April 2002

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

Contents page

Terms of Reference for the project....................................................................................................1Executive summary...........................................................................................................................2Introduction.......................................................................................................................................3Regulation and Comparative Competition........................................................................................5Ownership and the loss of comparators.............................................................................................9Are mergers beneficial?...................................................................................................................13Making comparisons with ‘averaged’ data......................................................................................15Why are the companies the size they are now?...............................................................................18Big companies, big schemes and technocracy.................................................................................19Can the size of (regulated) companies be objectively determined?................................................22Natural Monopoly as a justification for size...................................................................................23Economies of Scope and Scale........................................................................................................25Economies of Scope from Vertical and Horizontal Integration......................................................28Boundaries for Economies of Scale – Minimum Efficient Scale....................................................29Boundaries for Economies of Scale – Integrated design.................................................................32Capital Intensity...............................................................................................................................34Conclusions.....................................................................................................................................39Appendix One..................................................................................................................................42

Organisational issues...................................................................................................................42Appendix Two.................................................................................................................................45

Empirical and theoretical studies of mergers..............................................................................45Appendix Three...............................................................................................................................48

Why are the companies the size they are now?...........................................................................48Integrated River Basin Management (IRBM).............................................................................51Privatisation.................................................................................................................................54

Appendix Four.................................................................................................................................55Theoretical basis for firm size and industry structure.................................................................55Differences in Managerial Ability...............................................................................................60

Appendix Five.................................................................................................................................61Example calculation of limits to economies of scale in the water industry................................61

Appendix Six...................................................................................................................................63Analysis of published data...........................................................................................................63Assumptions................................................................................................................................63Observations................................................................................................................................63Final form of ‘models’.................................................................................................................64

References.......................................................................................................................................67

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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.

Utility Performance Consultants Ltd/Strategic Management Consultants 12/04/23Ref Ofwat entity size

* Nick Curtis BSc CEng MICE FCIWEM MBAis a Director of Utility Performance Consultants Ltdand a Consultant for Strategic Management Consultants

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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.


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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 competitionThis 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 comparatorsThis 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.


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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 sizeBy (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 ScaleThis 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 IntensityReturn 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.


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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, 19702 Arrow, K. J., The Economics of Agency, in Pratt, J. W. and Zeckhauser, R. J., (eds) Principals and Agents, Cambridge, Mass., Harvard Business, 19853 Rees, R., The Theory of Principal and Agent, Parts I and II, Bulletin of Economic Research, 374 Bos, D., Public Enterprise Economics, North-Holland Elsevier, 19865 Hansmann, H., Ownership of the Firm, Journal of Law, Economics and Organisation, 4 (2) 19886 Averch, H. and Johnson, L., Behaviour of the Firm under Regulatory Constraint, American Economic Review, 52, 19627 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


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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. 198911 Powell, K. M., Yardstick Competition and the Actions of the Water Companies in England and Wales, Doctoral Thesis, Imperial College, London, Jan 1998


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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, 198513 Argenti, J., Practical Corporate Planning, Unwin Paperbacks, 198914 Auriol, E. and Laffont, J-J., Regulation by duopoly, Journal of Economics and Management Strategy, 1 (3), 199315 Powell, K. M. and Szymanski, S., Regulation through Comparative Performance Evaluation, Utilities Policy, 5 (1), 1997


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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, 198617 Waterfacts (1984), Water Authorities Association, Jan 198518 Vickers, J. and Yarrow, G., Economic Perspectives on Privatisation, Journal of Economic Perspectives, 5 (2), 199119 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) 199520 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), 200121 Holtham, G., Water, Our Mutual Friend, New Economy, 3(4), Winter 1996


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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, 199523 Monopolies and Mergers Commission, Wessex Water plc and South West Water plc: a Report on the Proposed Merger, London, HMSO, 199624 Monopolies and Mergers Commission, Wessex Water plc and Severn Trent Water plc: a Report on the Proposed Merger, London, HMSO, 199625 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 199726 Caves, R. E. and Barton, D. R., Efficiency in US Manufacturing Industries, Cambridge, Mass: MIT Press, 1990


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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


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Table One Changes in Industry structure from privatisation

Date Companies Trading in water as Owner No Cos1988 East Worcester, Bournemouth and

West HantsContinued separate reporting

Biwater Supply, Biwater Group

38

1990 Colne Valley, Lee Valley, Rickmansworth

Three Valleys Compagnies Generales des Eaux (later Vivendi)

36

1990 Newcastle & Gateshead, Sunderland & South Shields

North East Water Lyonnaise des Eaux (later Suez Lyonnaise des Eaux)

35

1990 Mid-Sussex, Eastbourne, West Kent

South East Water Saur group (Bouygues) 33

1991 Bournemouth, West Hants Bournemouth and West Hants

Biwater Supply, Biwater Group

32

1992 Essex, Suffolk (East Anglian) Essex & Suffolk Lyonnaise des Eaux (later Suez Lyonnaise des Eaux)

31

Sept 93 Severn Trent, East Worcester Severn Trent Severn Trent plc 30Oct 95 East Surrey, Sutton Sutton & East Surrey Sutton & East Surrey 29Nov 95 North West & Norweb United Utilities United Utilities plcDec 95 Northumbrian, North East Northumbrian Lyonnaise des Eaux

(later Suez Lyonnaise des Eaux)

28

Jan 96 Dwr Cymru, Swalec Hyder HyderJuly 96 Southern, Scottish Power Southern Scottish PowerMay 97 Chester, Wrexham Dee Valley Dee Valley 27

1997 Mid-Southern, South East South East, but some separate reporting 1997-8

Saur group (Bouygues) 26

July 97 Anglian, Hartlepool (HPL) Anglian, but HPL continued separate reporting to 2000

Anglian 25

Aug 98 South West South West PennonSept 98 Wessex, Azurix Wessex EnronMar 99 Yorkshire, York Yorkshire 24Jan 00 Cambridge, Union Fenosa SA Cambridge Union Fenosa SADec 00 Thames, RWE Thames RWEDec 00 Hyder Glas Cymru Glas Cymru2000 Yorkshire Yorkshire Kelda2000 Northumbrian, Essex & Suffolk Northumbrian but ESK

separate 2000Suez Lyonnaise des Eaux 23

2000 North Surrey, Three Valleys Three Valleys Vivendi 22


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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 efficienciesLarger company Residuals Smaller Company

Essex 0 0 SuffolkSevern Trent -11 +8 East WorcesterEast Surrey -14 +5 SuttonNorthumbrian +9 -13 North EastWrexham -5 -11 ChesterSouth East 11 -8 Mid SouthernAnglian -5 -7 HartlepoolYorkshire -11 -26 YorkNorthumbrian (NNE) 0 0 Essex & SuffolkThree 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 costsLarger company p/m3 Smaller Company

Essex 50 61 SuffolkSevern Trent 48 57 East WorcesterEast Surrey 62 53 SuttonNorthumbrian 42 52 North EastWrexham 63 57 ChesterSouth East 86 52 Mid SouthernAnglian 59 39 HartlepoolYorkshire 53 48 YorkNorthumbrian (NNE) 46 53 Essex & SuffolkThree Valleys 48 46 North Surrey

28 Ofwat, 1993-94 Report on the Cost of Water Delivered and Sewage Collected, Ofwat, Birmingham, Dec 1994


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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.


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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 199930 Curtis, N. J., Independent Comparators in the Water Industry of England and Wales, Dissertation for MBA, University of Warwick, June 199131 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, 198432 Cloke, P. J., An Index of Rurality for England and Wales, Regional Studies, Vol 11, 197733 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


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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 and some other company areas

Population density (persons/ square km)(1980/81)

Mains per capita (metres/ head)(1980/81)

Unaccounted for water (leakage)m3/km/d(1980/81)

Marginal cost of water p/m3 (1980/81)

Leakage revenue expend’re £000/Ml/d(1980/81)

Service reservoir storage (days of average demand)(1980/81)

Avon (Coventry) 416 5.1 14.9 4.0 0.74 2.1Derwent (Derby) 366 5.5 11.6 3.0 0.76 1.9Lower Severn (Tewkesbury)

298 7.1 14.9 2.9 0.68 1.7

Lower Trent (Nottingham)

569 4.6 17 3.0 0.63 1.45

Soar (Leicester) 338 5.5 13.1 4.1 0.70 1.0Tame (Birmingham and Wolverhampton)

1705 3.8 17.1 1.0 0.26 1.03

Upper Severn (Shrewsbury)

73 10.6 5.9(S-T o’all now 7.9)

2.9 1.02 2

Upper Trent (Potteries) 376 5.5 20 2.2 0.78 1.8South Staffs Water Company

808 4.2 17(now 12.5)

3 (author’s estimate)

1.0+ 1.1

Thames Metro 3793 2.9 (now 33)(Metro only)

0.93(but large bankside)

Welsh Gwynedd 73 9.5 (now 9) 1.4Chester 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.


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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


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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.


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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, 197437 Twort, A. C., A Textbook of Water Supply, London, Edward Arnold, 196338 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, 198339 Fischer, F., Technocracy and the Politics of Expertise, California, Sage, 199040 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, 198441 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


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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, 197843 Archibald, G. G., Forecasting Water Demand – a Disaggregated Approach, Journal of Forecasting, 2, 198344 Pearce, F., Watershed: the Water Crisis in Britain, London, New Junction Books, 198245 Ward, C., Reflected in Water: a Crisis of Social Responsibility, London, Cassell, 199746 Thackray, J. E., Future Perspectives, in Brandon, T. W., (Ed), Water Services Planning, Water Practice Manual 6, Institution of Water Engineers and Scientists, 198647 Maloney, W. A. and Richardson, J., Managing Policy Change in Britain: the Politics of Water, Edinburgh University Press, 199548 Malefakis, E. E., Agrarian Reform and Peasant Revolution in Spain: Origins of the Civil War, New York, Yale University Press, 1970.


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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, 198850 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


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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 198353 Beesley, M., The Regulation of Privatised Monopolies in the UK, Rand Journal of Economics, 20 (3), 198954 Young, A., The Politics of Privatisation: Privatised Utilities in Britain, Palgrave, 200155 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), 199356 Myers, S., Water Services Management: A Public-Private Partnership, Financial Times Energy, FT Business Limited, 1998


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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 1158 Baumol, W. J., Panzer, J. and Willig, R. D., Contestable Markets and the Theory of Industry Structure, New York, Harcourt Brace Jovanovich, 198259 Train, K. E., Optimal Regulation: The Economic Theory of Natural Monopoly, Cambridge, Mass., MIT Press, 199160 Newbery, D. M., Privatisation, Restructuring and Regulation of Network Industries, MIT Press, 200061 Schmalensee, R., A Note on Economies of Scale and Natural Monopoly in the Distribution of Public Utility Services, Bell Journal of Economics, 9, 197862 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 199063 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, 198964 Sharkey, W. W., The Theory of Natural Monopoly, Cambridge University Press, 1982


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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 averageAll 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.


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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


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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), 198867 Lynk, E. L., Privatisation, Joint Production and the Comparative Efficiencies of Private and Public Ownership: the UK Water Industry, Fiscal Studies, 14 (2), 1993


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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.


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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), 197969 Williamson, O. E., The Logic of Economic Organisation, Journal of Law, Economics and Organisation, 4 (1), 198870 Moore, J., The Firm as a Collection of Assets, European Economic Review, 36, 199271 Morse, L. B., Water: The Case for Cooperatives, IPPR Working Paper by Dept. of Economics, N Carolina, Arkansas & Tennessee State University, 199772 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, 200074 Lichtenberg, F.R. and Siegel, D, Productivity and Changes in Ownership of Manufacturing Plants, Brookings Papers on Economic Activity: Microeconomics, 3, 198775 Gort, M., An Economic Disturbance Theory of Mergers, Quarterly Journal of Economics, 83, 1969


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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, 193877 Bain, J. S., Economies of Scale, Concentration and the Condition of Entry in Twenty Manufacturing Industries, American Economic Review, 44, 195478 Stigler, G. J., The Economies of Scale, Journal of Law and Economics, 1, 195879 Saving, T. R., The Four-parameter Log-normal, Diseconomies of Scale, and the Size Distribution of Manufacturing Establishments, International Economic Review, 1, 196580 Sherman, R., and Tollison, R., Public Policy Towards Oligopoly, Antitrust Law and Economics Review, 4, 197181 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, 197582 Neuberg, L. G., Two Issues in the Municipal Ownership of Electric Power Distribution Systems, Bell Journal of Economics, 8, 197783 The information given throughout this paragraph is reported by Kelly in Ref 72


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Kelly goes on to document learned criticism of use of mathematical regularities in activities of this kind, where there is customer choice, and concludes that MES has little practical value in determining the size of distribution utilities, but was useful in refuting the ‘biggest is best’ argument (see below).

Sutton84 argues that the ‘most natural’ measure for MES is engineering estimates which aim to identify the level of average cost achievable using alternative technologies and plant sizes. The MES is defined as corresponding to the smallest level of output at which, using any available technology or plant size, a firm can attain a level of average cost within a given percentage (usually 10%) of the lowest achievable level. Such an estimate omits to identify the degree to which firms below this level are penalised. Some studies seek to estimate the increase in average costs of working at different percentages of MES, but these are available for very few industries, and in most cases the MES is defined differently – as the size of the industry’s median plant.

Sutton found that MES as the size of median plant holds up for the food and drinks sector (R-squared 0.83 in one study by Connor et al85). Canned vegetables’ engineering estimate for 1972 is very much higher than the census MES reported in this study, whereas it conformed in the 1958 data. This suggests that there has been stagnation of investment. MES estimates are available for all 4-digit SIC industries in the US, but not elsewhere (another reason for using US as a base reference). Hence the MES measure used by Sutton is the ratio between the output level of the industry’s median plant, relative to industry output. Using data on explanatory factors supplied by the England and Wales water companies in their annual returns, an estimate can be made of the average plant size of all suppliers. Borehole supplies are locally efficient at small scale with lower than average costs, but only account for about one third of all supplies. Nearly half of the current companies derive more than 50% of source water from boreholes (Cambridge, Sutton & East Surrey, Folkestone, Mid Kent, Southern, South East Water, Tendring Hundred, Three Valleys and Wessex). They include most of the smallest companies (only Bournemouth and Dee Valley remain as independent smaller companies predominantly on surface water supply), but not necessarily lower in cost. The average number of properties served by the average surface water treatment works in England and Wales in 1993 was 35000, equivalent to a population of about 85000.

