REGULATION OF THE PRIVATE PROVISION PUBLIC WATER-RELATED SERVICES

The theory of contestable markets A perfectly contestable market is one in which entry and exit are absolutely costless. In such a market, competitive pressures supplied by the perpetual threat of entry, as well as by the presence of actual current rivals, can prevent monopoly behaviour. If sunk costs were zero, even where economies of scale are significant, a potential entrant could undercut any excessive prices (or unnecessary costs) of incumbent firms yet earn an attractive rate of return. This is a very improbable situation in most water­related industries. In the absence of other restrictions on entry and exit, economies of scale alone do not constitute an effective barrier to entry. Perfect contestability precludes excess ive profits and prices as well as waste and inefficiency, and prevents anti­competitive behaviour. Baumol, Panzar and Willig (1982) showed that "if an industry is structurally contestable and is behaving accordingly, and if, in addition, it has sustainable configurations available to it, and if none of these involve any significant welfare problems, then that industry is best left to its own devices with no government interference, even if it is composed of a very small number of firms". Where an industry is not behaving in that way, even though there are no inherent structural impediments to contestability, then the most promising course for public policy is identification and removal of any artificial obstacles to contestability and the prevention, so far as possible, of anti­competitive behaviour by incumbents. This is normally called a process of deregulation. If the industry is structurally not contestable, it may still be possible to seek measures that decrease "natural" entry barriers. Another option would be to isolate the portion of the industry's activities that causes uncontestability and regulate that portion, leaving the remainder of the industry's activities free from government interference. Competitive discipline can prevail if sunk costs were zero, but sunk costs weaken the disciplining power of market contestability and thus yield a wide diversity of dynamic patterns of market performance. Yet the disciplining power of contestability remains impressive in preventing sustained monopoly pricing. Although at a first glance, most water­related industries do not seem to come close to satisfying the conditions of contestability, since entry involves substantial sunk costs and dominant incumbents have at their disposal a range of instruments of strategic entry deterrence and of exit inducement, nevertheless some forms of private sector participation may create an environment of contestability. For example, although sunk costs are a fundamental characteristic of networks, they are not necessarily so important for the provision of services over networks. For the tradable goods and services produced in the water sector (e.g. irrigation and hydroelectricity generation), freedom of trade and reduced transportation costs can supply the beneficent pressures of contestability. A market can remain highly contestable if it is feasible for an entrant to achieve contractual relations with prospective customers, which can render the entrant immune from retaliation. Where this is true, the incumbent can protect itself from intruders only by behaving well ­ for instance, by offering customers reasonable prices and a good level of service. Such behaviour will foreclose entry opportunities, but only by providing customers with all the benefits that an entrant could be expected to bring. The degree to which costs are sunk may depend in part on public policy. In the water sector, public authorities can use franchising and other measures to create an environment of contestability. Although there may still remain barriers to entry and competition imposed by protectionist policies, lack of adequate regulation (e.g. regarding access on a fair basis to network facilities) or other factors (e.g. access of potential entrants to capital markers and to foreign exchange), these barriers may be addressed separately as long as an activity is contestable in principle. Governments can facilitate contestability by encouraging new operators to be formed and ensuring that they can compete on fair terms with incumbent suppliers. Contestability can also be encouraged through the promotion of leasing and the development of a domestic market for reselling capital equipment. The French experience in the provision of drinking water supply and sanitation services demonstrates that the contestability of the franchise can achieve almost the same efficiency benefits as competition. In France, municipalities own the physical assets of the sector and secure management through a wide range of franchise contracts (e.g. leasing and concessions) with private companies as well as retain the right to operate the system themselves. Since the threat of being replaced provides a powerful incentive for good performance, incumbent franchisees normally win contract renewals over challengers. The end result is that the drinking water supply and sewerage market of each municipality is contestable and consumers appear to be satisfied with the level of service they receive. This approach creates a workable market for water services, a market that appears to work so well that price regulation, which is a major issue in the private water industry in England and Wales, and in the United States, is virtually non­existent in France. The French experience could have important implications for Latin American and Caribbean countries in that it underlines the desirability of the flexibility to switch from one form of contractual relation to another, from public to private and vice­versa, and existence of several companies that can operate in the sector. For this reason, as markets expand, governments that choose private participation would be well advised to encourage the emer gence of competing companies, rather than leave sector operation in the hands of a single private or state­owned company. In the privatized drinking water supply and sewerage industry in England and Wales, OFWAT can create partial contestability by making new appointments for new developments within existing allocated company areas. These are known as "inset appointments", the appointment of new licensees to supply new developments and customers that consume more than 250 megalitres of water a year within an existing undertaker's area. The competitor would have to be able to supply water to the site either by laying new pipes from an existing supply or via a bulk supply or sewerage connection from a local company. The terms and conditions of such connections are determined by agreement between the interested parties or by the DGWS if they fail to reach an agreement. In addition, OFWAT is considering introducing a common­carriage approach to competition for water services (use of a competitor's network to carry the product to the customer), an approach which is already widely used in the electricity sector. Common­carriage is already widely practiced in the water industry is the form of bulk supply. The existence of regulatory barriers ­ permissions, licenses, concessions, etc. ­ weakens the impact of contestability because some potential entrants who may wish to enter the market to compete cannot do so because they fail to hold the relevant permission or license. The existence of the regulatory instrument itself and the longevity of such instrument represent a barrier to free entry and limit the validity of the contestable markets theory in the sector. The barrier to entry is especially large when regulatory instruments are for long periods and require a long termination notice. The system of re­bidding for concessions at shorter periods lowers the barrier represented by the existence of the instrument itself by affording an opportunity to new entrants to outbid for the existing concession. However, this approach has its drawbacks. The practical application of contestability is also hampered by "invisible" barriers to entry, such as the information asymmetry between incumbent and challengers and the winner's curse. The theory of contestable markets is not universally accepted. On the whole, the main contribution of the theory may be as a guide for regulation. On the other hand, it has also been characterized as a theory of the consequences of deregulation rather than as a theory of regulation.

Source: the discussion of the contestable markets theory is based on Baumol and Lee (1991), Baumol, Panzar and Willig (1982) and Coursey et al. (1984); its criticism is to be found in Shepherd (1984); the discussion of its application in the drinking water supply and sewerage sector and examples are from Booker (1994) and Haarmeyer (1994); other sources are Kessides (1993), Lyon (1995), Mulgan (1994), Peterson (1991b), Stewart­Smith (1995), Triche (1993), Vickers (1991) and Winston (1993).

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