Asymmetric Information and Water Resource Management
By:
Asghar Sabbaghi, Indiana University South Bend
Navid Sabbaghi, Massachusetts Institute of technology
ABSTRACT
This study presents an economic analysis of water resources management and the various approaches
taken in the ownership and management of water resources, including the pricing policies of water
services over the last two decades. It compares and contrasts government ownership and regulatory
arrangements with privatization in water resources management and its implementation in various
countries and economies.
Asymmetric Information
Asymmetric information, when one party lacks access to another party’s information, has been
extensively examined in economics (Akerlof 1970, Stiglitz 1977). For example, borrowers know more
than the lenders about their loan repayment prospects, sellers are often better judges of product quality
than are the buyers, prospective employees know more about their own skills and abilities than do the
employers, and managers and boards of directors know more than shareholders about the company’s
economic health. Asymmetric information problems could and will create market distortions and
accordingly recognizing the existence of asymmetric information may be viewed as part of a broader
institutional approach to the analysis of market imperfections.
The theory of economics of information analyzes these market distortions and seeks to explain the
existence of various market arrangements and institutions that aim to cope with such problems. One
important example of asymmetric information problems is the existence of asymmetries in centralized
private information and centralized government information. In a free market, each side can use their
particular information, called one’s knowledge of particular circumstances of time and place. However,
in a centralized market, when the government participates as the main supplier of the good/service, the
buyer can not communicate what they want through the market, because in essence, there is no real
market, and sellers produce to satisfy the central planners not the ultimate users.
Important implications result from asymmetric information in a regulated water market and water
pricing, i.e., when one party in a market (buyer or seller) disposes of more information than those on the
other side. When the government ownership defines the supply and distribution management of water
resources for various purposes, there is an information gap between the individual buyer of qualitybased water and the public supplier. In this scenario the government and its management determines the
production and distribution costs. Given the limited local knowledge and flexibility of government
agencies in controlling cost, there is limited flexibility for responding to the market’s demands for
various grades of quality water. In New Orleans, for instance, the lure of privatization resulted from the
government’s inability to finance $500 millions in sorely needed improvements to a water and sewer
system that routinely leaked untreated waste into Lake Pontchartrain. According to some estimates,
private water companies can cut the cost of operation and maintenance of the 1225-worker system by
between 10% and 40%. The cut would free funds to pay back new bonds for infrastructure.
According to Bulckaen (1997), within the partial equilibrium, while the regulator decides that a unit
emission charge should be used as a price incentive in order to obtain an optimal pollution level, the
regulator takes into consideration only the damages suffered by the victims of pollution and clean-up
costs incurred by firms. However, the regulator, at least in a relevant region, has no information
concerning the clean-up cost functions for the firms in order to estimate the social damages function
resulting from pollution. Therefore, the regulator may be in the position to monitor the results of cleanup activities of each individual firm, but does not know the costs of such activities.
The management of water as an economic good has been promoted as a solution to the challenges facing
government agencies and water planners in various economies. There has been a tendency to favor the
private sector’s participation from the 1980s and since then various forms of privatization of water industry
has emerged in various countries. For example, while in the U.K., privatization is defined as including the
sale of water and/or sewerage undertaking; in France this includes delegated management or concession to
a private company. Much has taken place in this respect since the 1980s and a number of models have been
adopted in various countries. In the following section, we will present an economic analysis of water
resource management and some of the implications of asymmetric information in ownership, and the
management of water resources and the pricing policies.
Management of Water Services and privatization
In addressing water management issues, the literature has traditionally treated water quantity and water
quality as two separate and independent issues. Furthermore, water has been managed by various
government agencies with the traditional emphasis on supply-oriented policies. There is no real market for
water that can represent the real value of water for various uses and the opportunity cost of quality-based
water. Considered as a public good and a service industry and administered by government agencies, the
water industry is isolated from other markets such as product, financial, capital markets, etc., and thus,
there are no economic incentives for greater economic efficiency in the form of lower prices and better
quality water. Therefore, an efficient allocation of these valuable resources is often lacking. Water
allocation has also been made by administrative and judicial decisions using a mostly supply-oriented
approach and causing water management to be viewed as an engineering issue. The concept of efficiency
in water policy management has taken an engineering efficiency approach in water supply rather than
economic efficiency in managing demand for the supply of water.
