreased in varying degrees at smaller output levels and that it was constant beyond some particular level of output for each industry. Stigler78 focused on optimal firm size, which would not exist uniquely if firms experienced constant long-run average costs. He used the concept of ‘survival’ and observed changes in the market share from different size classes of firms. He found no tendency for firms to converge on a unique ‘best size’ which tends to confirm the constant long-run average cost premise. Saving79 used Stigler’s technique and found evidence of economies at a small scale and diseconomies at large scale, but a wide range of output with apparently equal average costs. To the extent that cost functions can be identified, they show scale economies at quite small scales, and that beyond some particular size, the average cost is constant.80 Saving found that in more than 70% of US manufacturing units the minimum optimum size was less than 1% of the industry size. In an international study Scherer et al81 found that in most industries scale economies are exhausted at a low output relative to the size of the market. For the water industry in England and Wales, 1% represents a ceiling of about half a million population. A recent paper by Kelly72 provides a review of writings on economies of scale in electricity distribution in the US and internationally. The conclusions below are borrowed from Kelly’s paper. Kelly refers to Neuberg’s 1977 study82 in which he wished to examine “unevidenced claims” about scale economies. Neuberg found that the relationship between cost and size is U- shaped, and concluded very large firms were probably over optimum size, and very small ones considerably under optimum size. Other studies by Mark Roberts (1986) and the National Regulatory Research Institute (NRRI 1996) show that there are no efficiency savings from horizontal integration of vertically integrated supply/distribution firms. The NRRI study also looked separately at power supply alone with the same conclusion. Kwoka’s recent work confirms the findings of Saving79 that there is a wide area with level unit costs between the opposite higher-cost thresholds (for electricity utilities) of small scale (10000 customers) and large scale (more than 3m customers). Yatchew (2000) found MES at about 20000 customers for electricity utilities in Ontario, and reported on the work of Giles and Wyatt (1993) in New Zealand who had identified a MES of about 30000 customers, and Salvanes and Tjotta (1994) in Norway who found the optimal plant size was one serving about 20000 customers.83 76 Reynolds, L. G., Competition in the Rubber-tire Industry, American Economic Review, 3, 1938 77 Bain, J. S., Economies of Scale, Concentration and the Condition of Entry in Twenty Manufacturing Industries, American Economic Review, 44, 1954 78 Stigler, G. J., The Economies of Scale, Journal of Law and Economics, 1, 1958 79 Saving, T. R., The Four-parameter Log-normal, Diseconomies of Scale, and the Size Distribution of Manufacturing Establishments, International Economic Review, 1, 1965 80 Sherman, R., and Tollison, R., Public Policy Towards Oligopoly, Antitrust Law and Economics Review, 4, 1971 81 Scherer, F. M., Beckenstein, A., Kaufer, E. and Murphy, R. D., The Economics of Multiplant Operation: an International Comparisons Study, Cambridge, Mass: Harvard University Press, 1975 82 Neuberg, L. G., Two Issues in the Municipal Ownership of Electric Power Distribution Systems, Bell Journal of Economics, 8, 1977 83 The information given throughout this paragraph is reported by Kelly in Ref 72 Utility Performance Consultants Ltd/Strategic Management Consultants 31/05/10 Ref Ofwat entity size

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