To measure the extent to which scale economies exist in an industry Audretsch86 suggests a common proxy measure of the minimum efficient scale (MES) developed and applied by Comanor and Wilson.87 They measured the MES as the mean size of the largest plants accounting for one-half of the industry’s value-of-shipments. The average size of surface water treatment plant of the five largest water industry companies in 1993 (Anglian, Yorkshire, United Utilities, Severn Trent and Thames, serving approximately 45% of the surface water supplied) is 44500 properties. This is equivalent to a population served of 107000, which is very close to the key number in examination of technical economies of scale, as reported by the author in 1991,30 and updated in Appendix Five. At flotation only Hartlepool served a smaller number of properties than this (37000), but this is still above average plant size.

84 Sutton, J., From Theory to Measurement and Econometric Evidence, in [Ref 54]Sunk Costs and Market Structure: Price Competition, Advertising and the Evolution of Concentration, Cambridge, MA: MIT Press, 199185 Connor, J. M., Rogers, R.T., Marion, B. W. and Mueller, W. F., The Food Manufacturing Industries: Structure, Strategies, Performance and Policies, Lexington MA: Lexington Books, 198586 Audretsch, D. B., New Firms, in Innovation and Industry Evolution, Chapter 3, Cambridge MA, MIT Press, 199587 Comanor, W. S. and Wilson, T. A., Advertising, Market Structure and Performance, Review of Economics and Statistics, 49 (4), 1967


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The approximate average sizes of surface water treatment works of the 16 smallest companies in 1992/3 is plotted in the graph below. Since that time eight of the data points have been lost through merger. The position of companies relative to the logarithmic trend line is well explained by the degree of treatment and the proportion of groundwater. The trend line of this rather crude and incomplete dataset has an R-squared of 0.41 suggesting that more detailed work on weighting the proportion of surface sources and the treatment level should produce a treatment costs model which is much more robust than the R-squared of 0.43 Ofwat obtained from the resources and treatment model in 1993. The average of the largest five 5 companies (not plotted) is very close to the trend line.

A similar analysis was carried out on treatment asset construction costs for Ofwat for the price-setting in 1993/4 and adjustments were made to the unit capital cost adjustment factors (the Cost Base adjustment) for companies on the basis of capital scale economies. The form of the curve above is very similar to the operating cost curves used by Deloitte Haskins & Sells in their efficiency studies of the industry for privatisation.65 A doubling of the size of works from 50000 properties (about 20Ml/d) to 100000 secures a 20% decrease in overall cost to customer. The Deloitte Haskins & Sells unit cost curve has an almost identical impact on treatment cost across the same output range.


0 20 40 60 80 100 120 140

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Boundaries for Economies of Scale – Integrated design

Infrastructure specialists31 40 88 have fought for twenty years to obtain integrated design of supply and distribution but the faith in universal technical economies of scale remains widespread.

From the author’s personal experience, on more than one occasion during design of least-cost distribution systems it was found that the costs of overcoming existing cost imperfections in the delivery system exceeded the benefits obtained (in total cost terms). Two examples are given below.

In each of these examples, an organisation with a regulatory incentive to undertake capital works would have been able to justify the system rationalisation with a contribution from reduced operational pumping costs without the evidence of lower total costs. Sunk or stranded assets (mis-positioned, ageing, but fully functional infrastructure) taken into account in appraisals produce different solutions to an economic approach which might dismiss some assets on the grounds of age, rather than performance.89 In its Report34 on Severn-Trent WA in 1981 the MMC found that Operating Divisions (8 at the time) made decisions on whether to employ capital solutions before appraisal was conducted, and noted a lack of documentation supporting the decisions. The MMC found that design standards were chosen without consideration of the trade-off between the standard and the costs of achieving it, and that sizing was not based on economic criteria. MMC recommended that justification for water supply projects should include the likely costs and benefits of a leakage control exercise to achieve the same end. They also found that the analysis undertaken on the proposal to link the Avon and Soar Divisions with a large diameter trunk main (one of the largest items in the WA’s construction programme) was insufficient to justify the linking of the two Divisions in the short term.

88 Huntington, R., Resurrection of Water Supply Distribution – New Life for a Faithful Servant, Journal of the Institution of Water Engineers and Scientists, 33, 197989 Ainsworth, R. G., A Strategy for Water Mains Rehabilitation, Proceedings of the IWES Symposium on Deterioration of Underground Assets, Institution of Water Engineers and Scientists, 1982


Example 1. In the late 1960s, before the fuel crisis of the early seventies, all the water to a low-lying new town was directed in new mains (with spare capacity for growth) across the only hill between the sources and the development because of the historical arrangement of service reservoirs. Post-fuel-crisis analysis seeking lower costs of supply in the 1980’s found that the costs of re-directing mains round the hill exceeded the benefits of lower pumping costs because of the additional costs of replacing relatively new pumping plant added to the costs of duplicating a nearly-new large main. An initial energy-efficient design of the same system would have gone round the hill at very similar capital costs. The appraisal indicated that it was necessary (in total cost terms) to wait until at least some of the assets were due for renewal (or modification for growth) to justify rationalising the system.

Example 2. All of the borehole sources and a surface water transfer to a supply zone pumped to the pressure of the only storage reservoir in the zone. More than 70% of the zone supplies required pressure reduction of at least 40 metres (head of water pressure) to stay within distribution pipe pressure limits. The construction of a lower level service reservoir (of less than half the capacity of the original) and revised pumping arrangements at the boreholes could only be justified (in total cost terms) because of the existence of a ‘spare’ trunk main. This main (most of which was more than 80 years old, but in excellent condition) allowed the pumped water transfer (which was all in the peak energy tariff period and increasing in volume) to be introduced by gravity instead, making large energy cost savings which balanced the new construction costs. The ‘spare’ main was available because it had previously served an area of heavy industry and coal-mining which had massively declined in the late 1960’s.

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In some respects the continuing lack of awareness and utilisation of total cost appraisal in the industry31 is illustrated by the delay in establishing satisfactory theoretical treatment of the economic level of leakage (since Judith Rees’ landmark paper in 197490 until the last 5 years.91

When looking at integrated design it is important to separate economies of scale, efficiencies and effectiveness. Whilst Lynk67 identified economies of scale in the WA’s he also reported that they were less efficient after privatisation than before.

A simple example of the trade-off between economies in capital construction and operation of larger treatment works versus the escalating costs of distribution of the larger works output is given in Appendix Five. The diseconomies of distribution of water to the location of demand can be shown to balance the scale economies of the treatment works over relatively short distances.

90 Rees, J., Waste Control in the Water Industry: an Economic Approach, presented to the Symposium on Waste Control: its Importance in the Planning and Management of Water Supply Systems, Institution Of Water Engineers, Reading, 197491 Ofwat, Leakage of Water in England and Wales, Office of Water Services, 1996, and subsequent annual Report(s) on Leakage and Water Efficiency, 1997-2001


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Capital Intensity

The background to the rise of technocracy and the well-known tendency of large companies to be more capital intensive has been described earlier in this paper. Larger firms are more capital intensive, have higher capital utilisation rates, invest more in new equipment, and employ more educated, salaried and full-time workers who receive more training, greater wages and fringe benefits.73 More able entrepreneurs head larger firms and have a higher opportunity cost to monitor workers therefore engage in various practices to economise on monitoring costs, which include using more capital-intensive methods of production and employing better quality and more highly compensated workers.73

Many researchers have noted that producers within the same industry differ in their capital-labour ratios with large producers generally being more capital-intensive. Also some researchers have shown that larger plants are more likely to adopt a range of newer more capital-intensive technologies (Mansfield92, Romeo93, Kelley and Brooks94, and Dunne95).

In free markets, given the basic shut-down rule that a plant will remain in operation as long as it can cover its variable costs, plants with higher capital-labour ratios will have a lower ratio of variable to fixed costs hence will stay in business for longer. Also if there are sunk entry or exit costs then there is an option value to remain in the market even when the producer is incurring losses.96 A third reason comes from the active learning models – efficient firms generate higher levels of investment and larger capital stocks. In this case capital intensity may act as a proxy for other unobserved sources of efficiency.97

Oi98 has demonstrated linkage between capital intensity and firm size from three sources: Factor Proportions.

The capital to labour ratio is positively related to firm size (supported by looking at machine tools, sawmills and restaurants). Stronger evidence is obtained from comparing two concentration ratios. The ratio which uses size of assets (value of capital) is substantially higher than the ratio which uses employment as the measure of size.

Capital utilisation. Capital is idle for a significant fraction of the time. Hutt and Alchian have shown that pseudo-idleness can be efficient. It can be shown that larger firms achieve higher capital utilisation rates.

Age structure of capital stock. Investment can be in new or used capital goods. Shinohara found that 40% of the assets of small Japanese manufacturing firms were acquired second-hand, while the corresponding figure for large firms was 6%. US firms are said to follow a similar pattern. Large firms tend to buy new specialised equipment, and smaller firms often buy and rebuild used capital goods. Oi reports that work by Bond at Pennsylvania State University showed that

92 Mansfield, E., Industrial Research and Technological Innovation, New York: Norton, 196893 Romeo, A. A., Interindustry and Interfirm Differences in the Rate of Diffusion of an Innovation, Review of Economics and Statistics, 57, 197594 Kelley, M. R. and Brooks, H., External Learning Opportunities and the Diffusion of Process Innovations to Small Firms, Technological Forecasting and Social Change, 39, 199195 Dunne, T., Plant Age and Technology Usage in U.S. Manufacturing Industries, Rand Journal of Economics, 25, 199496 Dixit, A., Entry and Exit Decisions under Uncertainty, Journal of Political Economy, 97, 198997 Doms, M., Dunne, T. and Roberts, M. J., The Role of Technology Use in the Survival and Growth of Manufacturing Plants, International Journal of Industrial Organisation, 13, 199598 Oi, W. Y., Heterogeneous Firms and the Organisation of Production, Journal of Economic Inquiry, XXI (2), 1983


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when fleets of truck-tractors are divided into three size categories (thirds) the median age of the fleet fell from 6.3 years to 4.8 years in the largest fleets. Thus the age of the capital stock is inversely related to firm size.

Amortisation and maintenance make up the full cost of the services for a durable capital input. The former component can be reduced by extending the economic life through higher maintenance outlays. Oi found that the optimal economic life will be longer, the higher the ratio of the asset’s price V to the price of maintenance which may be appropriated by the wage rate W. The age distribution of cars across countries is consistent with a model in which mean age is positively related to V/W. In the water industry where costs are in effect passed through to customers (and more recently with higher gearing, the shareholders) companies have had incentives to construct more expensive and sophisticated plant to meet new standards, but at the same time the assumed asset lives have been reducing, both of which effects enhance capital intensity.

Previous work by the author highlighted the large differences in capital intensity of water service providers, both in the period up to privatisation and afterwards.31 The differences have been largely preserved over the past ten years. Preliminary modelling of total costs to customer has been carried out on public domain data to explore the relationship of capital intensity with the size of the remaining independent companies in the water industry (Appendix Six). A wide range of additional potential explanatory variables has also been tested for impact on total costs to customers.

The modelling process is described in outline in Appendix Six. No rigorous statistical tests have been performed on the outcomes, but some simple relationships have been observed. These are described in more detail in Appendix Six, but in summary, logarithmic relationships with size can be demonstrated, based on analysis of smoothed annual capital expenditures and costs to customers (averages of published data over periods up to 10 years). Averaging of the time series data has been found to improve the modelled relationships. The best fit was obtained by separating the companies into high capital and low capital companies (i.e. using two ‘models’). For any given capital intensity, in both ‘models’ there is a rapid reduction in the costs to customer with size which diminishes to a stable and slightly declining relationship once a size of around 400,000 billed properties is reached. This is illustrated in the minimum cost surface plot at the end of this section of the paper. This surface was constructed using the value of each variable at the lowest (or highest) level occurring in any company which would produce the minimum cost to customer. It thus represents the lowest practical cost surface.

Above 400,000 billed properties the modelled surfaces become effectively planar with continuing returns to scale. However the capital intensity of companies larger than around 400,000-500,000 billed properties increases and this eclipses the scale returns and drives cost to customer upwards for larger companies. Unfortunately, the model(s) cannot demonstrate a unique optimum size in respect of costs to customers. There are two main reasons for this: Too many comparators which bracket the likely optimum size range (400,000 to 600,000

billed properties) have now been lost through mergers or common ownership (Lee Valley, Colne Valley, Sunderland and South Shields, Newcastle and Gateshead, North East (the last two combined), Northumbrian, South East, Mid Southern, Essex & Suffolk). Some data is available for those ‘merged’ companies which started reporting combined data only recently, but the earlier mergers (often from common ownership) had a larger impact on the success of an exercise such as this one. The earlier loss of comparators prevents calculation of average


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capital and operating costs over a time sufficient for smoothing of the pronounced capital cycle in the industry between price caps (at least one full 5-year cycle is needed for this).

The lowest-cost companies remaining in the ‘optimum’ region (Portsmouth and South Staffs) are known to have some relatively benign operating cost characteristics which influence the historical MEA, and therefore the capital intensity. Portsmouth has 50% groundwater in the downs above its dense urban supply area, and its two surface treatment works are on average 50% above the higher MES sizes (44500 properties) calculated in an earlier section of this paper. South Staffs also has a substantial proportion of groundwater close to demand centres (again approximately 50:50 with surface water). Because of having to pump over the Severn-Trent watershed from its largest surface works (which is a joint scheme with Severn-Trent) it has a massive scale advantage and opportunity for gravity delivery. The average size of its two surface water works is nearly 3 times the MES. Only five companies have an average surface treatment works size at or above the size of Portsmouth’s - South Staffs, Three Valleys, York (only a little larger, but now part of Yorkshire Water), Severn Trent and Thames. The South Staffs’ average size is exceeded only by Thames.

Further work would be needed to unravel the relationship between asset characteristics (which are largely an accident of location – the inter-relationship of available source water and demand) and capital intensity for the companies. In the larger companies capital intensity appears to be driven by policy rather than necessity or least total cost analysis. The contrast with the two companies above, which have larger works than average but very low capital intensity, could not be more marked. The policy choice in larger companies may still in part be influenced by the legacy of the big-scheme men of the 60’s and 70’s, in that the larger than optimum network sunk assets have to be maintained. The fledgling relationship described earlier between the average sizes of surface treatment works and cost to customers suggests that researching this in more detail could prove worthwhile. It is unfortunate that Ofwat has chosen in recent years to aggregate source works types (ground water and surface water) in some data tabulations since this diminishes opportunities for modelling the impact of economies of scale at the company level. The snapshot of the 1994 price setting Asset data could still be utilised for this analysis, with data for the companies which at that time reported separately and did operate at or near what appears to be the optimum technical scale. The form of the models obtained is shown in the copy of a surface constructed from an earlier version of the final models, reproduced on the following page. Two models have been combined into one surface – splitting the model data into 12 low capex companies and 10 high capex companies better represented the data, and the two ‘models’ interface quite successfully, as shown below. The surface was built by fixing each variable at the lowest/highest value within the range of all company values (for each group of current combined companies) which generated the lowest cost to customers. I.e. the surface represented a virtual company performing for all variables at the ‘best in industry’ level. The initial modelling was carried out with a partial dataset (i.e. some years’ data missing but averaged between available years). The models resulting from analysis of the full dataset are simpler than those found initially, whilst still retaining the same order of fit.