In Britain, the government's belief in the innate inefficiency of traditional public sector provisioning of
goods and services has inspired a number of initiatives which have resulted in the management of public
sector enterprises including water companies being confronted by an improving economic and business
environment, tighter financial controls, increased competition, and privatization. Thus, privatization of the
water industry has been in the forefront of public debate for the last fifteen years in Britain. The ten
regional water authorities of England and Wales were finally privatized in 1989 establishing, alongside 28
privately-owned statutory water companies, a water industry that is almost entirely privately owned.
The 1989 Water Privatization Act has been succeeded by the: (1) the 1991 Water Industry Act dealing with
Office of Water Services (OFWAT), headed by Director General Water Services (DGWS), its regulatory
powers, and (2) The 1991 Water Resource Act dealing with National River Authority (NRA). The water
companies, thus, face two regulatory agencies: (1) Environmental and quality regulation by NRA; and
Drinking Water Inspectorate (DWI) and (2) Economic regulation by OFWAT. DGWS was given
responsibility for the economic regulation of the industry, for monitoring efficiency and facilitating
effective competition as well as for protection of its customers. The NRA was charged with responsibility
for river quality and DWI took over responsibility for household water quality in addition to the
implementation of European community directives. The DWI requires that companies supply wholesome
water defined in terms of chemical and aesthetic parameters. Some of the environmental regulations have
been tightened since privatization. For instance, the program for achieving compliance with the Bathing
Beaches Directive was accelerated and in 1990 the Secretary of State announced that the dumping of
sewage sludge at sea would be phased out by 1998 and that UK would adopt the EC's municipal
wastewater directive which will require additional facilities at sewage treatment works in order to
discharge into the sea and estuaries. In particular, much experience has been accumulated with regard to
improving the performance of privatized ownership/ management in provisioning and distributing water
resources.
The privatization approach in France has taken a different form and it originates from the
peculiarities of legal and constitutional culture that profoundly affect the nature and delivery of
government policy in general and in particular, the privatization process. According to Prosser (1995),
major divergences in the way economic policy is implemented including privatization and regulation
policy, were influenced not only by formal constitutional provisions but also by a number of associated
cultural influences. Three elements of different national cultures affecting policy implementation: (1) the
role of institutions, (2) The role of constitutions, and (3) the concept of the state. Dealing with institutional
analysis, in the UK, lawyers have played a somewhat limited role, because legal controls have been viewed
as a negative constraint on policy makers, rather than implying some more general ideal of legitimate
government. Therefore, policy-makers in the UK are remarkably free of legal constraints compared to the
U.S., Germany, or France. The reasons may include:
1.
Parliamentary sovereignty remains central to constitutional ideology, i.e. the UK lacks critical
principles that can be used to judge the constitutionality of legislative acts, and lacks constitutional
restrictions on government actions.
2.
UK is a highly centralized nation or a set of nations. This centralization of constitutional authority
provides for an environment of peculiar freedoms for central government.
3.
UK still lacks a properly developed system of administrative law, especially compared to France
and the U.S.
Thus, lawyers in the UK have been relatively little concerned with the design of institutions; this is a
technical matter to be left to governments unconstrained by constitutional law.
According to David (1992), Privatization may correct other inefficiencies: those associated with the under
pricing of water and wastewater services. Politicized decision making in the public sector distorts the
relationship between prices and costs and encourages subsidies to various interest groups. Shifting
responsibility to the private sector often allows governments to discontinue subsidies. In a competitive, or
alternatively, a well-regulated system, competition or regulation sets prices that better reflect costs (Peter,
Wolff, and Elizabeth 2002). Privatization also allows for the de-politicization of environmental and health
regulation. Governments that own, operate, and finance water and wastewater utilities cannot properly
regulate them. All too often, conflicts of interest prevent them from enforcing compliance with laws and
regulations. Privatization reduces those conflicts, freeing regulators to regulate and increasing the
accountability of all the parties.
Different Pricing Strategies in France and England
In a market economy, pricing is the central mechanism for allocating resources. Prices reflect the
opportunity costs; they provide information to change consumption and production patterns and indicate
when it is appropriate to undertake investments to make the best use of the community’s scarce resources.
The role of regulatory agencies such as OFWAT in UK has been to check the misuse of monopoly power
and to encourage private companies to improve their performance efficiency. These strategies should
enhance competition and improve the cost effectiveness of private companies. Different pricing strategies
have been considered to keep the private sectors intact and to encourage efficiencies for the best interest of
the community as well as the companies. Comparative competition is used in the UK’s privatized water in
two ways. First, the information is published in tables of performance against key indicators. Second, the
comparative unit cost information is used in quantitative analysis by the regulatory agencies to help make
decisions that have the potential for cost reductions in the price cap formula.
