Investigation into evidence for economies of scale in the water and sewerage industry in England and Wales

Presentation of FindingsWater UK City Conference, 21st January 2004

Dr. Scott Reid, Associate Director

Stone & Webster ConsultantsTennyson House

159-165 Great Portland StreetLondon

W1W 5PA

+44(0) 207 907 0600

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Overview

The brief The existence and evidence for economies of scale in the England and Wales water and sewerage

industry.

The impact of mergers on economies of scale.

Trends in scale economies over time, in particular in relation to changing standards and related investments/assets.

Extended to look at economies of scope in the light of chosen methodology

Outline of approach

Main findings

The full report www.ofwat.gov.uk

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Our study framework

Water companies “produce” multiple outputs

Relevant to how economies of scale is defined and measured

Relevant also to whether economies of scale is what matters

– Baumol (1977) - key concept is whether costs are sub-additive

“Scale economies are neither necessary nor sufficient for sub-additivity”

Other dimension is scope economies across different outputs

– indivisible inputs, cost complementarity in production

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Multiple outputs

WaSCs

WoCs

Servicefunction

Water collection &treatment

Water distribution

Customer services

Wastewater collection &conveyance

Wastewater and sludgetreatment

Sludge treatment &disposal

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Definitions and measurement

Economies of scale

– defined as change in outputs for a given change in inputs

– can be measured by inverse of % change in costs from 1% change in outputs

> 1 = economies of scale

< 1 = diseconomies of scale

Economies of scope

– exist if joint production of multiple outputs costs less than separate production

sharing of indivisible inputs across different “products”

cost complementarity in production

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Output definitions

Water Supply

– Volumes of water delivered

also control for changes in water quality over sample period

– Number of water connections served

Sewerage service

– Equivalent population served

Measure of loads treated

also control for rising treatment standards

– Number of sewerage connections

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Data

Most of the data from Ofwat’s Annual Returns (costs, outputs, capital stocks)

– Some “external” sources to measures input prices (labour and energy) and measures of output quality

Looking at the 1992-93 to 2002-03 period

– captures most of the post 1989 consolidations

Data set allows industry structure to change

– controls for any rationalisation in inputs following actual mergers / take-overs (e.g. capital stocks, labour inputs)

– controls for any change in input prices following actual mergers / take-overs (e.g. cost of capital)

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How we measured economies of scale

Scale measure defined by % change in costs for same % change in volumes/loads and connections

– Estimates derived from estimated cost functions

operating cost models, controlling for

– Outputs, price of variable inputs, capital stock, operating environment, measures of quality

total cost models, controlling for

– outputs, price of all inputs (including capital), operating environment, measures of quality

Estimates evaluated for average size firm in the sample

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How we measured economies of scope

Horizontal scope economies from integration of water supply and sewerage

– % difference in costs associated with integration vs. separation

Vertical scope economies from integration of water production and distribution

– % difference in costs associated with integration vs. separation

Measures derived from same cost models as scale estimates

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Main findings - 1

Long-run diseconomies of scale observed for WaSCs, but evidence that this is declining

Year

mean se mean se mean se

1993 0.69 0.09 0.17 0.20 0.58 0.17

1994 0.69 0.08 0.15 0.20 0.59 0.17

1995 0.68 0.08 0.13 0.20 0.60 0.16

1996 0.68 0.08 0.11 0.20 0.60 0.16

1997 0.67 0.08 0.09 0.20 0.61 0.16

1998 0.67 0.07 0.07 0.20 0.62 0.16

1999 0.66 0.07 0.05 0.20 0.63 0.16

2000 0.65 0.07 0.03 0.20 0.64 0.16

2001 0.65 0.07 0.01 0.21 0.64 0.16

2002 0.64 0.07 -0.01 0.21 0.65 0.16

2003 0.64 0.07 -0.03 0.21 0.66 0.16

Figures in bold statistically different from one at 5% level

Short-run K elasticity Long-run

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Main findings - 2

Long run constant returns to scale not rejected for water only companies

– estimates suggest small economies of scale, but not different statistically to 1

– opex models:

estimate for average WoC = 1.06 (se = 0.11)

– total cost models:

estimate for average WoC = 1.11 (se = 0.09)

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Main findings - 3

Horizontal integration of water supply and sewerage associated with overall diseconomies of scope

Evidence on contribution to scope economies

Volumes Connections

Loads + -Connections - +?

Water Supply

Sewerage

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Main findings - 4

Some evidence of scope economies from vertical integration of water production and distribution

By contrast diseconomies of scope associated with vertical integration of sewerage service functions

Direct relevance to competition agenda and Water Act 2003

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Main findings - 5

Examined whether data on companies that had been subject to merger with other water companies supported a “shift” in the underlying cost function for that sub-sample

Evidence of:

– % change in costs associated with change in outputs is lower for merger companies

– % scope economies are higher for merger companies

– BUT CANNOT REJECT DIFFERENCES EQUAL ZERO

Statistical insignificance might reflect

– insufficient “merger” observations

– differences between the mergers

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Stone & Webster interpretations

Industry structure

– Current structure not optimal on economic criteria

Privatisation preserved the inherited RWA structure from 1973 Act

– 1973 structure motivated by benefits of integrated river basin management

– But 1989 Act separated environmental planning function without re-assessment of the optimal scale and scope of RWA operations

Merger policy

– difficult to see case for further consolidation in context of present industry structure of WaSCs and WoCs

– But different patterns of ownership might be justified under a different organisation of water supply and sewerage services

Market competition

– vertical separation of water supply would lose benefits from economies of scope