In fact one or two of the former independent but now merged companies were found to have operated below this surface (e.g. Mid Southern) but there was not a full data set available following merger, and adjustment of the part-set for capital cycling would have been unreliable. The general shape remains consistent irrespective of the final mathematical expression of the models. Only the smaller-size end of the surface is shown for clarity at the ‘optimum’ range of


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company sizes. The surfaces continue across the whole range of company sizes with a steady but lower rate of reduction in total costs to customer with increased size.

The models have been constructed with the assumptions and adjustments identified in Appendix Six. In the modelling used to create the surface shown, costs shown are all in £/property at 2000-01 prices, and size is in thousands of billed properties. Capital expenditure for earlier years has been adjusted by COPI financial year average, cost to customers has been adjusted by RPI financial year average, and net debt used to weight gearing for combined companies has been adjusted by year end RPI.

Current combined companies find themselves on or above this surface. No conclusions are drawn as to the relative efficiencies of companies from this analysis. There is a very good fit for the 12 companies with low capital intensity (R-squared between 0.95 and 0.97 depending on the number of variables). However amongst the 10 higher capital intensity companies two companies (Welsh (Glas Cymru) and South West) were consistent outliers in every alternative set of variables tested for correlation. A plot of all companies, modelled cost to customers against actuals with Welsh and South West removed exhibits an R-squared of 0.97, which tends to suggest that there is something wrong with the figures for these companies. The degree of departure from the modelled relationship for these two companies suggest that it must be the most influential variable (capital expenditure) which is governing the differences.


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Conclusions

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. There is a trade-off between allowing take-overs to encourage productive efficiency and keeping enough firms in existence to permit cross-company comparisons.

Mergers within the water industry (many of them resulting from common ownership rather than take-over) have reduced the number of comparators from 38 to 22 since privatisation. There is support in the literature for the premise that mergers and acquisitions amongst water companies are not justified in terms of cost efficiency. Those that have occurred in the water industry have generally resulted in the absorption of smaller, more efficient companies by larger less efficient ones.

Most of the current companies have passed through a long series of organisational changes, with many companies reducing the number of operating divisions and then increasing them again. There are differences between the operating characteristics of management areas within companies which are as great (sometimes greater) than the differences between companies. Ofwat has sought separate data for sewerage efficiency work, and might consider seeking separate information for water supply areas, now that the number of independent comparators has been reduced. It appears that both size and capital intensity are now polarised because of the loss by amalgamation of medium sized companies.

The size of water supply entities worldwide tends to be related to the size of the ‘local government’ administrative unit. In the UK, the creation of the Water Authorities in 1974 was promoted by a long-held belief in the need for national management of water resources to combat drought, and then later the concept of integrated river basin management of the water cycle was incorporated into the management structure. There was no attempt to identify an optimum size since there was unswerving belief (in government and technical circles alike) in continuing returns to scale across the whole range of water cycle activities. The number of large water and sewerage companies (WASC) currently in the industry was the result of political negotiation nearly thirty years ago (in 1973).

In particular, the technocracy was rooted firmly in the engineering of large capital works rather than network management. The culture of biggest is best remains with us in the asset base legacy of the larger companies, which itself has consequences for differences in capital intensity between companies. The definition of natural monopoly is based upon an inherent tendency for decreasing unit costs over the entire extent of the market, and water distribution has been described as ‘the most natural monopoly’ despite technical evidence to the contrary. Infrastructure specialists have fought for twenty years to obtain integrated design of supply and distribution but the faith in universal technical economies of scale remains widespread.

The extensive modelling which is reported in the literature fails to explain in depth the heterogeneity of successful firms within industries, even within free markets. By implication the most efficient companies will be those with the greatest number of similar plants around the minimum efficient scale (MES) whilst still small enough to avoid incurring the diseconomies apparent in larger companies. There is much evidence in the literature of economies at a small scale and diseconomies at large scale, and a wide range of output with apparently equal average costs. These studies have concentrated on industrial firms but similar patterns have been observed


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in electricity distribution, and can be demonstrated for water distribution technical operations, as shown in Appendix Five. Applying the findings of work on MES carried out in other industries to the water industry suggests plant level MES for surface water treatment plants in the range of 35000 – 45000 households. Technical appraisal of idealised distribution systems in Appendix Five also suggests limiting surface water treatment supply systems to about this magnitude (equivalent to a population served of 100,000). This would be most efficient in terms of least cost of the whole supply and distribution system. The companies with the lowest costs to customers in the water industry operate at about ten times this level, but no conclusions can be drawn on whether this represents the optimum scale of management of multiple MES-sized plants, because their low costs are largely the result of low capital intensity. In turn this may be due to benign supply characteristics, but there are no longer enough medium sized companies in the industry for this to be tested using public domain data.

There appears to be no right size for a water supply entity across the full range of its functions. Modelling of the largest companies shows continuing (albeit slight) returns to scale in respect of total costs to customer. However this is at least partly attributable to the legacy of some very large works in these companies, which deliver lower operating costs than companies with similar capital intensity but smaller works. For sewerage systems, the drainage areas offer a more obvious management unit, but these can vary enormously in size because of the population settlement pattern. Urban development in the UK follows the pattern of industrial location on the lines of rivers (the traditional source of power and transport) in sheltered bays and inlets or otherwise in ‘gaps’ in the landscape associated with glacial or fluvial processes. The only urban areas that do not conform to this pattern are new towns like Letchworth and Stevenage, or Spa towns like Tunbridge Wells and Harrogate.

Thus the demand pattern of the country is already biased to be close to the available surface source water, and groundwater is most accessible in the valleys, wherever suitable rock/sand formations exist. These circumstances, in a relatively wet country, lend themselves to an expectation that development of sources close to demand can frequently be carried out at the optimum plant scale (which will depend on the source type). The exceptions are clearly the large conurbations, whose polluting activities threaten their own local resources, and whose demands may exceed them.

It is also clear that the water supply companies do not need to be constituted as single operators of an optimum scale plant. There are continuing returns to scale on many of the service and labour-based activities of the companies, and common management of multiple plants close to demand will be a first-best solution. Modelling carried out in the course of this review shows a rapid reduction in the costs to customer with size which diminishes to a stable and slightly declining relationship once a size of around 400,000 billed properties is reached.

Companies have been experimenting with out-sourcing company-wide services. For example, distribution operations (where there is a costly geographical place utility of moving plant and materials around) tends to be subdivided between a number of contractors on an area basis, whereas customer call centres (with low costs of common collection of contacts) gain advantages from a single location. The optimum scales of operation are very different.

The lesson which can be taken from history and from recent outsourcing examples is that there is a range of water service activities, each with its own optimum scale. This was true of the


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proposals for national water resource management over 50 years ago, and integrated river basin management, but the mistake was to assume that one size fits all. There is no justification for retention of the large regional organisations for network activities. The reality is that there are sub-areas within existing companies which are far closer to optimum technical scale than the company as a whole, but which benefit from a lower company-wide unit cost for administration, finance and customer contact activities where optimum scale may be larger than the company itself. It is these activities which contribute to continuing cost reductions with scale at company sizes well above the optimum technical (operational) scale.

However hard they try, companies with a legacy of large assets are unable to re-write the history of industrial and domestic settlement patterns, and change either their supply/demand asymmetries or the scale of the asset base which in part drives their capital intensity. Nevertheless the element of capital intensity which continues to be driven by external obligations could be better managed towards the technical optimum.


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Appendix One

Organisational issues

Coase99 and Williamson68 argue that the size of an (incumbent) enterprise will be determined by answering Coase’s postulate “The question always is, will it pay to bring an extra exchange transaction under the organising authority?” Coase also said “ceteris paribus, a firm will tend to be larger the less likely the (firm) is to make mistakes and the smaller the increase in mistakes with an increase in the transactions organised”. Both Coase and Williamson noted that an obvious source causing an increase in transaction costs is uncertainty and imperfect information.100

The basic Agency problem arises in the context of an organisation responding to an agent who possesses potentially new economic knowledge (it may be a defined role in the organisation) (Alchian and Demsetz101, Jensen and Meckling102, Holmstrom and Milgrom103, Holmstrom and Tirole104, Milgrom105). Because the Principal cannot observe the Agent’s efforts or outcomes there are monitoring, incentive and possible hostage problems. Information asymmetries or divergence in risk will lead to different values being assigned to a proposed expansion project (Kihlstrom and Laffont106). The Agent will have an incentive to exaggerate the expected value along with the effort to develop and implement it. If the Principal introduces some method of monitoring (usually of inputs101), it can deduce something about the Agent’s efforts from a particular signal. However the riskier the any project might be, the less able the Principal is to infer this from monitoring. I.e. the costs of monitoring will rise and the expected value of the project falls as risk increases. In turn this reduces the incentive for the Agent to develop risky expansion projects, or at least their likelihood of being approved and implemented by an incumbent firm.

Holstrom and Milgrom103 postulated the existence of a “bureaucratisation dilemma” where “To say that increased size brings increased bureaucracy is a safe generalisation; to note that bureaucracy is viewed as an organisational disease is equally accurate.”107 Milgrom105 argued that bureaucratic rules are a rational way for organisations to limit investments by agents in influence activities. Tirole108 and Milgrom and Roberts109 have pointed out that bureaucratic decision-making is a mechanism to avoid collusion among coalitions of subordinates and bosses, because the integrity of the evaluation of subordinates depends upon the incentives facing the monitor.

99 Coase, R. H., The Nature of the Firm, Economica, 4 (4), 1937 also in Williamson, O. E. and Winter, S. G., Eds, The Nature of the Firm: Origins, Evolution and Development, New York: Oxford University Press. 100 Reported in Audretsch, D. B., New Firms, in Innovation and Industry Evolution, Chapter 3, Cambridge MA, MIT Press, 1995101 Alchian, A. and Demsetz, H., Production, Information Costs and Economic Organisation, American Economic Review, 62, 1972102 Jensen, M. C. and Meckling, W. H., Theory of the Firm: Management Behaviour, Agency Costs and Ownership Structure, Journal of Financial Economics, 3, 1976103 Holstrom, B. and Milgrom, P., Aggregation and Linearity in the Provision of Intertemporal Incentives, Econometrica, 55 (2), 1987104 Holstrom, B. and Tirole, J., The Theory of the Firm, in Schmalensee, R. and Willig, R., Eds, Handbook for Industrial Organisation, Amsterdam, Elsevier, 1989105 Milgrom, P., Employment Contracts, Influence Activities and Organisation Design, Journal of Political Economy, 96 (1), 1988106 Kihlstrom, R. E. and Laffont, J-J., A General Equilibrium Entrepreneurial Theory of Firm Formation Based on Risk Aversion, Journal of Political Economy, 87 (4), 1979107 Holmstrom, B., Agency Costs and Innovation, Journal of Economic Behaviour and Organisation, 12, 1989108 Tirole, J., Hierarchies and Bureaucracies, Journal of Law, Economics and Organisation, 2 (3), 1986109 Milgrom, P. and Roberts, J., Bargaining and Influence Costs and the Organisation of Economic Activity, in Alt, J. and Shepsle, K., Eds, Positive Perspectives on Political Economy, Cambridge: Cambridge University Press.


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Bureaucratic decision-making favouring non-discretionary rather than discretionary rules reduces such collusions.

To minimise Agency problems and the cost of monitoring, bureaucratic hierarchies develop objective rules. Kreps110 has argued that such rules promote internal uniformity and that a uniform corporate culture, in turn, promote the reputation of the firm. However the rules themselves make it more difficult to evaluate the efforts and activities of Agents involved in activities which do not conform to the rules. Holstrom107 says “Monitoring limitations suggest the that the firm seeks out activities which are more easily and objectively evaluated. Assignments will be chosen in a fashion that is conducive to more effective control.” Authority and Command systems work better in environments which are more predictable and can be directed with less investment in information. Routine tasks are the comparative advantage of a bureaucracy and its activities can be expected to reflect that. Williamson111 comments on the tension between hierarchical bureaucratic organisations and entrepreneurial activity; “Were it that large firms could compensate internal entrepreneurial activity in ways approximating to that of the market, the large firm need experience no disadvantage in entrepreneurial respects. Violating the congruency between hierarchical position and compensation appears to generate bureaucratic strains, however, and is greatly complicated by the problem of accurately imputing causality.” This leads Williamson to the following conclusion:

“I am inclined to regard the early stage innovative disabilities of large size as serious and propose the following hypothesis: An efficient procedure by which to introduce new products is for the initial development and market testing to be performed by independent investors and small firms (perhaps new entrants) in an industry, the successful developments then to be acquired, possibly through licensing or merger, for subsequent marketing by a large multidivision enterprise…. Put differently, a division of effort between the new product innovation process on the one hand, and the management of proven resources on the other may well be efficient.”

The degree to which an industry experiences knowledge asymmetry and Agency problems with respect to innovation will be industry-specific111. Where new information and innovations come from non-routine knowledge they tend to be rejected by hierarchical bureaucracies. These two situations are said to reflect two distinct regimes – the entrepreneurial and routinised technological regimes (Nelson and Winter112 113 114). Support for the existence of these regimes comes from Acs and Audretsch.115 116 117 Given the relatively stable technology within the water industry for many years, it is not surprising that the organisations have been bureaucratic in nature, and larger than would be indicated by consideration of optimum technical scale.

110 Kreps, D., Corporate Culture and Economic Theory, in Alt, J. and Shepsle, K., Eds, Positive Perspectives on Political Economy, Cambridge: Cambridge University Press.111 Williamson, O. E., Hierarchical Control and Optimum Firm Size, Journal of Political Economy, 75, 1967112 Nelson R. R. and Winter, S. G., Forces Generating and Limiting Concentration under Schumpeterian Competition, Bell Journal of Economics, 9 (2), 1978113 Nelson R. R. and Winter, S. G., An Evolutionary Theory of Economic Change, Cambridge MA: Harvard University Press, 1982114 Nelson, R. R. and Winter, S. G., Neoclassical vs. Evolutionary Theories of Economic Growth: Critique and Prospectus, Economic Journal 84, 1974115 Acs, Z. J. and Audretsch, D. B., Innovation, Market Structure and Firm Size, Review of Economics and Statistics, 69 (4), 1987116 Acs, Z. J. and Audretsch, D. B., Innovation in Large and Small Firms: An Empirical Analysis, American Economic Review, 78 (4), 1988117 Acs, Z. J. and Audretsch, D. B., Innovation and Small Firms, Cambridge MA: MIT Press, 1990


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Gort and Klepper118 found that if information based on non-transferable experience in the market is an important input in generating innovative activity, then incumbent firms will tend to have the advantage over new firms. The converse is true, and the holder of the external knowledge must enter the industry to exploit the market value of the knowledge. In a routinised regime Agents will not start their own firms, but in an entrepreneurial regime the Principal and Agent’s evaluations will diverge and new firms will be started.