Here, we will briefly examine various methods of pricing regulation including the Rate of Return
Regulation, Price cap Regulation, and Cost-plus pricing.
Rate of Return Regulation
Rate of return regulation aims to control monopoly behavior of the private sector by limiting maximum
allowable profits by setting the price and considering efficiency at the same time. Rate of return allows
tariffs to rise subject to a predetermined rate of return (Kim and Horn 1999). This approach has emerged
due to the public’s concern regarding the large profits earned by some private monopolies and the
possibility of charging higher prices to achieve even greater profits. Under rate of return regulation, the
regulator will review the water utility costs and will set the expected rate of return on assets (OFWAT
Reports, 1998). The utility company then sets its prices to achieve that target rate, assuming that it cannot
retain any extra returns. This technique may sound simple and sensible; however, in practice it is more
complicated. Setting the regulated rate of return to guarantee only fair profits is extremely difficult. If the
rate of return is too high or too low, it may exacerbate production and pricing inefficiencies. The regulator
will not know whether it has set an appropriate rate of return because of the lack of information about the
demands and the company’s accounts (Bradburd , 1992).
It is difficult for regulatory authorities to value assets accurately due to long and unclear durations of
assets. One may ask how much to charge in a particular year and how to distribute evenly over the years
and what could be the scrap value of those assets in the future. As Kim and Horn (1999) note, the basis of
calculation may be inflated due to unrealistic or spurious costs or investments. These types of questions
make it very difficult for regulatory authorities to fix reasonable prices for companies as well as
consumers. The valuation of assets to which the rate is applied is also problematic, particularly for water
suppliers that have been operating for long periods of time. This technique takes the total cost into
consideration without any differentiation between fixed and variable cost, and this makes it difficult for the
regulator to decide on an appropriate price.
Cost-plus Pricing
Cost-plus pricing aims to control monopoly power by restricting price increases to reflect changes in all or
a selection of production costs. The difference between rate of return and cost-plus pricing is that in cost
plus pricing the costs are divided into fixed cost and variable cost but in the rate of return regulation the
total cost will be used as a whole. This technique also has some potential to lead to inefficiencies, and it
doesn’t encourage firms to minimize cost either. Instead, it may encourage the firm to over invest in capital
(Kim and Horn 1999). For example, there is little incentive to minimize costs if water tariff increases are
guaranteed as cost increases. If changes in the total costs are used as the determinant factor for rises in
water tariffs, there will be an incentive to incur costs that do not necessarily add to the quality of the
service such as excessive expenditure on personnel training or unnecessary heavy expenditure on
advertising or public relations.
On the other hand, if prices are based on specific component costs such as labor and electricity, there is
little incentive to minimize these costs but substantial incentive to minimize other costs. Setting the initial
price or the tariff might be the most complicated issue. There could be a number of problems as to how to
take care of depreciation, how to break down investment in fixed capital or subsidies from the government
and other related issues. Linking water tariff increases to costs might also limit the opportunity for water
tariffs to reflect changes in the level of demand or supply. For example, if water prices can only change to
reflect cost increases there are no opportunities to use the price mechanism to reflect seasonal factors or
other demand management concerns.
Price Cap Regulation
A variant of the price formula, similar to that used in Telecom and Gas in the UK, known as RPI + K was
defined for water companies where the K factor is an allowable price increase above inflation to be used to
finance the investment plans necessary to upgrade capacity and meet quality standards. Thus, a weighted
average of proportional price increase cannot exceed PRI+K. The K-factor is assessed separately for each
water company on the basis of investment requirements, operating costs and revenues, and an efficiency
target. The pricing formula is expected to promote efficiency as far as it provides incentives for
management to reduce costs as a means of enhancing profitability. The K-factors for the privatized water
and sewage companies, similar to the X factor for Telecom and Gas privatized companies, vary between
3% (for Yorkshire) to between 6.5% to 11.5% (for South West), and for the water only (previously
statutory) companies, between 3% to 22.5%. The weights are given by the share of that service in total
regulated revenue in the previous year. The K-factors for water and sewage companies are lower on
average than for water companies because of the capital restructuring undertaken by government in
privatization. For example, the average K in 1990-91 for the water and sewerage companies was 5.4%
(with standard deviation of 1.1), while the corresponding number for the water-only companies were
11.6% (with a standard deviation of 6.5). The K-factors were set initially for ten years with a five-year
periodic review in 1994. There is also a provision for interim determinations or reviews of K on an annual
basis in case significant deviations from the norm are expected to occur for the company’s capital.
