Public and private ownership of network utilities

An issue that provokes strong but often hard to explain feelings is whether infrastructure networks should be owned or operated by public enterprises or private companies. As a rational person, my basis for judging this question is: what works “best”, though “best” is often very hard to assess. However, for some people the idea that private firms can own and operate water networks, in particular, prompts a deeply felt emotional reaction.

The usual logic is that water is essential for life and should not be controlled by private organisations that might or will deny water supplies to those who cannot pay. However, many other things are essential for life. The same people tend not to argue that all production of food or medicines should be publicly owned monopolies. The reason is that ample experience tells us that such arrangements tend not to work very well. So why not apply the same assessment to water companies?

In this article I will compare three types of network utilities: water, energy (both electricity and gas), and telecoms. The history of these utilities is similar. They started as private companies developed by entrepreneurs who identified potential markets for network services, particularly in cities and other urban areas. In most cases, they were initially regulated and often bought out by municipal authorities, which wished to ensure that (a) networks were expanded to serve as many people as possible, and (b) services were provided in a non-discriminatory manner. Later, central governments intervened and eventually took control of municipal enterprises to gain economies of scale and to ensure some level of universal service outside the largest urban areas.

During the 20^th century, the crucial factor determining whether network utilities were publicly or privately owned was the question of how best to raise the funds needed to extend networks to meet universal service goals. In the US, regulated but privately owned utilities were the standard model for telecoms and energy, while municipally owned utilities dominated the water industry. Once the legal basis for what economists refer to as rate of return regulation was established in the early decades of the 20^th century, both investors and lenders were willing to finance a large expansion in telecoms and energy networks in areas where the density of population was sufficient to allow utilities to recover their capital costs. Rural areas and small towns that were less attractive for private investment were initially served by cooperatives partly funded by federal programs which provided either grants or subsidised loans for “rural” operators. Gradually, either these cooperatives merged to gain network scale economies, or they were taken over by the regulated operators for political or economic reasons.

Water services have much more limited network economies. The primary reason is that water is costly to transport but relatively easy to store, if topography is favourable. Building large grids is usually unattractive. Water companies serving urban populations tend to rely upon small or large water reservoirs or underground aquifers to feed dispersed treatment plants that serve supply zones that may have limited interconnections. Such arrangements could be funded either by individual municipalities or groups of them. However, that model in the US was undermined by the imposition of more stringent federal requirements for drinking water quality and wastewater treatment in the 1970s. For nearly two decade publicly owned water companies resisted these obligations, because they could not afford the investments required. Eventually a political compromise was reached under which federal grants funded up to 95% of the cost of complying with the quality requirements. In effect, municipal ownership survived because the federal government took on the financial burden of funding the investments required to meet stricter water quality and environmental requirements.

Other solutions to the problem of funding universal service were adopted in other countries, reflecting both political traditions and capital markets. There were two major differences between the US and European countries.

First, European countries had not developed the legal and regulatory doctrines which enabled private companies to raise both debt and equity with relatively low risk premiums. Economists point out that rate of return regulation creates incentives that encourage excessive capital spending (nuclear power plants are an example). Still, we should remember that it provided sufficient security to allow companies to develop large networks. The example of private concessions in France (discussed below) is a limited exception, but concession operators do not fund capital projects.

Second, wartime damage to infrastructure combined with the neglect of routine maintenance and renewals meant that there was a huge demand for capital spending in the 1920s and late 1940s that could not be funded by private capital markets. This constraint on private finance was reinforced because governments did not want to endorse the large increases in charges that would have followed.

In the UK, a centralised country with a highly developed bond market, the solution for telecoms and energy was the formation of public corporations that could rely, in effect, upon government debt to fund capital spending. The water industry remained under local authority control until the early 1970s. There was a small number of private, debt-financed, water companies including, for example, Bristol Water and Cambridge Water. Following a major reorganisation of local government, what had been companies controlled by local authorities were merged into regional authorities responsible for both water services and river basin management. These relied on public debt to finance their capital spending.

In countries with a federal structure or strong traditions of local government, such as Germany, energy networks remained under state or local control, relying upon the capacity of such governments to fund capital spending by borrowing. However, in most countries telecoms operations were developed as public corporations financed by public debt and managed by national postal monopolies - for example, in Germany from 1877 and in France from 1889.