There are well known examples of large organisations turning down products of real value – Xerox was started after photocopying was rejected by Kodak, and Apple was started to produce PC’s after rejections by all the big Computer companies (ironically including Xerox), because ‘we are not in that business’. Similarly IBM failed to buy into Microsoft (because of a sniffy attitude to credentials and personal characteristics).

Lucas 119 120 constructed a model in which individuals are alike as workers but have different amounts of entrepreneurial ability. Better entrepreneurs were better at transforming inputs of labour and capital into output. An individual will become an entrepreneur if the profits he can earn exceed the competitive market wage rate. The shape of the distribution of abilities function above the equilibrium level (below which workers are hired) determines the equilibrium size of firms. A technical advance which increases labour productivity leads to larger firms because some entrepreneurs become workers.

Williamson111 121 posited a model in which the firm grows by adding layers to its hierarchical pyramid. Each supervisor has a span of control extending over S subordinate workers who achieve a productive compliance rate . Control loss is a cumulative function of the pyramid’s height (1- )m, and this rising cost of supervision limits the size of the firm. The optimum profit-maximising firm size is positively related to and S as well as the net product price (P-r) where r is raw material cost. An increase in the wage of manual workers or the pay progression parameter for supervisors reduces the firm’s size. The model predicts that the ratio of administrative staff to total employment will be higher in larger firms. However the data flatly refutes his contention that labour productivity will be higher in smaller firms which experience less control loss. Other factors need to be introduced to explain the differences between large and small firms.

Oi98 found that there is a positive relation between the size of firm and the incidence of shift work, particularly in manufacturing. Capital is a durable asset whose productivity depends on inputs of co-operating factors and maintenance and repairs that add an increment of value dV to the capital asset. Every firm jointly supplies two “products” output Q and dV. Repairs and maintenance can be for remedial or preventive purposes. Small firms are more likely to substitute internal for external investments by extending the economic life of their capital assets. Higher levels of maintenance can be more economically supplied by small firms. There are apparent parallels for this in the distinctly different capital intensities of companies the water industry, despite the commonality of technology (refer to the section of the main paper on capital intensity).

118 Gort, M. and Klepper, S., Time Paths in the Diffusion of Product Innovations, Economic Journal, 92, 1982119 Lucas, R. E. Jr, Adjustment Costs and the Theory of Supply, Journal of Political Economy, 75, 1967120 Lucas, R. E., On the Size Distribution of Business Firms, Bell Journal of Economics, 9 (3), 1978121 Williamson, O. E., Markets and Hierarchies: Analysis and Anti-trust Implications, New York: The Free Press, 1975


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Appendix Two

Empirical and theoretical studies of mergers

Lichtenberg and Siegel122 document the rise of mergers and acquisitions in the 70’s & 80’s in the US. From a total of 926 in 1974, the numbers of mergers grew to 2326 in 1981 and 4024 by 1986. Value increased 1980-86 by factor of 6 times the Retail Price Index increase of 33%, and Producer Price Index of 17%.

Several attempts to determine the impact of mergers have been made: with reference to stock prices: Halpern123 124, Jensen and Ruback125 with reference to profitability: Hogarty126, Melicher and Rush127, Weston and Mansinghka128 with reference to market shares: Mueller129, McGuckin, Andrews and Monahan130

Lichtenberg and Siegel claim that their analysis is different in the level of aggregation of the data (at plant level) and the measure of efficiency (Total Factor Productivity TFP). They also observed partial mergers because they were working with plant level data. The authors claim ‘a consensus’ that TFP is the best way to measure efficiency. 18000 plants were studied and 21% changed hands in a ten-year period.

Evidence from combined market values suggests shareholder wealth is increased.125 Hostile merger activity might be detrimental to the other stakeholders (workers, suppliers, government, the community etc through layoffs, lower tax). The authors cite Shleifer and Summers131 (not published at time) as concluding that increases in stock prices associated with mergers merely reflect a transfer of wealth from stakeholders to shareholders. There are counter arguments that social gains are obtained (improved efficiency) and Lichtenberg and Siegel test the validity of these opposing positions.

Different theories of ownership are said to have different implications for how mergers and acquisitions affect economic performance.

Neoclassical theory (Meade132) suggests that takeovers promote economic natural selection. Efficient firms survive (i.e. remain autonomous) and inefficient firms are taken over. The threat of takeover causes managers to seek to maximise profits.

122 Lichtenberg, F.R. and Siegel, D, Productivity and Changes in Ownership of Manufacturing Plants, Brookings Papers on Economic Activity: Microeconomics, 3, 1987123 Halpern, P. J., Empirical Estimates of the Amount and Distribution of Gains to Companies in Mergers, Journal of Business, 46, 1973124 Halpern, P. J., Corporate Acquisitions: a Theory of Special Cases? A Review of Event Studies Applied to Acquisitions, Journal of Finance, 38, 1983125 Jensen, M. and Ruback, R., The Market for Corporate Control, Journal of Financial Economics, 11, 1983126 Hogarty, T. F., The Profitability of Corporate Mergers, Journal of Business, 73, 1970127 Melicher, R. W. and Rush, D. F., Evidence on the Acquisition-related Performance of Conglomerate Firms, Journal of Finance, 29, 1974128 Weston, F. J. and Mansinghka, S. K., Tests of the Efficiency Performance of Conglomerate Firms, Journal of Finance, 26, 1971129 Mueller, D. C., Mergers and Market Share, Review of Economics and Statistics, 67, 1985130 McGuckin, R., Andrews, S. and Monahan, J., The Efficiency of Conglomerate Mergers: New Evidence from Longitudinal Research Data Base, presented to National Bureau of Economics Research Summer Institute on Productivity, 1987131 Shliefer, A. and Summers, L. H., Hostile Takeovers as Breaches of Trust, unpublished in 1987132 Meade, J. E., Is the New Industrial State Inevitable?, Economic Journal, 78, 1968


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Manne133 suggested that the threat of takeover is serious because ownership change provides a way of getting rid of ineffective managers.

Jensen134 asserted that mergers increase the efficiency of resource allocation and provide a framework for ensuring that management will act to maximise shareholder wealth.

Mueller135 and Galbraith136 contended that corporate leaders pursue a policy of growth rather than maximisation of profit or stockholder wealth. Executive pay is often based on revenue increases, and because of imperfections in capital markets, large firms are less likely to be taken over (this premise is certainly no longer true from experience in the 1990s).

Roll137 argues that the net effect of mergers is to reduce stockholder wealth because acquiring firms systematically overestimate the value of their targets. Roll attributes this myopic behaviour to the hubris of top level executives.

Gort138 proposed a theory of economic disturbance implying that mergers have a neutral effect on efficiency. The model treated assets transferred through ownership change in the same manner as other income-producing assets. He argued that mergers are caused by divergent expectations: the acquiring and target firms have vastly different perceptions of the present value of the target company’s stock, based on different expectations about future levels and sources of income. These discrepancies are more likely to occur during periods of economic disturbance (e.g. bull markets or rapid technological change). In exceptional circumstances, mergers can also be for tax savings.

Lichtenberg and Siegel propose a ‘matching’ theory of ownership change. The authors believe that ownership change is primarily a mechanism for correcting lapses of efficiency. The target generally has a deteriorating economic performance. This may be due to an inherent incompatibility between plant and owner (relative disadvantage) or an overall lack of managerial competence (an absolute disadvantage). They cite the Jovanovic job separation model139 to support a relationship between job tenure and earnings – essentially this ownership change theory is based on the same principles.

There are three primary assumptions: Some plants have a comparative advantage – a combination of managerial expertise,

technological skill, and ability to exploit efficiencies of scale or scope. The quality of the match determines retention or disposal – don’t assume that there a good and

bad owners, just good and bad matches The quality of the match is represented by TFP – the quality of which is determined by

experience. Plant efficiency cannot be determined in advance, only upon operation.

An illustration is provided by the Lichtenberg and Siegel. Plants and owners are matched initially and match quality varies randomly. The lower the plant productivity, the higher the likelihood of ownership change. Because of the transaction costs of plant sale, there is a threshold below which

133 Manne, H. G., Mergers and the Market for Corporate Control, Journal of Political Economy, 73, 1985134 Jensen, M. C., The Takeover Controversy: Analysis and Evidence, in Coffee, J. C., Jr., Lowenstein, L and Rose-Ackerman, S., Eds, Knights, Raiders and Targets: The Impact of the Hostile Takeover, Oxford University Press, 1988135 Mueller, D. C., A Theory of Conglomerate Mergers, Quarterly Journal of Economics, 83, 1969136 Galbraith, J. K., The New Industrial State, Boston, Mass., Houghton Mifflin Co., 1967137 Roll, R., The Hubris Hypothesis of Corporate Takeovers, Journal of Business, 59, 1986138 Gort, M., An Economic Disturbance Theory of Mergers, Quarterly Journal of Economics, 83, 1969139 Jovanovic, B., Job Matching and the Theory of Turnover, Journal of Political Economy, 87 (5), 1979


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the relative efficiency of the plant must fall before a change in ownership is sensible. When a change occurs, even an average match quality leads to above-average growth in productivity or increase in efficiency. The theory has two implications – low productivity induces change in ownership, and a change will result in an increase.

Data was an extract from the full Longitudinal Research Database file (LRD) and covered 20000 plants employing more than 10 million people. Average plant size was thus > 500 employees. The data excluded plants which closed or failed (which is a common occurrence in US manufacturing plants). Dunne, Roberts and Samuelson140 found 30% failures in five years, and 56% in ten. Failure rates for larger plants were much lower (10%) and these firms are heavily represented in the data. It was not possible from the data to determine whether new owners closed plants. Data also excluded new firms. The data included a high percentage of spin-offs of units acquired through conglomerate mergers, because this was the nature of the business environment in the 1970s. DR&S quote Ravescraft and Scherer’s estimate that 40% of acquisitions were spin-off sales, and 70% of those sold 1974-81 were originally purchased.

The analysis showed that plants changing owners were 3.2% less efficient than non-changers. 50% of the deficit had gone by year 4 after takeover, 68% at year 7, but the difference in year 7 is not significant, hence it could be assumed that all of the difference is recovered by year 7. Other analysis showed that efficiency gains do not occur immediately. Increases were slightly greater for more than one ownership change.

140 Dunne, T., Roberts, M. J. and Samuelson, L., The Growth and Failure of U.S. Manufacturing Plants, The Quarterly Journal of Economics, CIV (4), 1989


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Appendix Three

Why are the companies the size they are now?

In Victorian times, some direct competition was practised between rival water companies and municipal suppliers with duplicated assets, but this was sensibly dropped quite quickly.141 However there was disenchantment with private ownership and control, and many private water companies were taken over by local government.46 Frazer142 quotes from Samuel Holme (Liverpool, 1844) “water is as essential to the health and comfort of mankind as the air we breathe, and when mankind congregate in masses counted only by tens of thousands, it is essential to the public health that it should be most abundant, not doled out to yield 30% interest, but supplied from the public rates at net cost”. In Birmingham, where by 1875 the Birmingham Waterworks Company’s share value had risen from £25 to £48, it was seen that good service was not given except where it was profitable to do so. Mayor Joseph Chamberlain argued that “the quantity and quality of water to be supplied to the public were matters of greater importance than mere profit, and that a monopoly like water supply should be controlled and managed by the representatives of the people, and not by private speculators.”143 The Birmingham Waterworks Company was compulsorily purchased in 1875.

Hassan141 presents a table of the change in numbers of water suppliers over the twentieth century. The table shows numbers of suppliers in key years in the development of the industry’s structure.

Local Auth’s

Boards or Joint Comm’s

Water Cos

Other Total Non-piped Rural

parishes1904 870 8 2211914 786 34 200 1139 2100 62%1934 790 48 173 1000 20001944 1196 33%1956 883 42 90 15 1030 12%1970 64 101 33 198 3%

Notes: Others includes small and non-statutory companiesFigures included where available from contemporary surveys

In the main it has been drought which has triggered public and parliamentary interest in the industry throughout the twentieth century. Unfortunately the political impetus of drought washes away with the rainfall which inevitably follows, and real progress is slow. Drought experience has ultimately led to a disaffection with the privatised industry in contrast to the previous perception as a community service (what Kay refers to as the loss of ‘common cause’ and a ‘lack of legitimacy’ for the new private companies144).

141 Hassan, J., The Water Industry in the 19th Century, Water Bulletin, WAA, 1983.142 Frazer, D., Power and Authority in the Victorian City, Oxford, Basil Blackwell, 1979143 Matthews, C. E., The Water Supply of Birmingham, Birmingham Corporation, 1886.144 Kay, J., Regulating Private Utilities: The Customer Corporation, Journal of Cooperative Studies, 29 (2), 1996


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Droughts which had most impact on impounded sources and direct abstractions have affected some parts of England and Wales on at least nine occasions in the twentieth century. The regional impact of these events was varied (approximated here as different quadrants of the UK): 1911 (NW); 1921 (SW, SE, NE); 1933/34 (NW, SW, SE); 1943-5 (SE); 1949 (SW, SE); 1959 (NW); 1975/76 (NW, SW); 1984 (NW, SW); 1994/5 (NW, NE).17 41 145

Groundwater sources are more stable, but have been severely affected during two-season droughts (rural supplies in particular in 1933/34, more generally in 1975/6, 1991-93 (SE)) and when plundered to offset loss of surface supplies (East Yorkshire 1995).

In the first quarter of the century it was the impact of drought on rural communities which engendered most concern and led to review of the provision of piped supply. In 1914 62% of 12869 rural parishes were without piped supply.146 Even through to the mid 1920’s many rural areas were on bucket sanitation, and piped water supply remained essentially an urban service. The drought experience of 1921 led the parliamentary Advisory Committee on Water to propose in 1923 to release additional resources from existing impounded catchments by halving of the rather conservative Victorian design allowances for maintenance of downstream flows (termed compensation water) from impounding reservoirs. It had been common for between one third and two thirds of the catchment yields to be reserved for downstream mill-owners. This additional resource reinforced the urban supply systems but did little to correct the real problems of water supply to rural communities.

