Privatization Revisited: Lessons from Private Sector Participation in Water Supply and Sanitation in...

8/22/2019 Privatization Revisited: Lessons from Private Sector Participation in Water Supply and Sanitation in Developing Co

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Economics and REsEaRch dEpaRtmEnt

prvz Reve:

Le fr prve ser

pr Wer

suly s

develg cure

Herath Gunatilake and Mary Jane F. CarangalSan Jose

May 2008

RD WoRking PaPER SERiES no. 115


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ERD Wrking Paper N. 115

Privatization revisited: Lessonsfrom Privatesector ParticiPationin Water suPPLy

and sanitationin deveLoPing countries

HeratH gunatiLakeand mary Jane f. carangaLsan Jose

may 2008

Herath Gunatilake and Mary Jane F. CarangalSan Jose are Senior Economist and Economics Ofcer, respectively, at

the Economic Analysis and Operations Support Division, Economics and Research Department, Asian DevelopmentBank. The authors thank Juzhong Zhuang, Assistant Chie Economist, or his valuable comments and guidance in

fnalizing this paper.


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Asian Development Bank6 ADB Avenue, Mandaluyong City1550 Metro Manila, Philippineswww.adb.org/economics

2008 by Asian Development BankMay 2008ISSN 1655-5252

The views expressed in this paperare those o the author(s) and do notnecessarily reect the views or policieso the Asian Development Bank.


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FoREWoRD

The ERD Working Paper Series is a orum or ongoing and recently completedresearch and policy studies undertaken in the Asian Development Bank or onits behal. The Series is a quick-disseminating, inormal publication meant tostimulate discussion and elicit eedback. Papers published under this Seriescould subsequently be revised or publication as articles in proessional journalsor chapters in books.


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CoNtENts

Abstract vii

I. INTRDCTINI. INTRDCTIN 1

II. PBIC SECTR PRISIN WSSII. PBIC SECTR PRISIN WSS 2

A. Norms or Successes in Public Water SupplyA. Norms or Successes in Public Water Supply 3 B. essons earned: Public Water tilities 7

III. PRIATE SECTR PARTICIPATIN IN WATER SPP AND SANITATINIII. PRIATE SECTR PARTICIPATIN IN WATER SPP AND SANITATIN 7

A. Perormance o PSP in the WSS Sector 1A. Perormance o PSP in the WSS Sector 11 B. Norms or Successul PSP in Developing Economies 16 C. Supply-Side Conditions 16 D. essons earned: Private Sector Participation 19

I. PTTIN ESSNS T PRACTICE 2I. PTTIN ESSNS T PRACTICE 20

. CNCDIN REMARS 2. CNCDIN REMARS 22

Appendix 1 Market and Nonmarket ailures: The Role o the Public Sector 2Appendix 1 Market and Nonmarket ailures: The Role o the Public Sector 23 Appendix 2 Evidence o Nonmarket ailures in WSS 27 Appendix 3 Private Sector Investments in the WSS Sector 30

Appendix 4 Studies on irm-evel Efciency 31

Reerences 34


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AbstRACt

This paper examines the experiences o private sector participation (PSP)in the water supply and sanitation (WSS) sector. The paper frst uses nonmarketailures as a concept to briey explain why public sector provision o WSS is proneto ailures. The widely sought solution, PSP, has not shown encouraging results inthe WSS sector. In particular, private resources have not been adequately mobilizedto solve WSS sector problems as anticipated by the proponents o PSPs. PSPs inthe WSS sector managed to succeed in environments where eective regulation,

good governance, and contract enorcement were prevalent. Eective demand orimproved WSS services and innovative approaches or competition also paid animportant role. Experience also showed that public water utilities can work wellwhen anchored on reorms with ingrained internal and external accountability,customer orientation, and autonomy. While ownership itsel hardly inuences theefcient provision o WSS services, the interdependence o the public and privateplayers should not be overlooked; a reasonably well-unctioning public sector isa precondition or the success o private provision o WSS.