As noted, the benefits of scale in the water industry are limited, so almost everywhere water networks followed the pattern of local control and funding. However, one arrangement emerged in France and spread to some other countries that followed the French example. These are known as concessions under which the local authority retained ownership of network assets but had a contract, usually for 20 to 30 years, with a private company to operate the network and, where necessary, manage capital spending on the network. Through a succession of mergers, two large French operators emerged – Generale des Eaux (now part of Vivendi) and Lyonnaise des Eaux (now part of the Suez Group). These were asset-light operators that relied upon their staff and accumulated expertise in designing and managing networks to allow local authorities to retain ownership of networks without having to take responsibility for complex operational and environmental requirements.

In many countries, arrangements which relied on funding by public debt came under pressure during the 1980s. The large increase in inflation during the 1970s pushed up interest rates and put governments under great pressure reduce borrowing. Public corporations had to increase charges sharply to cover both the higher cost of debt and capital spending. Privatisation was a way of moving the debt of public corporations off the public balance sheet, while enabling the newly privatised companies to increase borrowing to fund both network expansion and environmental improvements.

The underlying motivation was similar for different sectors but the reasons for increasing capital spending varied. For telecoms, the key concerns were to accelerate the extension of fixed line networks, while also starting to build mobile phone networks. In the energy sector, the transition from manufactured gas to piped natural gas required large spending to develop gas distribution networks. The development of nuclear power stations and stricter emission controls for coal-fired power stations increased capital spending sharply in the electricity sector.

Even so, the biggest shock was faced by the water industry in EU countries. The reason, as I explained in my article on South East Water, lay in EU Directives that imposed much stricter requirements on wastewater treatment and drinking water quality. In the UK these varied from stopping the discharge of untreated sewage to coastal waters to much higher sewage treatment standards and the removal of agricultural chemical residues from drinking water. However desirable these goals were, the UK government knew that it could not contemplate financing the cost of implementing these directives while the water industry relied on public borrowing. It was unwilling to raise water charges sufficiently to fund the capital spending required, which is what happened in Germany. So, privatisation in a manner that would enable the private companies to raise the debt necessary to fund the capital spending required appeared to be the only option.[1]

Despite all the rhetoric about the benefits of privatising utilities, the reality was that the policy was a financial strategy. The UK government faced a difficult choice. Either it could follow the federal government in the US by funding network expansion and environmental improvements out of public debt. Or, it had to transfer control of utilities to private companies that would be able to borrow large amounts without adding to public debt. In truth, there was no choice, as the government believed that it could not afford to increase public borrowing. Forget all the nonsense about ideology, the issue was one of hard financial reality.

This version of the story is reinforced by what happened in Scotland and Northern Ireland. Even though these regions were nominally controlled by Westminster, in practice they had substantial executive autonomy. Both regions initially refused to go along with privatisation of electricity and water – they had no control over telecoms and gas. However, in the early 1990s both regions privatised their electricity companies. Later, in the early 2000s both regions converted their water industries to non-profit corporations to provide the financial and operational autonomy required to comply with EU directives. The result was half-hearted and a failure in Northern Ireland, but much more successful in Scotland.

Critics of private involvement in network utilities focus primarily on the water sector. There are some advocates of bringing electricity networks back under public control. They are vague, at best, about how this could be financed, given the severe constraints on public borrowing in most countries. In the case of the water industry, critics focus on poor environmental performance judged by current standards, but they ignore how much worse things were before privatisation.

Private water companies are often their own worst enemy. Like most modern corporate bureaucracies, they fall back on PR-speak when challenged. There is a key reason for this: they are unwilling to jeopardise the goodwill of the regulators and government bureaucrats with whom they work and who are often responsible for key constraints. Criticism is coded and there is little honest public discussion of the trade-offs which must be made. Their critics are almost silent on the issue of how the improvements they lobby for should be funded, other than being clear that they and their friends should not be expected to bear any of the cost.

More generally, the idealistic view of independent regulation of private utilities that was common in the 1990s has proved to be only temporary. It relied on assumptions about improvements in productivity that once achieved left the question of what comes next. A combination of (i) understanding that regulation is a repeated game in which gains become smaller and harder to achieve, and (ii) increasing interference from bureaucrats pursuing various political goals has created a framework in which privatised utilities are barely more than financial instruments whose function is to implement government policies. Their shareholders are paid for fulfilling this function and have little incentive to bite the hands of those which feed them.

To alter this impasse will require both new sources of funding and new ways of organising the relationship between operating companies and policy management.

[1] Other EU countries either faced lower spending costs or decided to postpone compliance with the new requirements for as long as possible, The EU eventually sued Belgium because Brussels had delayed compliance for long after the relevant deadline. Italy took various evasive measures and interpreted the rules in ways designed to minimise the costs of compliance. In addition, it persuaded the EU to fund much of the capital spending required in the south of country under regional assistance programs.