Connection of every property in the country was seen as impractical (advice from the Advisory Committee on Water to parliament in 1923141) but this policy position was changed by the experience of the 1933/4 drought. Cross-subsidised development of rural supplies was facilitated by the cost-spreading provisions of the Local Government Act of 1926, but only finally triggered in large volumes by the provision of £1m grant aid for rural connections within the Rural Water Supplies Act 1934. As a result County Councils promoted schemes with a value in excess of £6m. There was much discussion of options for a National Water Grid but it was recognised that the volume and low value of the product rendered this hopelessly un-economic in contrast to treatment of surface abstractions closer to supply areas.147 It was in 1934 that the Labour Party adopted a policy of water ‘nationalisation.’148

After the Second World War the emphasis of national water policy was on re-grouping of suppliers, but further funding (£15m) had also been made available for rural connections through the Rural Water Supplies and Sewerage Act 1944. The Labour administration proposed large regional water boards, but the nationalisation proposal was not taken forward because they lost the 1951 election. From 1951 re-grouping was encouraged but secured little progress. The number of Joint Boards had only risen from 33 in 1932 to 55 by 1953. Overall numbers of suppliers had only fallen from 1186 to 1030 between 1945 and 1956. In the period 1953-55 the Conservative government and the British Waterworks Association jointly launched a new initiative, described by Kinnersley149 as ‘a pragmatic campaign to achieve mergers substantially by agreement.’

145 Data presented to a Seminar on Surface Water Yield Assessment, NRA R&D project 414, June 1993146 Hassan Ref 141 makes reference to the Return of Water Undertakings, 1914: xxxvii – a parliamentary paper.147 Municipal Year Book 1935.148 Nationalisation as a term was never defined by the Labour Party149 Kinnersley, D., Troubled Water: Rivers, Politics and Pollution, London: Hilary Shipman, 1988


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The government had concluded:141

some of the smaller and less efficient water companies could not meet all demand placed on them

the state possessed weak instruments to progress reform voluntary regrouping had achieved little

Still impatient with the pace of progress, in 1956 government issued a circular150 to all undertakings emphasising the Minister’s view that re-grouping should proceed faster and more radically. All suppliers were asked to consider immediately the effects of combining in the interests of efficiency. The approach had an interventionist element which was probably necessary to overcome the concerns over loss of identity felt by the incumbents. Finally it was this action supported by statutory Orders in some cases (see below) which secured rapid reduction in the number of suppliers. In 1956 half of the population of England and Wales was served by the 55 largest suppliers and the remainder were served by around a thousand other suppliers. By 1971, there were only 198 suppliers, with the 6 largest all serving populations greater than 1 million. In particular the boundaries of existing suppliers were progressively extended to include large rural areas, and the supply duties of the Municipal Boroughs and Urban Districts were incorporated in County Borough areas of supply.

Supplier Year Area sq. milesNewcastle & Gateshead W. Co. 1945

19701531854

Bristol Waterworks Co. 19521964

78934

Cambridge Water Co. 19451956

60453

Note: Cambridge W. Co. was extended by statutory Order to amalgamate 5 LA’s and 2 Jt BoardsEssex W. Co. was created by Order, to cover an area served by 6 LA’s and 2 companies

Of the 700 suppliers which were regrouped in the period 1956 to 1966 only 35 (5%) were secured by Ministerial compulsion.151

By 1971 the industry structure had concentrated significantly:152

Population Local Boards Joint Boards Statutory Co’s Total<50k 26 6 2 34

50-100k 9 21 3 33100-250k 12 49 15 76250k-1m 14 24 11 49

>1m 3 1 2 6Total 64 101 33 198

Despite the change in the scale of operations, there was no guarantee of rational planning.141 It was argued that some resource developments still took place without regard to regional needs.153

150 Ministerial circular r/e re-grouping Sept 1956151 Smith, K., Water in Britain, London, Macmillan Press Ltd, 1979152 DoE, 1971, reported in Hassan Ref 141153 Mitchell, B., Water in England and Wales: Supply Transfer and Management, Department of Geography, University of Liverpool Research Paper 9, 1971


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Okun154 describes the benefits which were expected to come from the re-grouping: more efficient management of water resources larger organisations with better staff better services for rural and isolated areas suppliers better able to deal with large new users

The re-grouping philosophy had been developed in the interests of securing large-scale supplies of water to meet the projected doubling of water use over the period to the end of the century, to prevent the hardships of drought, and probably to lay the ghost of nationalisation. According to Barty-King155 the Local Authorities were relaxed about relinquishing control to Joint Boards (which of course still had political representatives) and this can be seen as a first step towards a National Water Policy. Hassan141 thinks that this is too generous an interpretation since some questions are left open to debate:

1. how far did re-grouping lead to an optimal restructuring of the industry2. what was the contribution of the Joint Boards3. how voluntary were the mergers4. what was the longer term significance

Hassan141 provides some answers to these questions. A few regional schemes were constructed, but the organisational structure was not a good match to any technically based structure (particularly a resource-based hydrological organisation structure). Most importantly it is not possible to demonstrate that combining smaller undertakings in Joint Boards secured any savings – some Boards remained so small they were only staffed part-time. The key to later structural change lies in the separate development of integrated river basin management (IRBM) in which the UK led the world, and the extent to which that overlapped or conflicted with the industry structure of Boards and Companies.

Integrated River Basin Management (IRBM)

The drought-driven interest in the industry had until the early 1960’s failed to create any institutional structure to deal with the problem of droughts. There was no single authority charged with the duty of overall planning of the development of water resources and the management of rivers.

Catchment Boards had been set up in England and Wales under the Land Drainage Act 1930 to exercise pollution control duties and some drainage functions. In 1943 CAWC recommended the creation of River Boards, and these came into operation (with additional duties added) through the 1948 River Boards Act.41 However the River Boards had no powers to control abstractions or to police competition between the various interests. Government had reconstituted the former 1930’s Advisory Committee in 1955 as the Central Advisory Water Committee (disappointingly shortened as CAWC, rather than the ornithologically resonant CWAC). In part as a response to the 1959 drought, CAWC was charged with a review of the future demands for water and means of meeting them. In its report (the Proudham Report in 1962) CAWC recommended that the rights of riparian owners would have to be curtailed, and surface and underground abstractions controlled, to manage water resources effectively.156 It suggested management at the river basin level with a national body controlling resource development.

154 Okun, D. A., Regrouping of Water Supplies in the UK, Public Works, June 1967155 Barty-King, H., Water, The Book: An Illustrated History of Water Supply and Wastewater in the United Kingdom, London, Quiller Press Ltd, 1992156 Central Water Advisory Committee, Sub-committee on the Growing Demand for Water: Final Report, HMSO, London, 1962


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The Water Resources Act 1963 was the first statutory requirement for suppliers to plan the development of their resources. The Act changed the status of the River Boards to River Authorities which became active 1st April 1965 (reducing them at the same time from 34 to 29), and charged them with the planning and control of water resources. The Water Resources Board (WRB) was also set up by the Act to advise government on national water resource matters and to advise the River Authorities on the execution of their water resource functions. In its 1970/71 Report157 the WRB concluded that developing the industry from the existing structure of Boards was “an exercise of forbidding difficulty involving protracted negotiation, complicated drafting and all the expense and delay of private legislation. The procedure is quite inadequate for the kind of dynamic operational system which the regional approach requires.” Regional plans were developed and coordinated through the period 1963-73 into an overall plan for England and Wales which turned out to be the swan-song of the WRB.158 The resource developments identified became the capital shopping list for the new Regional Water Authorities set up by the 1973 Water Act. Many of the WRB staff found themselves in charge of implementing the grand plans in the new Authorities (e.g. Barry Rydz and R. Graham Sharp at Severn Trent WA).

The legislation had failed to provide for water quality to be taken into account in planning resources, but WRB had cooperated with the Trent River Authority in quality modelling of the Trent basin.159 Concern over water quality issues led to the setting up of a working party on sewage disposal in 1969. This Working Party concluded that sewage disposal should be considered as part of the management of the water cycle.160

The government instructed CAWC to review the arrangements for the industry in the light of the proposals for reform of local government. CAWC argued in its 1971 Report161 for the creation of strong regional bodies and a national water authority to include quality. Only two alternative structures were discussed, multi-functional or single purpose regional Water Authorities (WA’s), with up to 50 water suppliers and 50 sewage disposal authorities working alongside the 29 River Authorities. An earlier report in 1969 had suggested between 7 and 13 WA’s, but not as multi-functional bodies. CAWC voted 14 to 13 in favour of multi-functional authorities, an approach which also found favour with senior Civil Servant Jack Beddoe (Under-Secretary at the MOHLG Water Division). CAWC did not recommend a system of organisation, and this was ultimately left to government to determine. Jack Beddoe favoured 6 WA’s. The bargained solution was 10 WA’s with a greater democratic representation on the Boards than Beddoe had favoured. Kinnersley149 suggests that Beddoe lost the debate because of the transfer of Local Authority assets without compensation, and the requirement for political validation of a regulatory authority (the water resource regulation functions).

Civil Servants had initially proposed that the WA’s should absorb the Statutory Water Companies, but the Conservative administration had pledged to halt expansion of the public sector, and a DoE circular was issued which described them as ‘viable and efficient’.162 In a letter to the Times163 a CAWC member (clearly an economy of scale adherent) claimed that the statement ‘viable and efficient’ was ‘ludicrous’ given that out of the [then] 31 Water Companies 18 supplied fewer than

157 Water Resources Board, Annual Report 1970/71, HMSO, London, 1971158 Water Resources Board, Water Resources in England and Wales, Volume 1, HMSO, London, 1973159 Water Resources Board, The Trent Research Programme, Volume 1, HMSO, London, 1973160 Ministry of Housing and Local Government and Welsh Office, Report of the Working Party on Sewage Disposal: Taken for Granted, (the Jeger Report) , HMSO, London, 1970161 Department of the Environment, Report of the Central Advisory Water Committee: The Future Management of Water in England and Wales, HMSO, London, 1971162 DoE Circular 92/71, 1971163 Nicholls, B. J., Letter to The Times, 20 Dec 1971


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250,000 population and 7 supplied less than 150,000 population. He described the decision to retain the Companies as “a political expedient rather than a technical appraisal of the situation.” Retention of the Companies was opposed by the Association of Municipal Corporations, the Urban District Councils Association, and the Rural District Councils Association. In response to the pubic debate, the British Waterworks Association posed the question ‘if the Companies were viable, why not the old Local Authorities?’

Bumstead’s opinion164 of the factors which shape the development of large-scale or regional utilities could describe the decision process followed in arriving at a structure for the water industry in England and Wales – based on 70% politics, 20% engineering know-how and 10% luck. Kinnersley165 remarks that “the conspicuous change in the last 15 years or so is how prominent and compelling economic, social and legislative, or regulatory, issues have become.”

A great many things were expected from the new Authorities in 1973. For example, ‘instead of a widely scattered body of expertise usually with little power, authority or influence, and with an image that failed to attract people of even average competence, there are now large multi-disciplinary organisations offering status, scientific facilities and job satisfaction.’166 It was also anticipated that the introduction of integrated management would enable a more efficient use and coordination of water resources to be achieved. It had not been impossible in the past to conceive large-scale regional supply schemes but with the new structure they did become easier to develop and implement.141

The Association of River Authorities welcomed the Water Bill 1972 as “a logical development of its own members’ work in water and conservation management.”167 The Water Authorities can thus been seen as a policy progression, but this gives no guide as to the optimum size at which they should operate. It is difficult to understand why the final structure allowed for so few suppliers unless the (probably flawed) argument for continuing returns to scale was paramount.

Notwithstanding the political background to its inception, Maloney and Richardson47 (with reference to McDonald and Kay168) list the claimed benefits from Integrated River Basin Management:

Small systems generate insufficient revenues. This weak financial base constrains possible expansion and improvement

Reduction of competition among utilities encourages a socially equitable allocation of resources across the region as a whole

Amalgamation of utilities encourages economies of scale and allows the provision of specific facilities and staff that can’t be justified within each smaller authority

Larger management units facilitate basin-wide integration of functions and encourage long-term planning

Water resource fluctuations which can be severe over a small area are moderated in the regional context

164 Bumstead, J. C., The Politics of Regionalisation: a Public Perspective, Journal of the American Waterworks Association, 71 (12) 1979165 Kinnersley, D., Coming Clean: the Politics of Water and the Environment, London, Penguin, 1994.166 Sidwick, J. M. and Murray, J. E., A Brief History of Sewage Treatment, Effluent and Water Treatment Journal, 1976167 Reported in Porter, E., Water Management in England and Wales, Cambridge, Cambridge University Press, 1978168 McDonald, A. T. and Kay, D., Water Resources: Issues and Strategies, London, Longman, 1988


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They also identified a few downsides: Excessive concentration of power within one organisation A dilemma over the operation of resources and controls over them Growth in administrative bureaucracy that may slow decision-making, and separate

decision-making from the communityApart from the separation of regulation of resources, most of the claimed advantages have been little in evidence, and the other downsides have emerged in the privatised companies, for example in the performance of Yorkshire Water during the 1995 drought.

Privatisation

WA’s were privatised as they stood. The government 1986 White Paper on the future of the industry advanced 11 reasons for privatisation.169 They retained the belief that WA’s would behave more efficiently in the private sector when motivated by profit due to incentive regulation.170

Saal and Parker20 include a helpful review of literature on the impact of privatisation on performance, included in an appendix to the reference list of this paper, together with the papers identified by Morse71 and Vickers and Yarrow.18

169 Reasons are listed in Ref 11170 Glynn, D. R., Baker, W. R., Jones, C. A. and Leisner, J. L., Economic Issues in Water Privatisation and Regulation, NERA mimeo, 1992


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Appendix Four

Theoretical basis for firm size and industry structure.

Audretsch73 has suggested recently that “traditional static analyses have proven to be more of a burden than an instrument of enlightenment in making sense of issues (of evolutions of industry, etc). Firms and entire industries may not be well described by traditional equilibrium models – there is evidence from how new product industries evolve.” There are now alternative frameworks and methodologies for analysing economic phenomena involving change. They seek to explain how and why firms are diverse, and how firms industries and regions change over time, and how and why successful or surviving firms are so diverse in structure and performance.

Schumpeter171 suggested that relative (rather than absolute) size or market power is the key stimulus to entrepreneurial activity. Other ‘neo-Schumpeterians’ (Audretsch’s term73) include those stressing size alone (Lilienthal172 & Galbraith173), diversification (Nelson174) and size plus oligopolistic rivalry (Villard175). Schumpeter176 argued that the larger firm would be free to innovate, whereas the rest base their position on economies of scale, because of the large fixed costs involved of formal research.