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I. INtRoDUCtIoN

Water scarcity has reached alarming proportions leaving some 1.1 billion people without accessto sae water, and 2.6 billion without basic sanitation, in developing countries. It is commonlysaid that the problem o water supply and sanitation (WSS) is not one o economics but o politics;not one o physical shortage but o governance. The generic problem o WSS is one o matchingdemand with supply, o ensuring that there is water o a suitable quality at the right location andthe right time, and at a price that people are willing to pay (Hanemann 2005, 26). As Hanemann(2005) contends, the difculty in providing water supply and sanitation to the poor is partlyinstitutional. During the past fve to six decades, developing country governments have exploredvarious ways by which they can provide water and sanitation to the poor households. This paper

reviews the lessons learned rom the eorts o developing countries to engage the private sectorin water supply and sanitation.

nlike other goods, water has unique characteristics because certain orms o water representordinary private goods while other orms represent dierent types and degrees o market ailures. Thishas spurred a long-standing debate over the institutional provision o WSS, i.e., a choice betweenthe public and the private sectors. iven that WSS services have the characteristics o a naturalmonopoly, traditionally it has been provided by the public sector. The poor perormance o developingcountry public water utilities instigated a privatization1 drive in the 1990s. Sixty-eight developingcountries have brought private sector participation (PSP) to their water sector since 1990. By 2005,54 o those countries still had the private sector engaged in operational water projects (consistingo more than 220 contracts). rom 2002 to 2005, countries as diverse as Albania, Algeria, hana,

Peru, and Russia have opened their water sectors to private participation (Marin and Izaguirre2006). The experience o PSP in the WSS sector has now been adequately documented so that it istimely to ask the question whether the private sector has met the expectations in delivering WSSservices. This paper attempts to answer this question and also analyzes the circumstances underwhich private and public water utilities have experienced successes or ailures.

The paper is organized as ollows: Section II discusses the rationale, ailures, norms o success,and lessons learned rom public sector provision o WSS. Section III deals with similar issues orthe private sector. Synthesizing the lessons and converting them into suggested courses o action,Section I discusses useul general guidelines or successul PSP in the WSS sector. Section concludes the paper.

1 As will be explained later, publicprivate partnership is the most commonly observed mode in the WSS sector ratherAs will be explained later, publicprivate partnership is the most commonly observed mode in the WSS sector ratherthan complete privatization.


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May2008

Privatization revisited: LessonsfroM Privatesector ParticiPationinWater suPPLyand sanitationindeveLoPing countries

HeratHgunatiLakeand MaryJanef. carangaLsan Jose

II. PUbLIC sECtoR PRoVIsIoN oF Wss

In a market economy, the government should play the role o steering rather than rowingaccording to conventional economic thought. Private sector, in such an economy, should play theleading role o producing and distributing the goods and services. Market ailures and unequaldistribution o economic outcomes are the two undamental reasons or governments interventionin a market economy. Market ailures, however, only provide necessary justifcation or governmentsinterventions. overnments ailure to intervene optimallynonmarket ailuresshould also be givendue consideration beore launching any intervening actions in the economy. Appendix 1 providesa brie description o the role o government in an economy using the ramework o market andnonmarket ailures. It also discusses related specifc eatures o water.

Market ailuresnatural monopoly, externalities, and public good characteristicsare theprime justifcations or public provision o WSS. It is commonly held that productive efciency inan industry with declining long-run average costs (i.e., a natural monopoly) requires that a singlefrm serve the market, but a sole supplier will restrict output to the monopoly level, generatinga social welare loss (Savenjie 2001, Megginson and Netter 2001). In such settings, efciency can

be achieved only i the government regulates the price that the monopolist can charge. Moreover,positive externalities in the orm o health improvements can result rom a reliable supply o water.In Bangladesh or instance, the combined improvement in drinking water and primary health careled to a drop in mortality caused by diarrhea rom 300,000 deaths per year in 1980 to 150,000 in1997 (Biswas and Adank 2004). In the British water industry, municipalization was motivated inpart to achieve certain nonmarketable benefts such as reduced fre losses (Hassan 1985). It hasalso been argued that access to water is generally perceived to be a socially desired or merit2service compared to other utilities such as telephones or electricity (Savedo and Spiller 1999).