In this formula, RPI+K, K may be defined as follows:
K =Q±V±S-Po-X
Where, Q = Quality Standards, V = Enhancements to the security of the Supply, S = Enhanced Service
Levels, Po = Past Out performance, and X = Future Efficiency gains (OFWAT 1998).
The regulatory agency may include a positive factor for Q, meaning that the company incurred expenditure
to improve the quality of the water so this would certainly increase the price of water. Enhancements to the
security of Supply (V) and Enhanced Service levels (S) could either increase or decrease water prices. This
is because there is a lack of proper security for users of water and the levels of servicing are really low.
Variables V and S are positive if the companies provide better security and service levels to the
community. The Past performance and the Future efficiency gains are based on the levels of share of cost
savings transferred to the customers. These cost savings may arise from increased productivity,
technological changes or changes in economies of scale or scope. In simple terms, price increases are
capped by the formula RPI+K.
Price capping formula can become complicated as it may include multiple products and other expenses and
gains that might be beyond the scope of the formula and allow for additional price increase or decrease.
According to OFWAT, Price caps operate for a fixed period, say five or ten years, after which regulated
maximum tariffs and the components in the formula are reviewed and reset. In recent years, regulators in a
number of countries have tended to use price caps rather than rate of return mechanism. Price cap is chosen
because they help avoid some of the pitfalls commonly associated with rate of return technique such as
over estimation of the costs. RPI+K would allow the companies to concentrate on minimizing costs. It also
encourages firms to share cost savings with the consumers.
There are a number of elements that may affect the setting of value of K in this Price Cap formula. They
include the amount of operating expenditure needed by the companies to cover ongoing costs of supply, the
amount of capital that needs to be financed from profits, the allowed rate of return on assets and the size of
initial asset base. Price changes will affect the distribution of cost recovery when charging customers,
whether is it important to recover the fixed charges or the Variable Charges. An issue of consideration in
this formula is that it does not allow companies to increase both price and quality. Hence optimal
incentives to maintain or improve quality may not exist.
Asymmetric information may have some implication in achieving efficient pricing. Due to improper and
unfair revealing of information between the regulator and the regulated firm, the regulator may be unable
to provide incentives that encourage the firms to maximize social Welfare. The regulator requires
companies to provide all the information requested. However, companies may present costs and capital
expenditure that overestimate their revenue requirements in future years. Setting the industry value for K
depends on estimates of operating and investment costs that might be required for a particular firm. These
estimates may be derived from the analysis of the costs incurred by similar firms. This would facilitate
yardstick competition whereby K can be set with regard to the average efficiency of firms within the
industry hence giving individual firms better incentives to cut down their own costs.
Yardstick Competition
Since the water industry is composed of geographically separate natural monopolies, and although there
was the possibility of competition in the capital market, the chances of competition in water industry is
extremely limited. In the absence of direct market competition, and market forces there was a heavy burden
on the economic regulation to promote economic efficiency and to protect customers. Particularly, it was
necessary to develop an industry-wide yardstick to benchmark performance and prospect in the industry as
a whole, so that each authority knows that the future level of K-factor is essentially independent of its own
performance. More specifically, if any particular authority fails to maintain comparable efficiency to the
rest of the industry, it loses profits and hurts its shareholders, but if it performs above average, it keeps the
profits and benefits to its shareholders.
OFWAT worked towards a system of comparative "Yardstick" competition despite the technical
difficulties in operationalizing the econometrics modeling required and the problems in measuring
outputs and costs given the variety of geographical differences between the water authorities.
According to this "yardstick" competition, each company's allowed price increase under the K formula
is related not to its own costs, but rather to the costs achieved by the most efficient companies in the
industry. Under this procedure there was no incentive for any authority to hold back on improving
performance, due to the fear of jeopardizing the prices and profits allowed to it in the future. On the
other hand, failure to maintain comparable efficiency to the rest of the industry would have definite
adverse consequences, not only from the DGWS, but also from financial markets, which will take full
advantage of the opportunities for comparative judgments about management performance.