In the conventional theory for free markets there is high initial entry and innovation then eventually entry dries up and a shake-out occurs – the number of producers declines sharply for a prolonged period despite continued growth in the industry’s output. Innovation tends to become more incremental and oriented towards improving the production process. Observation has led to development of ‘product life-cycle models’. Shakeout is brought about by major innovation which increases the minimum efficient scale of production e.g. the US tyre industry.177 Firm size conditions the returns and process more than product innovation and mature firms emphasise production process improvements. Decline in the number of producers after shakeout compromises industry diversity which in turn retards the rate at which a product is improved over time. The work on model development has been international but with an emphasis on US work. However it should be transferable to UK industry - Caves found that market mechanisms are ‘overwhelmingly similar’ from country to country.178

Sutton179 critically reviews the development of analytical work on firm size, in particular the interaction of theoretical work and empirical studies. He identifies a heavy emphasis on discarding the older type of purely “stochastic” models in favour of introducing stochastic elements into standard “maximising” models.

171 Schumpeter, J. A., Capitalism, Socialism and Democracy, 2nd edn, New York: Harper 1942, 3rd edn, New York: Harper, 1950172 Lilienthal, D. E., Big Business: A New Era, New York 1952173 Galbraith, J. K., American Capitalism, Boston 1952174 Nelson, R. R., The Simple Economics of Basic Scientific Research, Journal of Political Economy, 67, 1959175 Villard, H. H., Competition, Oligopoly and Research, Journal of Political Economy, 66, 1958176 Reported in Mueller, D. C., and Tilton, J. E., Research and Development Costs as a Barrier to Entry, Canadian Journal of Economics, II (4) 1969177 Klepper, S. and Graddy, E., The Evolution of New Industries and the Determinants of Market Structure, Rand Journal of Economics, 21, 1990178 Caves, R. E., Industrial Organisation and New Findings on the Turnover and Mobility of Firms, Journal of Economic Literature, XXXVI, 1998179 Sutton, J., Gibrat’s Legacy, Journal of Economic Literature, XXXV, 1997


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Primary data for empirical studies and analytical power has been unavailable until the last ten years – Mueller180 cites a problem of computing constraints “estimating more than 140 parameters by a non-linear regression technique would most likely have exhausted the Institute of Management’s computer budget for one year – 1986.”

The development of models has been limited by the data available. Initial models looked at differences between industries, and then as data has become available between firms, and now more recently between individual plants (or similar units of production).122 The literature has thus progressively come to terms with new layers of data which lend themselves to explanation of the heterogeneity of successful and surviving firms. Many of the earlier studies had to restrict themselves to industries where there was some homogeneity of products (primary producers) in order to arrive at a model of firm growth. Although this research has been overtaken by the more recent work for firms in more complex and competitive product markets, it has been reviewed within this project because it remains relevant for monopoly utilities. It is more difficult to establish the minimum feasible size of a firm than to establish the minimum feasible size of plant. Bain181 found that in most industries there was consensus about this for an efficient plant.

Simon and Bonini182 claim that the static cost theory is irrelevant for the size distribution of firms. Bain’s work shows that plant cost curves generally are J-shaped. Below some critical scale unit costs rise rapidly. Above the critical scale costs vary only slightly with size of firm. In only a very few industries (especially typewriters) does the critical scale represent a substantial percentage of the total market. Hence the characteristic cost curve for the firm shows virtually constant returns to scale for sizes above some critical minimum. The static analysis may predict the minimum size of firm in an industry with a known critical minimum size, but it will not predict the size distribution of firms.

Among the earliest studies was that of Lennart Hjalmarsson183 which examined the size distribution of plants in a homogeneous-goods industry, in the presence or returns to scale at plant level. He later tested the model on particle board and cement where the assumption of homogeneity is reasonable. Jovanovic184 also assumed a homogeneous-goods industry but introduced a learning mechanism which gradually revealed firm-specific efficiency differences as the industry evolved.

Sutton uses Simon’s work182 185 186 and that of Hart and Prais187 to typify the structure of an industry which develops from the earlier models as highly positively skewed (an increase in concentration with several very large firms). The theoretical approach views expansion opportunities as a series of separate markets which will sustain one plant, which will be set up either by an incumbent or a new entrant. In many respects such a model would be appropriate for the geographically dispersed demand centres in many water company areas.

180 Mueller, D.C., Profitability and Market Structure, in Profits in the Long Run, Cambridge: Cambridge University Press, 1986181 Bain, J. S., Barriers to New Competition, Cambridge, MA, 1956182 Simon, H. A. and Bonini, C. P., The Size Distribution of Business Firms, American Economic Review, XLVIII (4), 1958183 Hjalmarsson, L., The Size Distribution of Establishments and Firms Derived from an Optimal Process of Capacity Expansion, European Economic Review, 5 (2), 1974184 Jovanovic, B., Selection and the Evolution of Industry, Econometrica, 50 (3), 1982185 Simon, H. A., On a Class of Skew Distribution Functions, Biometrika, 52, 1955.186 Ijiri, Y. and Simon, H. A., Skew Distributions and the Sizes of Business Firms, Amsterdam: North-Holland Publishing Company, 1977187 Hart, P. E. and Prais, S.J., The Analysis of Business Concentration, Journal of the Royal Statistical Society, 2, 1956


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Sutton179 borrows from an earlier summary of modelling progress by Steindl.188 The models incorporated Gibrat’s Law of Proportionate Effect189 to assume that the probability that the next growth opportunity is taken up by an incumbent is proportional to the size of the firm whereas the probability of a new entrant is constant over time. At the same time (during the 1950’s and 1960’s) many empirical studies (e.g. Mansfield190) failed to confirm these assumptions, and the studies themselves have been criticised for ignoring horizontal integration (mergers and acquisitions).191 192 193 There is wide disparity in these studies, but there was agreement that the standard deviation of growth rates rose less than proportionally with firm size.183 188 194 195

In particular there is no obvious rationale for positing any general relationship between a firm’s size and its expected growth rate, nor is there any reason to expect the size distribution of firms to take any particular form for the general run of industries. Most authors now claim only that the distribution will be skew but do not specify the extent of skewness, or the particular form which the size distribution might take. Empirical investigations from the 1960’s onward have thrown doubt on whether any single form of size distribution can be regarded as “usual” or “typical” for the general run of industries; wide differences in the form of the size distribution occur between one industry and another.179 195

That the size distribution of firms (whether within a single industry or a whole economy) is almost always highly skewed, that its upper tail resembles the Pareto distribution has often been observed, but has not been related very much to economic theory. Attempts at economic explanation of the observed facts about concentration of industry have always assumed that the basic causal mechanism was the shape of the long-run average cost curve. There has been little discussion of why this mechanism should produce, even occasionally, the particular highly skewed distributions that are observed.182

Sutton179 is more generous to the earlier modellers than other writers, seeing the main flaw as the dependence on Gibrat’s Law. Based on game-theoretic analysis the Gibrat Law is replaced by a constraint: the probability that the next market opportunity is filled by any currently active firm is non-decreasing in the size of that firm. The new literature contains more concern with econometric issues such as heteroskedasticity, and the introduction of stochastic elements to maximising models. The new “maximising” models have focused on various specific market settings (environments) which differ in the assumptions made on the nature of the technology, the information available to firms, and the description of the product market. Empirical evidence on size-profitability relationships across businesses of different sizes within an industry suggests that RoR is nondecreasing in the size of the business.

188 Steindl, J, Size Distribution in Economics, in Sills, D. E., Ed, International Encyclopaedia of Social Sciences, London: Collier Macmillan, 1968189 Gibrat, R., Les inegalites economiques; applications: aux inegalites des richesses, a la concentration des entreprises, aux populations des villes, aux statistiques des familles, etc., d’une loi nouvelle, la loi de l’effet proportionnnel, Librairie du Recueil Sirey, Paris, 1931190 Mansfield, E., Entry, Gibrat’s Law, Innovation and the Growth of Firms, American Economic Review, 52 (5), 1962191 Prais, S. J., The evolution of giant firms in Britain, London: Cambridge University Press, 1976192 Hannah, L. and Kay, J. A., Concentration in Modern Industry: Theory and measurement and the UK experience. London: Macmillan 1977193 Hannah, L. and Kay, J. A., The Contribution of Mergers to Concentration Growth: A Reply to Professor Hart, Journal of Industrial Economics, 29 (3), 1981194 Selten, R., A Model of Oligopolistic Size Structure and Profitability, European Economic Review, 22 (1), 1983195 Schmalensee, R., Inter-industry Studies of Structure and Performance, in Handbook of Industrial Organisation, Vol 2, Amsterdam: North-Holland Elsevier, 1989


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Sutton179 sets out four “statistical regularities” which have emerged from the new models:196 140

The probability of survival increases with firm (or plant) size and the proportional rate of growth of a firm (or plant)

For any given size of firm/plant the proportional rate of growth is smaller according as the firm/plant is older, but its probability of survival is greater.

These findings prompted new interest in theoretical models of firm growth e.g. Jovanovic 1982.184

The Jovanovic model is described as a ‘learning’ model. Each firm has some level of efficiency (its unit cost of production) but does not know its relative efficiency prior to entering. Over time its profits provide information on this. More efficient firms grow and survive, others learn of their relative inefficiency and choose to exit. The model did not say much about the size of the firm. The renewed interest in age-growth relationships led to more work on modelling life-cycles, and the evolution of market structure over time. This work was led by Klepper et al.73 118 177 197

Klepper’s work led to a third statistical regularity: It is frequently observed that the number of producers tends first to rise to a peak, and later

falls to some lower level (shakeout).The extent of shakeout varies widely across product markets. In some it is early and very sharp (US tyre industry) and was explained by innovation leading to a higher level of output per firm (scale economies). Klepper modified the stochastic approach with the idea that each firm would spend some effort on process innovation – larger firms find it profitable to devote more time to process innovation (because their fixed costs are spread over larger sales). This means smaller firms exit as prices from large producers fall. This shakeout process is similar to the escalation process studied in recent game-theoretic literature (e.g. Sutton 1991198). A few critical assumptions made in development of the new models do not fit the water industry situation very well. In particular it is assumed that the industry grows over time, and that there is no strategic interaction or economies of scope (which is a pre-requisite of definitions of natural monopoly).

Turbulence is the 4th statistical regularity identified by Sutton:179

Across different industries, there is a positive correlation between gross entry rates and gross exit rates (i.e. the turnover is greater in some industries). Most of this has little effect on the largest companies in the industry.

Within a country, there is a strong correlation between entry and exit rates. Geroski199 reports R-squared 0.796 for 95 industries in the UK in 1987. This work suggested that there is at least a weak correspondence between the ranking of industries by turbulence in different countries. Turbulence covers at least three types of influence: patterns of demand across product varieties or locations, displacement of existing technologies and displacement of existing products. Within the water industry, the sources of turbulence include the application of cost yardsticks arising from cross-company comparisons (which are possible because of different technology choices).

196 Hall, B. H., The Relationship between Firm Size and Firm Growth in the US Manufacturing Sector, The Journal of Industrial Economics, XXXV (4), 1987197 Klepper, S. and Simons, K. L., Technological Change and Industry Shakeouts, Mimeo, Carnegie Mellon University, 1993198 Sutton, J., Sunk Costs and Market Structure: Price Competition, Advertising and the Evolution of Concentration, MIT Press: Cambridge MA, 1991199 Geroski, P. A., in Geroski, P. A. and Schwalbach, J., Eds, Entry and Market Contestability: An International Comparison, Oxford: Basil Blackwell, 1991


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Sutton’s own modelling (of 5-firm concentration ratios in the UK in 1977200) and that of Evans201

202 leads him to the conclusion that there is no typical form for a size distribution. Conversely the study by Ericson and Pakes203 of the 4-firm to 8-firm concentration ratio over a 20-year period when firm numbers fell by 40% shows no change i.e. no convergence (or skew reduction) as the industry declines. Pakes and Ericson204 evaluate two models in representing different market structures. They test the Jovanovic model184 (a Bayesian passive learning model) and the active learning model (research and exploration) of Ericson and Pakes.203 It was found that the manufacturing data was consistent with the implications of the active learning model, but inconsistent with passive learning; The retail trade data (possibly more transferable to the water industry) was consistent with the passive learning model but inconsistent with active learning. The authors concluded that the choice between modelling frameworks might be aided by simple non-parametric procedures which focus on the general implications of the alternative models, and the characteristics of the industry – back to Kahn’s advice1 to use “judgement informed by economic theory and experience.”

Robert Lucas120 proposed a model in which some people are endowed with more skills, but there is a diminishing return to skill as it is applied to larger and larger plants. An implication of this model is that there is an optimal (output-maximising) distribution of firm sizes. The model assumes factor prices are the same across all plants, hence output is proportional to employment (average labour productivity is the same across all plants). The differences in skill among managers have all been absorbed in size.27

Holmes and Schmitz205 found that the failure and sale of small businesses vary with the age of the business and with the tenure of the current manager of the business. Two findings are notable in directing the form of the model: Among small businesses of the same age the probability that a business is discontinued and

the probability that a business is sold are both the highest for the businesses with managers who have the shortest tenure. The term job is applied to owning and managing the business, hence the probability that a business manager changes jobs (which occurs if a business is discontinued or sold) is the highest for those with the shortest tenure.

Among businesses with managers who have the same tenure at their business, the probability that a business fails is decreasing in the age of the business.

To capture the first finding the concept of a job match139 is introduced (after Jovanovic 1979). The second finding suggests that business success relies more on how well the individual is suited to it. This finding indicates that significant characteristics of businesses exist that are separate from managers, such as location, and these must be allowed for.205

200 Sutton, J., The Size Distribution of Businesses, Part I, STICERD Discussion Paper No EI/9, London School of Economics, 1995201 Evans, D. S., The Relationship between Firm Growth, Size and Age: Estimates for 100 Manufacturing Industries, Journal of Industrial Economics, 35 (4), 1987202 Evans, D. S., Tests of Alternative Theories of Firm Growth, Journal of Political Economics, 95 (4) 1987203 Ericson, R. and Pakes, A., Markov Perfect Industry Dynamics: a Framework for Empirical Work, Review of Economic Studies, 62 (1), 1995.204 Pakes, A. and Ericson, R., Empirical Implications of Alternative Models of Firm Dynamics, Journal of Economic Theory, 79, 1998205 Holmes, T. J. and Schmitz, J. A. Jr., On the Turnover of Business Firms and Business Managers, Journal of Political Economy, 103 (5), 1995


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Differences in Managerial Ability.

Baily, Hulten and Campbell27 found that good plant managers run high-productivity plants and good firm managers have many high-productivity plants. Persistent differences in management ability have been suggested as an explanation for persistence in relative productivity and for the importance of plant ‘fixed effects’ - unchanging factors (Abernathy, Clark and Kantrow;206 Hayes, Wheelwright and Clark;207 Caves and Barton;26 Dertouzos, Lester and Solow208).

Baily, Hulten and Campbell’s paper27 suggests that a kind of Parkinson’s Law is at work – the greater the skill, the larger the plant which is managed. Able managers will earn higher returns than poor managers, with returns proportional to the size of the plant. With a Cobb-Douglas production function, the model predicts decreasing returns to scale, which measures the effects of the loss of productivity resulting from a given manager being spread too thin.