At the end o the 19th century, many privately owned water utilities in the nited States andthe nited ingdom reverted to state ownership as governments were believed to be more adeptand judicious in providing water. The depression in the 1930s, the ensuing worldwide recession, the

end o the second World War, and the fnal break-up o colonial empires pushed many governments,developed and developing alike, to assume a more active role in owning and providing all typeso goods and services, including WSS. In developing countries however, government ownershipgrew or slightly dierent reasons. The postcolonial countries o Asia, Arica, and atin Americachose to nationalize a number o strategic industries borne o their historical resentment towardoreign colonizers who had previously owned many o the largest frms. Moreover, these countriessaw government ownership as essential to promoting growth by attracting heavy investments inphysical acilities, including in water and sanitation (Megginson and Netter 2001). In view o theabove developments, WSS has remained largely in the hands o the public sector. It is estimatedthat over 90% o the worlds population continues to be supplied by the public sector (Madhoo2007, Baietti et al. 2006, Prasad 2006).

Experience has shown that publicly owned water utilities have not always been successul bothin developed and developing economies. Nonmarket ailures in supplying water were however, muchmore severe in developing economies. Clearly on grounds o efciency, public WSS services haveremained wanting. arge proportions o the population remain with little or no access to publicservices, and the quality o services or those who receive them had oten been poorcharacterizedby requent breakdowns and unreliable supply. At the same time, water utilities could barely cover2 Merit goods are goods or services that are deemed to have positive externalities or considered to be so important thatMerit goods are goods or services that are deemed to have positive externalities or considered to be so important that

society believes that everyone should have access to these goods or services.


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section ii

PubLic sector Provisionof Wss

erd WorkingPaPer seriesno. 115

operational costs, leaving no surplus available to fnance the expansion o water networks. In theAppendix 2, we provide examples o nonmarket ailures in the WSS sector.

or many developing economies, the widespread nonmarket ailures eventually led to a downwardspiral (see igure 1) that eroded the quality o WSS services. This spiral combines weak perormance

incentives, low willingness o customers to pay, insufcient taris to recover costs, and lack ounding or maintenance, ultimately leading to a deterioration o assets and squandering o fnancialresources. This downward cycle attracts urther political intererence and regenerates the downwardtrend with increased velocity (Baietti et al. 2006, Spiller and Savedo 1999).

FIGURE 1

VICIOUS SPIRAL PERFORMANCE DECLINES OF UTILITIES

Consumers use

water inefficienly

Investment, maintenance

are postponed

Customers are ever

less willing to pay

Managers lose autonomy

and incentives

Subsidies often fail

to materialize

Motivation and servicedeteriorates further

Low tariffs, low collection

High usage and system

losses drive up costs

Services deteriorates

Utility lives off state subsidies

Efficiency keeps dropping

Utility cannot pay wages and

recurrent costs or expand

system

System assets go

down the drain

Crisis, huge rehabilitation costs

Source: Baietti et al. (2006).

A. Nrm r succee in Pulic Waer suppl

While perormance o the public sector in supplying water and sanitation in developingeconomies has been generally poor, there are limited instances o success.3 Success was due in partto the new public management philosophy in the 1980s that was intended to reorm the publicsector in developing economies. While not exhaustive, these reorms are deemed undamental toachieve eective provision o WSS. The analysis in this section is complemented with anecdotalexperiences rom case studies o public water utilities.43 The ailures o public sector WSS provisions are well documented in the literature. However, the success stories are not

well known. Thereore, we provide some details on the success stories in this section.4 The case studies undertaken by the World Bank (Baeitti et al. 2006) included utilities owned by the national governmentThe case studies undertaken by the World Bank (Baeitti et al. 2006) included utilities owned by the national government

and municipal governments across 11 countries. Public water utilities in the sample are distributed across various


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May2008



Among many actors, the need to ingrain internal accountability is crucial or success. Internalaccountability looks at how the management and sta are held liable or eectiveness (the degreeto which the utility realizes its goals) and efciency (the cost-eectiveness o resources used toproduce water). Measures that highlight internal accountability in a utility may include having

well-defned perormance targets; enorcing incentives, sanctions, or both; annual perormanceevaluations o the utility sta; employee incentives or achieving perormance targets; and statraining. The internal accountability mechanism is aimed at preventing nonmarket ailures that arecustomary in public water utilities.