As mentioned earlier, water industry is heavily capital intensive and the competition in the core business
is locally limited. However an important benchmark in serving efficiency is played by competition in
the capital market. As Littlechild (1986) noted, the stock market sharpens the drive to efficiency
because it provides such an immediate feedback on performance, both past and expected in the future.
The stock market reflects the type of management over resources; more efficient companies will
command higher stock market ratings, thus, having easier and cheaper access to capital. Companies that
perform well will tend to expand, companies that perform less will tend to contract and inefficient
companies would be disciplined by the take-over threat. For example, Northumbrian Water Group, one
of Britain's biggest water and sewage companies, was taken over recently by Lyonnaise des Eaux, the
second largest water company in France (New York Times 1995). It has been reported that customers
benefited from this take over and their bills reduced fifteen percent by the end of 2001 as the British
government had agreed on the price reduction as a condition of approving the take over. The stock
market also sharpens competition in the market for managerial talent. Top managers can more easily
demonstrate success. The more able managers will be more quickly sorted from the less able, more
highly rewarded, and given control of more resources. The less able managers will be asked to step
down. Water companies will be competing between themselves, and with quite different business, for
the services of the best managers.
Concluding comments
Asymmetric information, when actors on one side of the market have more information than those on
the other, is caused under government ownership and management in a regulated water market and
water pricing. The theory analyses the market distortions created by such informational gaps and seeks
to explain the existence of various market arrangements and institutions that arise to cope with such
issues. In a water market under government ownership, there is an information gap between the
individual buyer of quality-based water and the public supplier. This consequently leads to market
inefficiency for water services, lack of efficient pricing strategies, and inefficient allocation of resources.
In this context, it is concluded that private ownership along with market-oriented approach in water
industry is the primary step needed to provide economic incentives for both water suppliers and
consumers to address the asymmetric information, and to achieve the efficient management of water
resources. In particular, peculiarities of the legal and constitutional culture in Britain and France
illustrate two different types of economic management systems for water resources that mix the roles of
the private sector and government regulation.
References
1. Akerlof, G. A. (1970) “The Market for Lemons: Quality Uncertainty and Market Mechanism.”
Quarterly Journal of Economics 84:488-500.
2. Dowdswell, E., 2001,” Is the World running out of water”,
www.watchtower.org/library/g/2001/6/22/article_01.htm
3. Dwyer, T. M.,(2001), Infrastructure Regulation, pp 32, Public Policy for the Private Sector,
World Bank Group, http://www.worldbank.org/html/fpd/notes/87/87irwin.pdf
4. ESCAP Region (1996), Overview of Water Pricing Policies and Structures in the ESCAP
Region, http://www.un.org/Depts/escap/enrm/wrs/pubs/1646.htm
5. Haarmeyer, D., Privatizing Infrastructure Options for Municipal Water Supply Systems,
http://www.rppi.org/ps151.html .
6. Hall, D. (2002) Water in private Hands,
http://www.globalpolicy.org/socecon/tncs/2002/waterprivat.htm
7. Loë,L. M., (1997), Water Resource Management news and Information,
http://www.cwra.org/news/arts/privatisation.html,
http://www.pacinst.org/reports/new_economy_of_water.pdf
8. Kim, S. R., and A. Horn (1999) Regulation Policies concerning natural monopolies in
Developing and transition Economies, ST/ESA/1999/DP.8 ,
http://www.un.org/esa/esa99dp8.pdf
9. OFWAT , 1999 Periodic Review, Setting Price Limits for Water and Sewerage Services,
http://www.ofwat.gov.uk/setting.htm
10. Peter H. Gleick, P. H., G. Wolff, and R. Rayes, The New Economy of Water, The Risks and
benefits of globalization and privatization of fresh water,
11. Roth, E., (2001), Water Pricing in the EU,
www.eeb.org/publication/Review%20Water%20Pricing%202001.pdf
12. Spulber N. and A.Sabbaghi (1998), Economics of Water Resources: from regulation to
Privatization, 1998 , Boston : Kluwer Academic.
13. Stiglitz, J. E. (1977), “Monopoly, Non-linear Pricing, and Imperfect Information: The Insurance
Market.” The Review of Economics Studies, 44:407-30.
14. Warford, J., Marginal Opportunity Cost Pricing for Municipal Water Supply,
http://www.eepsea.org/publications/specialp2/ACF298.html
15. William, J.C and F. R.Rijsberman (2000), “World Water Vision Commission , Report, A Water
Secure World, http://watervision.cdinet.com