Lucas120 postulates an equilibrium distribution of managerial abilities at all times. Jovanovic’s model184 is said to be similar to the Lucas framework. Both models assume fully optimal behaviour, but others have views that managers do not always perform up to the limit of their abilities.26 206 207 208 This suggests to Baily, Hulten and Campbell27 an innovative remnant model in which managers slack off over time and then are forced to change to survive. Hence plants move down the productivity distribution in a similar way to the vintage model, both from technical obsolescence and non-maximising behaviour by managers. Managers don’t change work arrangements or bother to innovate while the plant is performing satisfactorily. This suggests a rotation of plants up and down the productivity ladder (this is regarded as an oversimplification by Richard Nelson114).

The Baily, Hulten and Campbell paper27 also explores differences in workforce quality. They calculate labour input as production-worker hours plus a quality-adjusted estimate of non-production employees (using earning, at the site level). Non-production workers usually have higher wages (allegedly because of skill level). Wages at the plant level will depend on productivity.

Economists still pursue the search for mathematical ‘regularities’ (rules), and they change focus from time to time. Baily, Hulten and Campbell27 recognise that perfect competition is seen as an unusual market structure. They quote Mairesse and Griliches209 “The simple production function model, even when augmented by additional variables and further nonlinear terms, is at best an approximation to a much more complex and changing reality at the firm, product and factory floor level.” This continued quantification and objectification of economic theory has been criticised by Buchanan210 “attention is diverted to the manipulation of symbols and away from the initial leap into presumed objectivity itself.”

206 Abernathy, W. J., Clark, K. B. and Kantrow, A. M., Industrial Renaissance: Producing a Competitive Future for America, New York: Basic Books, 1983207 Hayes, R. H., Wheelwright, S. C. and Clark, K. B., Dynamic Manufacturing: Creating the Learning Organisation, New York: The Free Press, 1988208 Dertouzos, M. L., Lester, R. K. and Solow, R. M., Made in America: Regaining the Productive Edge, Cambridge, Mass: MIT Press, 1989209 Maitresse, J. and Griliches, Z., Heterogeneity in Panel Data: Are There Stable Production Functions?, in Champsaur, P., Ed, Essays in Honor of Edmond Malivaud, Vol 3, Empirical Economics, Cambridge, Mass.: MIT Press, 1990210 Buchanan, J. M., LSE Essays on Costs, LSE 1972


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Appendix Five

Example calculation of limits to economies of scale in the water industry.

Typically a works of 30Ml/d can serve a mixed population (with 20% industrial demand) of around one hundred thousand (about 40000 properties) which the calculations above suggest is close to the industry’s MES. This size of population is equivalent to the size of Norwich (124000) or Halifax (88000). The reason for selecting these two examples is that they have widely different ‘urban fields’ – they are extremes for the UK.211 The nearest equivalently sized settlement to Halifax is less than ten miles away (Huddersfield/Bradford), whereas for Norwich it is more than fifty miles (Ipswich 102000).

Unless a larger source of 60Ml/d can be situated conveniently between two settlements of 100000 size, when water can be sent in two directions over the same distance, there will be additional costs of transfer of water. In the ‘average’ case of a treatment works upstream of a town of 100000, there would be the expectation of a minimum transfer distance of ten kilometres to deliver to the nearest similarly sized town. The financing cost for the construction of a 700mm trunk main (assuming pumped transfer along the valley) to transfer 30Ml/d ten kilometres would be of the order of £220000 per year or about £20 per Ml transferred. The scale economies for construction of the treatment works reduce the capital cost from around £550k/Ml/d for two works of the same size to £400k/Ml/d for a single large works, and the financing savings are about £450000 per year. The unit operating cost would be reduced by a smaller margin of approximately 20%, or about £5.75/Ml/d, an annual cost saving on the larger output of £125000 per year. However because the transfer has to be pumped there is the additional cost of £4/Ml/d or an annual total of £45000 plus the cost for financing construction of a booster station of about £10000 per year. Hence there is a break-even transfer distance of around 24 kilometres. This conclusion is not very sensitive to the current low finance rate – 15 years ago a rate of 10% would have been used and the break-even distance would have been 22 km. The break-even will be much more like 12-15km transfer if the option is the extension of an existing works.

The calculation looks very different if a doubling of output from 60Ml/d to 120 Ml/d is considered. There are lesser economies of scale in constructing a larger main in place of two 700mm mains because of difficulties of routing mains of 1000mm size through urban areas and the transfer main finance cost would be at least £400000 per year. The economies of scale for the treatment works construction produce an annual equivalent financing saving of £430000 per year, and the pumping and booster station costs double. The unit operating cost would be reduced by £190000 per year. The break-even transfer distance reduces to 13km, and separate construction of a new local works would probably be cheaper than extending an existing works.

There are many water transfers in the industry which exceed these transfer distances and volumes of transfer because of the relative location of sources and demand centres. This example shows that smaller-scale local construction should be considered in most instances for development of sources unless there are reasons which prevent this. In particular for borehole sources the development costs are significantly less, and there are probably no returns to scale because most borehole sources deliver less than 30Ml/d. In this case the borehole development will always be cheaper close to demand.

In terms of population density, the average for Norwich and Halifax is approximately 6000-7000 per square kilometre since the urban areas are approximate circles of 5km and 4km respectively.

211 Hudson, F.S., A Geography of Settlements, Macdonald and Evans, London, 1970


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For larger conurbations the urban density is about the same e.g Bradford and Leeds, but when looking at water supply areas, even Thames Metropolitan only reaches 4000. Thus the example here is an extreme case of urban density and in real situations the costs of transfer of water will be higher.


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Appendix Six

Analysis of published data

This section has been left in note form, in part because it does not present a rigorous analysis of the ‘models’ developed, and also because there were a good many stages in reaching the final structure of the models, which are best expressed in note form for brevity.

Elected to use impact on customers i.e. Cost to Customer v. size. There are arguments against use of total costs for modelling (set out by the MMC in its report on price setting for South West – ref needed).

Restricted to Water Service data (could test on Sewerage, but more time needed)

Use minimum number of variables with least cross-correlation to test each element of Cost to Customers against size (Opex, Capex and Financial structure)

Gearing captures the differences in financial structures of companies

Capital intensity (sunk costs) is important in determining firm size in free markets

Water delivered is a key variable for the Operating cost element of Cost to Customer

Searched for systematic differences between low Capex and high Capex companies (based on WASC/WOC observations shown in 1991 thesis)

Assumptions

Public domain information used as far as possible

Capital intensity is represented by COPI adjusted Total Capex 1991-01 (11 yr average) in £/billed property

Combined company measures obtained by property weighting (billed properties)

Gearing taken as average 1993-01 (9 yr average); combined companies debt-weighted (RPI year end).

Logarithmic form assumed for testing correlation (as per published models for distribution & water service in Ofwat Report on Water Delivered 1993-4 Appendix 3, and Research papers, December 1993)

Observations

Cost to Customers per billed property correlates better with variables than per cubic metre

Cross correlation can be high for some measures (as observed by Stoneman in Research Paper 2, December 1993), but is limited for the revised models (most recent work).


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Plotting of outliers on all-company models suggested separate analysis of low Capex and high Capex companies, with the same variables initially, but final modelling with the full data has suggested a reduced set of variables.

NES and SRN can be treated as WOCs in respect of capital intensity (SRN is in effect three separate water companies and an island).

MKT and THD can be treated as WASCs in respect of capital intensity, MSE and FLK are borderline

Final form of ‘models’

The optimum split in the current dataset is obtained from separate modeling of highest 10 Capex and lowest 12 Capex

The exponent of water delivered in the lower 12 correlation using the common variables is 0.491, and with the same variables for all companies the exponent is 0.566. The unadjusted water service model using the 16 March 1994 dataset had the value 0.471 (Ofwat Report on Water Delivered 1993-4 Appendix 3). With data submitted by companies after their SBPs the adjusted WATDELA gave an exponent of 0.614 (Ofwat’s March 1995 Addendum to the Ofwat Report on Water Delivered 1993-4 & MMC report on SWT, Appendix 8.3 Table 1). The MMC makes additional comments about modeling in Appendix 8.3, including the price to customer (para. 8). The final modelling has found that Water delivered does not strongly influence the degree of fit R-squared is reduced by less than 3% if it is removed from the correlation.

For almost all variables tested including those in the final model, the high Capex potential ‘models’ placed SWT costs a lot higher than actual and WSH costs a lot lower than actual. No explanation for this is available, but the correlation of model and actual costs for the other companies is very close (R-squared 0.97)

Cost to Customer is a decreasing function of size

Cost to Customer is an increasing function of Capex and Water Delivered Cost to Customer is an increasing function of Gearing for high Capex companies (with little

influence on final cost to customer), but a decreasing function for low Capex companies (with a more significant influence on cost to customer). This may support a view that gearing is used by higher Capex companies to transfer funds from stakeholders to shareholders.

High Capex company ‘model’ with all variables takes the form :C to C = 22.63 x (Gearing) 0.029 x (Wat Del H/h)0.217 x (Av Capex)0.458 x (Size)-0.095

R-squared = 0.752 10 Company model puts all except SWT, WSH on a line with R-squared = 0.97

Without Gearing or Water delivered the model reduces to:C to C = 22.16 x (Av Capex)0.437 x (Size)-0.091

R-squared = 0.731

Low Capex company ‘model’ with all variables takes the form:


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C to C = 13.22 x (Gearing)-0.116 x (Wat Del H/h)0.49 x (Av Capex)0.806 x (Size)-0.039

R-squared = 0.973Without Water delivered the model reduces to:C to C = 8.25 x (Gearing)-0.127 x (Av Capex)0.825 x (Size)-0.186

R-squared = 0.947

None of Professor Stoneman’s impressive array of statistical tests (Research Paper 2 Technical Annex Dec 1993) has been carried out on these ‘models’, and the use of four variables on as few as 10 data points is potentially shaky, at the very least.

The most favourable real values of Gearing and Water delivered variables in each block of companies has been used to plot a minimum practicable cost surface from the initial model results.

Further work is needed to identify the factors which contribute to low capital intensity, to determine whether or not there is scope for change by the company (or regulator). This is expected to be a mathematical description of favourable and unfavourable physical circumstances which drive Capex. Some of the factors which influence this are described in the main report for the Portsmouth and South Staffs companies.. Many of the factors will be captured by net MEA, and a plot of net MEA/property for 1996-7 (combined companies MEA and property weighted) shows a frontier which explains some of the distribution of the modelled Capex/property by size (see the graphs on the next page). This is an area where additional research may prove fruitful, if older pre-merger data can be adjusted (smoothed) for capital cycling.


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104 Holstrom, B. and Tirole, J., The Theory of the Firm, in Schmalensee, R. and Willig, R., Eds, Handbook for Industrial Organisation, Amsterdam, Elsevier, 1989105 Milgrom, P., Employment Contracts, Influence Activities and Organisation Design, Journal of Political Economy, 96 (1), 1988106 Kihlstrom, R. E. and Laffont, J-J., A General Equilibrium Entrepreneurial Theory of Firm Formation Based on Risk Aversion, Journal of Political Economy, 87 (4), 1979107 Holmstrom, B., Agency Costs and Innovation, Journal of Economic Behaviour and Organisation, 12, 1989108 Tirole, J., Hierarchies and Bureaucracies, Journal of Law, Economics and Organisation, 2 (3), 1986109 Milgrom, P. and Roberts, J., Bargaining and Influence Costs and the Organisation of Economic Activity, in Alt, J. and Shepsle, K., Eds, Positive Perspectives on Political Economy, Cambridge: Cambridge University Press.110 Kreps, D., Corporate Culture and Economic Theory, in Alt, J. and Shepsle, K., Eds, Positive Perspectives on Political Economy, Cambridge: Cambridge University Press.111 Williamson, O. E., Hierarchical Control and Optimum Firm Size, Journal of Political Economy, 75, 1967112 Nelson R. R. and Winter, S. G., Forces Generating and Limiting Concentration under Schumpeterian Competition, Bell Journal of Economics, 9 (2), 1978113 Nelson R. R. and Winter, S. G., An Evolutionary Theory of Economic Change, Cambridge MA: Harvard University Press, 1982114 Nelson, R. R. and Winter, S. G., Neoclassical vs. Evolutionary Theories of Economic Growth: Critique and Prospectus, Economic Journal 84, 1974115 Acs, Z. J. and Audretsch, D. B., Innovation, Market Structure and Firm Size, Review of Economics and Statistics, 69 (4), 1987116 Acs, Z. J. and Audretsch, D. B., Innovation in Large and Small Firms: An Empirical Analysis, American Economic Review, 78 (4), 1988117 Acs, Z. J. and Audretsch, D. B., Innovation and Small Firms, Cambridge MA: MIT Press, 1990118 Gort, M. and Klepper, S., Time Paths in the Diffusion of Product Innovations, Economic Journal, 92, 1982119 Lucas, R. E. Jr, Adjustment Costs and the Theory of Supply, Journal of Political Economy, 75, 1967120 Lucas, R. E., On the Size Distribution of Business Firms, Bell Journal of Economics, 9 (3), 1978121 Williamson, O. E., Markets and Hierarchies: Analysis and Anti-trust Implications, New York: The Free Press, 1975122 Lichtenberg, F.R. and Siegel, D, Productivity and Changes in Ownership of Manufacturing Plants, Brookings Papers on Economic Activity: Microeconomics, 3, 1987123 Halpern, P. J., Empirical Estimates of the Amount and Distribution of Gains to Companies in Mergers, Journal of Business, 46, 1973124 Halpern, P. J., Corporate Acquisitions: a Theory of Special Cases? A Review of Event Studies Applied to Acquisitions, Journal of Finance, 38, 1983125 Jensen, M. and Ruback, R., The Market for Corporate Control, Journal of Financial Economics, 11, 1983126 Hogarty, T. F., The Profitability of Corporate Mergers, Journal of Business, 73, 1970127 Melicher, R. W. and Rush, D. F., Evidence on the Acquisition-related Performance of Conglomerate Firms, Journal of Finance, 29, 1974128 Weston, F. J. and Mansinghka, S. K., Tests of the Efficiency Performance of Conglomerate Firms, Journal of Finance, 26, 1971129 Mueller, D. C., Mergers and Market Share, Review of Economics and Statistics, 67, 1985130 McGuckin, R., Andrews, S. and Monahan, J., The Efficiency of Conglomerate Mergers: New Evidence from Longitudinal Research Data Base, presented to National Bureau of Economics Research Summer Institute on Productivity, 1987131 Shliefer, A. and Summers, L. H., Hostile Takeovers as Breaches of Trust, unpublished in 1987132 Meade, J. E., Is the New Industrial State Inevitable?, Economic Journal, 78, 1968133 Manne, H. G., Mergers and the Market for Corporate Control, Journal of Political Economy, 73, 1985134 Jensen, M. C., The Takeover Controversy: Analysis and Evidence, in Coffee, J. C., Jr., Lowenstein, L and Rose-Ackerman, S., Eds, Knights, Raiders and Targets: The Impact of the Hostile Takeover, Oxford University Press, 1988135 Mueller, D. C., A Theory of Conglomerate Mergers, Quarterly Journal of Economics, 83, 1969136 Galbraith, J. K., The New Industrial State, Boston, Mass., Houghton Mifflin Co., 1967137 Roll, R., The Hubris Hypothesis of Corporate Takeovers, Journal of Business, 59, 1986138 Gort, M., An Economic Disturbance Theory of Mergers, Quarterly Journal of Economics, 83, 1969139 Jovanovic, B., Job Matching and the Theory of Turnover, Journal of Political Economy, 87 (5), 1979140 Dunne, T., Roberts, M. J. and Samuelson, L., The Growth and Failure of U.S. Manufacturing Plants, The Quarterly Journal of Economics, CIV (4), 1989141 Hassan, J., The Water Industry in the 19th Century, Water Bulletin, WAA, 1983.142 Frazer, D., Power and Authority in the Victorian City, Oxford, Basil Blackwell, 1979143 Matthews, C. E., The Water Supply of Birmingham, Birmingham Corporation, 1886.