Municipal water companies in Netherlands that enjoy regional monopoly ensure efciency throughbenchmarking, while yardstick competition5 is used in setting prices (ECD 2004). Some empiricalstudies suggest that introducing explicit perormance incentives can help improve efciency (Estacheand ouassi 2002). An example would be the water and sanitation policy o Bogota in Columbiathat introduced transparent, perormance-linked budget transers rom the central government tothe municipalities (Calaguas 2006). The Phnom Penh Water Supply Authority (PPWSA) in Cambodia,which ranks among well-run utilities in Asia, incorporated a proft-sharing system that monitorscorrupt practices by all the employees (World Bank 2006a). iet Nams Haiphong Provincial Waterand Sewerage Corporation (HPWSC) and Singapores Public tilities Board (PB) institutionalizedperormance reviews as basic criteria or salary determination and promotion. These were also basedon seniority and experience, providing incentive or workers to stay with the utility. Benchmarkingwas introduced in some countries to improve the perormance o the public sector (Baietti et al.2006). or instance, gandas National Water and Sewerage Corporation (NWSC) benchmarks otherutilities in terms o fnancial perormance and operational efciency indicators such as water losses,energy cost, and revenue collection. Table 1 provides a sample set o perormance indicators orwater utilities.

Baietti et al. (2006) describe that well-run public water utilities also allocate substantialbudgets to sta training such as in gandas NWSC, Singapores PB, and Burkina asos fceNational dEau et dAssainissment. In Brazil, the state-owned water utility Departamento Municipalde gua e Esgotos (DMAE) motivates its workers through strong investments in education, healthcare, and insurance, among others (Maltz 2005). Malaysias Perbadanan Bekalan Air Pulau Pinanghas adopted a commercial outlook in managing the water system (Santiago 2005).

income levels and across all regions. The Transnational Institute and Corporate Europe bservatory (Hall 2005) exploredcases o public utilities in eight countries representing the northern tradition (ermany, the rench city o renoble,and nited States) as well as southern participatory models (Porto Alegre in Brazil; cooperatives in Santa Cruz,Bolivia; Colombia; and public sector development in Bogota and Malaysia). The Water tility Partnership (WP 2003)studied utilities (and other service providers including nongovernment organizations, communities, the private sector,and municipalities) in nine Arican countries. The Inter-American Development Bank (Savedo and Spiller 1999) usesexamples rom Argentina, Chile, Honduras, Mexico, and Peru to illustrate why it has been so difcult or governmentsto efciently manage and operate water systems.

5 Schleier (1985) was among those who pioneered in introducing yardstick competition as a regulatory policy. Thispolicy involves breaking up the dependency o a frms payo on its own perormance (basically the cost o servicecost o serviceregulation), and making it depend instead on other frms perormances, in which case, the regulator could actuallycreate artifcially some competition among locally monopolistic frms.


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section iv

PubLic sector Provisionof Wss

erd WorkingPaPer seriesno. 115 5

tabLe 1examPLesof Performance measuresfor Water utiLities

oUtPUts/PRoCEssEs PRoDUCtIVIty/EFFICIENCy AssEts

Cubic meters o water processed naccounted or water ength o installedpipes (various types)Cubic meters o water delivered Cubic meters o water delivered

(or processed) per employee (orlabor hour)

Water processingcapacity (various types)

Water substances and organismscontrolled or

Cost o a cubic meter o waterdelivered

Number o employees

utbreaks o health hazards in the watersystem per year

Cost o a cubic meter o waterdelivered, including the costso health hazards in the watersystem to the population

Employee education andexperience

Days without service or various types oconsumers

Consumer satisaction rating andother quality measures relative

to cost per cubic meter o waterdelivered

Expert rating o assetquality (technology,

maintenance, reliability,etc.)

Number o system breaks per kilometero pipeline

Expert rating o productivity/efciency

Restoration rate Percentage o repairs that do not

ail within a year Number o complaints per 1,000

customers per month Percentage o operational procedures

ollowed correctly Consumer satisaction rating (survey) Employee and other stakeholder

satisaction rating (survey) Expert rating o service quality

Source: Savas (2000).

ack o continuous and consistent eedback rom customers, as is usual with private commodities,is an important reason or nonmarket ailures. Customer orientation can overcome this problem asit guides in producing quality output. Well-run public water utilities are more systematic in gainingcustomer eedback. Customer eedback is apparent where there are strong oversight capabilities,routine customer satisaction surveys, and a exible partnering approach between those who monitorand the operator. or the NWSC in ganda, a magazine called Water Herald provides a platorm orutility managers to describe innovations, identiy constraints, and receive credit or good perormance,while iet Nams HPWSC solicits user suggestions through a customer box (Calaguas 2006). BrazilsDMAE maintains close relations with its users through city ofces that attend to billing complaints,and administer debt payments rom low-income users. DMAE can also be accessed easily via theinternet and telephone (Baietti et al. 2006). In rance, the public water utility in renoble allowsthe elected councils to set taris. An annual report on the price and quality o the public serviceis approved by user-consultation commissions, the council o exploitation and locally electedassemblies (Avrillier 2005).


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A sense o social responsibility persists in well-run public water utilities, enhancing theutilitys public image. ood public relations and a socially responsible image help utilities toharness public support in implementing difcult decisions such as a tari increase. CambodiasPPWSA exercises social responsibility by providing a revolving und to fnance domestic connections

to help the poor connect to the network (World Bank 2006a). South Aricas Johannesburg Watertility is more proactive in assisting the poor as it tests and implements ree water meters in thepoorest neighborhoods as part o its product testing. In iet Nam, HPWSC oers its customersvarious options by which they can pay their water bills (Baietti et al. 2006).

Widening stakeholders representation can help avoid or minimize nonmarket ailures throughstrengthening the utilitys external accountability. Water utilities can serve public interests well whenmultiple actors are able to oset the short-term political interests or internal goals o politicianswith objectives such as fnancial sustainability, good management, and service quality improvements.This was the case in gandas NWSC, which has ormed clearly defned perormance contracts withthe government, and where such contracts are subject to regular external audits. Moreover, customerorganizations and nongovernment organizations have been heavily involved in gandas NWSC as wellas in Burkina asos fce National dEau et dAssainissment, and stakeholders are widely representedin Singapores PB. In iet Nams HPWSC, fnancial audits are required as part o fnancial covenantswith donor institutions (Baietti et al. 2006). In atin America, democratization meant increasingconsumer participation in running a utilitys operations as exemplifed by the deliberative councilin Brazils DMAE and Bolivias ejuve, which controlled corruption in the water sector in El Alto(Miranda 2006, Maltz 2005). Wider stakeholder representation can guard against the pursuit o sel-interest by service providers and more importantly, contribute in defning product quality to ensurethat what is produced is needed and will be consumed and paid or willingly.

Some degree o autonomy is needed to exercise eective decision-making by utility managers.Cambodias PPWSA became autonomous in 1986 and has since been seen to be one o the betterrun utilities in developing Asia. Malaysia Perbadanan Bekalan Air Pulau Pinangs adherence to acommercial outlook meant being budget-conscious, adopting a commercial accounting system,instituting internal and external audits, a customer-riendly service, accurate recording o payments,and a systematic billing and collection system. It also involved developing a reliable and accurateintegrated customer and engineering data system (Santiago 2005). iet Nams HPWSC has exibilityto determine its own salary scale by introducing bonuses unded internally, although it is not easyto fre or terminate sta as the utility is subject to the governments labor regulations. In termso investment fnancing, South Aricas JNB and Singapores PB rely on internally generated undsto fnance water investments. Board appointments are impartial in gandas NWSC, where directorsare appointed based on their expertise in the felds o management, public fnance, engineering orpublic health (Baietti et al. 2006).