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144 Kay, J., Regulating Private Utilities: The Customer Corporation, Journal of Cooperative Studies, 29 (2), 1996145 Data presented to a Seminar on Surface Water Yield Assessment, NRA R&D project 414, June 1993146 Hassan Ref 141 makes reference to the Return of Water Undertakings, 1914: xxxvii – a parliamentary paper.147 Municipal Year Book 1935.148 Nationalisation as a term was never defined by the Labour Party149 Kinnersley, D., Troubled Water: Rivers, Politics and Pollution, London: Hilary Shipman, 1988150 Ministerial circular r/e re-grouping Sept 1956151 Smith, K., Water in Britain, London, Macmillan Press Ltd, 1979152 DoE, 1971, reported in Hassan Ref 141153 Mitchell, B., Water in England and Wales: Supply Transfer and Management, Department of Geography, University of Liverpool Research Paper 9, 1971154 Okun, D. A., Regrouping of Water Supplies in the UK, Public Works, June 1967155 Barty-King, H., Water, The Book: An Illustrated History of Water Supply and Wastewater in the United Kingdom, London, Quiller Press Ltd, 1992156 Central Water Advisory Committee, Sub-committee on the Growing Demand for Water: Final Report, HMSO, London, 1962157 Water Resources Board, Annual Report 1970/71, HMSO, London, 1971158 Water Resources Board, Water Resources in England and Wales, Volume 1, HMSO, London, 1973159 Water Resources Board, The Trent Research Programme, Volume 1, HMSO, London, 1973160 Ministry of Housing and Local Government and Welsh Office, Report of the Working Party on Sewage Disposal: Taken for Granted, (the Jeger Report) , HMSO, London, 1970161 Department of the Environment, Report of the Central Advisory Water Committee: The Future Management of Water in England and Wales, HMSO, London, 1971162 DoE Circular 92/71, 1971163 Nicholls, B. J., Letter to The Times, 20 Dec 1971164 Bumstead, J. C., The Politics of Regionalisation: a Public Perspective, Journal of the American Waterworks Association, 71 (12) 1979165 Kinnersley, D., Coming Clean: the Politics of Water and the Environment, London, Penguin, 1994.166 Sidwick, J. M. and Murray, J. E., A Brief History of Sewage Treatment, Effluent and Water Treatment Journal, 1976167 Reported in Porter, E., Water Management in England and Wales, Cambridge, Cambridge University Press, 1978168 McDonald, A. T. and Kay, D., Water Resources: Issues and Strategies, London, Longman, 1988169 Reasons are listed in Ref 11170 Glynn, D. R., Baker, W. R., Jones, C. A. and Leisner, J. L., Economic Issues in Water Privatisation and Regulation, NERA mimeo, 1992171 Schumpeter, J. A., Capitalism, Socialism and Democracy, 2nd edn, New York: Harper 1942, 3rd edn, New York: Harper, 1950172 Lilienthal, D. E., Big Business: A New Era, New York 1952173 Galbraith, J. K., American Capitalism, Boston 1952174 Nelson, R. R., The Simple Economics of Basic Scientific Research, Journal of Political Economy, 67, 1959175 Villard, H. H., Competition, Oligopoly and Research, Journal of Political Economy, 66, 1958176 Reported in Mueller, D. C., and Tilton, J. E., Research and Development Costs as a Barrier to Entry, Canadian Journal of Economics, II (4) 1969177 Klepper, S. and Graddy, E., The Evolution of New Industries and the Determinants of Market Structure, Rand Journal of Economics, 21, 1990178 Caves, R. E., Industrial Organisation and New Findings on the Turnover and Mobility of Firms, Journal of Economic Literature, XXXVI, 1998179 Sutton, J., Gibrat’s Legacy, Journal of Economic Literature, XXXV, 1997180 Mueller, D.C., Profitability and Market Structure, in Profits in the Long Run, Cambridge: Cambridge University Press, 1986181 Bain, J. S., Barriers to New Competition, Cambridge, MA, 1956182 Simon, H. A. and Bonini, C. P., The Size Distribution of Business Firms, American Economic Review, XLVIII (4), 1958183 Hjalmarsson, L., The Size Distribution of Establishments and Firms Derived from an Optimal Process of Capacity Expansion, European Economic Review, 5 (2), 1974184 Jovanovic, B., Selection and the Evolution of Industry, Econometrica, 50 (3), 1982185 Simon, H. A., On a Class of Skew Distribution Functions, Biometrika, 52, 1955.186 Ijiri, Y. and Simon, H. A., Skew Distributions and the Sizes of Business Firms, Amsterdam: North-Holland Publishing Company, 1977


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187 Hart, P. E. and Prais, S.J., The Analysis of Business Concentration, Journal of the Royal Statistical Society, 2, 1956188 Steindl, J, Size Distribution in Economics, in Sills, D. E., Ed, International Encyclopaedia of Social Sciences, London: Collier Macmillan, 1968189 Gibrat, R., Les inegalites economiques; applications: aux inegalites des richesses, a la concentration des entreprises, aux populations des villes, aux statistiques des familles, etc., d’une loi nouvelle, la loi de l’effet proportionnnel, Librairie du Recueil Sirey, Paris, 1931190 Mansfield, E., Entry, Gibrat’s Law, Innovation and the Growth of Firms, American Economic Review, 52 (5), 1962191 Prais, S. J., The evolution of giant firms in Britain, London: Cambridge University Press, 1976192 Hannah, L. and Kay, J. A., Concentration in Modern Industry: Theory and measurement and the UK experience. London: Macmillan 1977193 Hannah, L. and Kay, J. A., The Contribution of Mergers to Concentration Growth: A Reply to Professor Hart, Journal of Industrial Economics, 29 (3), 1981194 Selten, R., A Model of Oligopolistic Size Structure and Profitability, European Economic Review, 22 (1), 1983195 Schmalensee, R., Inter-industry Studies of Structure and Performance, in Handbook of Industrial Organisation, Vol 2, Amsterdam: North-Holland Elsevier, 1989196 Hall, B. H., The Relationship between Firm Size and Firm Growth in the US Manufacturing Sector, The Journal of Industrial Economics, XXXV (4), 1987197 Klepper, S. and Simons, K. L., Technological Change and Industry Shakeouts, Mimeo, Carnegie Mellon University, 1993198 Sutton, J., Sunk Costs and Market Structure: Price Competition, Advertising and the Evolution of Concentration, MIT Press: Cambridge MA, 1991199 Geroski, P. A., in Geroski, P. A. and Schwalbach, J., Eds, Entry and Market Contestability: An International Comparison, Oxford: Basil Blackwell, 1991200 Sutton, J., The Size Distribution of Businesses, Part I, STICERD Discussion Paper No EI/9, London School of Economics, 1995201 Evans, D. S., The Relationship between Firm Growth, Size and Age: Estimates for 100 Manufacturing Industries, Journal of Industrial Economics, 35 (4), 1987202 Evans, D. S., Tests of Alternative Theories of Firm Growth, Journal of Political Economics, 95 (4) 1987203 Ericson, R. and Pakes, A., Markov Perfect Industry Dynamics: a Framework for Empirical Work, Review of Economic Studies, 62 (1), 1995.204 Pakes, A. and Ericson, R., Empirical Implications of Alternative Models of Firm Dynamics, Journal of Economic Theory, 79, 1998205 Holmes, T. J. and Schmitz, J. A. Jr., On the Turnover of Business Firms and Business Managers, Journal of Political Economy, 103 (5), 1995206 Abernathy, W. J., Clark, K. B. and Kantrow, A. M., Industrial Renaissance: Producing a Competitive Future for America, New York: Basic Books, 1983207 Hayes, R. H., Wheelwright, S. C. and Clark, K. B., Dynamic Manufacturing: Creating the Learning Organisation, New York: The Free Press, 1988208 Dertouzos, M. L., Lester, R. K. and Solow, R. M., Made in America: Regaining the Productive Edge, Cambridge, Mass: MIT Press, 1989209 Maitresse, J. and Griliches, Z., Heterogeneity in Panel Data: Are There Stable Production Functions?, in Champsaur, P., Ed, Essays in Honor of Edmond Malivaud, Vol 3, Empirical Economics, Cambridge, Mass.: MIT Press, 1990210 Buchanan, J. M., LSE Essays on Costs, LSE 1972211 Hudson, F.S., A Geography of Settlements, Macdonald and Evans, London, 1970

Additional references on performance comparisons of public/private firms.

Finding no significant difference between private and public organisations:212 Boston, J., New Zealand’s Privatisation Programme: Objectives, Principles, Problems and Outcomes, Annals of Public and Cooperative Economics, 63 (4) 199216 Kay and Thompson (above)213 Feigenbaum, S. and Teeples, R., Public Versus Private Water Delivery: a Hedonic Cost Approach, Review of Economics and Statistics, LXV (4) 1983214 Sappington, D.E. and Stiglitz, J. E., Privatisation, Information and Incentives, Journal of Policy Analysis and Management, 6 (4), 1987215 De Fraja, G., Productivity Efficiency in Public and Private Firms, Journal of Public Economics, 30, 1993


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216 Laffont, J-J. and Tirole, J., Privatisation and Incentives, Journal of Law, Economics and Organisation, 7, 1991217 Pint, E., Nationalisation v. Regulation of Monopolies: the Effects of Ownership on Efficiency, Journal of Public Economics, 44 (2), 1991218 Willner, J., A Comment on Bradburd ‘Privatisation of Natural Monopolies’, Review of Industrial Organisation, 11, 1996219 Shaoul, J., A Critical Financial Analysis of the Performance of Privatised Industries: the Case of the Water Industry in England and Wales, Critical Perspectives in Accounting, 8, 1997

Finding public ownership more efficient:62 Hunt and Lynk (above)220 Peters, L., Nonprofit/For Profit Electric Utiliities in the United States: Pricing and Efficiency, Annals of Public and Cooperative Economics 64 (4) 1993

221 Bruggink, T. H., Public v. Regulated Private Enterprise in the Municipal Water Industry: a Comparison of Operating Costs, Quarterly Review of Economics and Business, 22, 1982222 Boardman A. E. and Vining A. R., Ownership and Performance in competitive Environments: a Comparison of the Performance of Private, Mixed and State Owned Enterprises, Journal of Law and Economics, 32 (1) 1989

Finding performance improvement not guaranteed, and efficiency more related to product market competition:18 Vickers and Yarrow (above)223 Bishop M. and Thompson, D., Regulatory Reform and Productivity Growth in the UK’s Public Utilities, Applied Economics, 24, 1992224 Bishop, M. and Green, M., Privatisation and Recession – the Miracle Tested, CRI Discussion paper 10, Centre for Regulated Industries, London, 1995225 NERA, The Performance of the Privatised Industries: Efficiency, Vol 3, A Report for the Centre for Policy Studies, London, NERA/CPS 1996226 Martin, S. and Parker, D., The Impact of Privatisation: Ownership and Corporate Performance in the UK, London: Routledge, 1997227 Parker, D. and Wu, H. L., Privatisation and Performance: a Study of the British Steel Industry under Public and Private Ownership, Economic Issues, 3 (2), 1998228 Parker, D., The Performance of BAA before and after Privatisation: a DEA study, Journal of Transport Economics and Policy, 33 (2), 1999

Finding private ownership more efficient:102 Jensen and Meckling (above)229 Ben-Nev, A. and Van Hoormissen, T., Nonprofit Organisation in the Mixed Economy: a Demand and Supply Analysis, Annals of Public and Cooperative Economics, 62 (4) 1991230 Crain , W. and Zardkoohi, A., A Test of the Property-Rights Theory of the Firm: Water Utilities in the United States, Journal of Law and Economics, XXI (2), 1978231 Galal, A. L., Jones, P. and Vogelsang, I., Welfare Consequences of Selling Public Enterprises, New York: Oxford University Press, 1994232 Meggison, W. L., Nash, R. C. and van Randeborgh, M., The Financial and Operating Performance of Newly Privatised Firms: an International Empirical Analysis, Journal of Finance, 49 (2), 1994233 Bhaskar, V. and Khan, M., Privatisation and Employment: a Study of the Jute Industry in Bangladesh, American Economic Review, 85 (1), 1995234 Newbery, D. and Pollitt, M. G., The Restructuring and Privatisation of the CEGB – was it worth it?, Journal of Industrial Economics, 45 (3), 1997235 Bonbakri, N. and Cosset, J. C., The Financial and Operating Performance of Newly Privatised Firms: Evidence from Developing Countries, Journal of Finance, 53 (3), 1998236 Alchian, A. A., Some Economics of Property Rights, Il Politico, 30, 1965237 De Alessi, L., The Economics of Property Rights: a Review of the Evidence, Research in Law and Economics, 2, 1980238 Bos, D., Privatisation: a Theoretical Treatment, Oxford: Clarendon Press, 1991239 Holmstrom, B. and Tirole, J., Market Liquidity and Performance Monitoring, Journal of Political Economy, 10, 1993


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Finding conflict with political and economic goals:240 Tullock, G., The Vote Motive, London: Institute of Economic Affairs, 1976241 Buchanan, J. M., From Private Preferences to Public Philosophy: the Development of Public Choice, in Buchanan, J. M. et al, Eds, The Economics of Politics, London: Institute of Economic Affairs, 1978242 Boycko, Schleifer, M. A. and Vishny, R., A Theory of Privatisation, Economic Journal, 106, 1996