The oregoing conditions o success were observed largely in the context o improving watersupply in the urban areas. There is scant literature on successul government provision o rural

water. or various reasons, many developing governments have either withdrawn rom, or drasticallyailed in supplying water to the rural areas. Rural areas proved unviable because they are usuallycharacterized by scattered populations that oten presented difcult technical, organizational, andfnancial sustainability issues (Biswas and Adank 2004).


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section iii

Privatesector ParticiPationinWater suPPLyand sanitation


b. Len Learned: Pulic Waer Uiliie

The experience o public water utilities in developing economies reviewed so ar oer essentialinsights. irst the concept o nonmarket ailures (see Appendix 1 and 2) provides reasonableexplanation to the poor perormance o public water utilities, hence this ramework helps inassessing the potential or ailures and suitable remedies. Basic human nature, which responds topersonal incentives; and the misalignment o such incentives under the structure and unctioningo public organizations, are the root causes o nonmarket ailures. The lack o a sense o ownershipin the public organizations otentimes provides a conducive environment or divergence o personalgoals rom social goals. Such divergences generally maniest in poor perormance. Second, poorperormance is exacerbated when the citizens who receive the services have virtually no means oinuencing what the utility can do (Robinson 2005). The absence o reliable measures to hold thepublic utility accountable or its actions provides room or rent seeking by public ofcials.

Third, in the absence o any competition that would have checked public water utility perormance,resource allocation tended to become widely inefcient. ack o competition meant that pressureson the water utilities to increase efciency and to pass the gains on to consumers were very weak

or nonexisting. The result is poor perormance and excessive costs. ourth, how the governmentcould eectively regulate itsel and insulate the public utilities rom short-term political goals hasbeen difcult in many developing countries. Short-term political goals have been interering withtari setting and other management aspects, severely undermining the fnancial sustainability owater utilities. Consequently, these utilities lose capacity to expand and provide services to thepoor. Many developing country governments have been regarded with incredulity or their lack oprobity and strong governance. This makes it difcult to undertake essential reorms, including tariincreases. These actors reinorce each other resulting in a downward spiral (see igure 2).

ith, the conventional view o economists that governments role should be to steer and notto row seems to be largely supported by the widespread ailures o water utilities in developingcountries. While it made theoretical sense or the government to intervene when market ailures

occurred, this did not always seem meritorious in practice. This understanding has translated torecent eorts at minimizing governments involvement in operating various entities, which wereoriginally considered to do better under public ownership.

Sixth, despite widespread ailures, efciency and better perormance can be achieved byreormed public water utilities as shown by a number o successes. Norms or success are embodiedin internal accountability, customer ocus, public image as a socially responsible agency, externalaccountability, and autonomy. These can successully reduce or minimize opportunities or nonmarketailures in the WSS sector. Moreover, these measures enable publicly owned water utilities to mimicthe market processes to perorm reasonably well.

III. PRIVAtE sECtoR PARtICIPAtIoN IN WAtER sUPPLy AND sANItAtIoN

As discussed earlier, the growing realization o nonmarket ailures since the 1970s encouragedmany countries to introduce PSP as a way o improving WSS services. Apart rom nonmarket ailures,some have argued that there is a compelling reason or the private sector to provide water andsanitation. undamentally, piped water has many characteristics o a private gooda airly homogeneouscommodity, purchased or domestic or industrial consumption, and with reasonable inormation aboutits quality and characteristics. Demand or water is normal and airly stable, and has predictable


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elasticities with respect to prices and income. Piped water also satisfes the traditional defnitiono a private good: rivalry in consumption. While there are public health benefts to a clean watersupply, the private benefts o clean water are similarly high, giving individuals a strong incentiveto pay or water quality (Savedo and Spiller 1999, Cowen and Cowen 1998).

The private sector has in act long played a role in the water sector, particularly in theindustrialized economies. Many o todays municipal and state-owned water companies in thenited States were once owned by the private sector6 (Water Science and Technology Board 2002).rance has had a long history where water is supplied by the private sector led by two companies,i.e., nrale des Eaux now owned by eolia (ormerly ivende Environment) and yonnaise desEaux now owned by Suez, which continue to dominate the world water industry.7 To date, the onlymajor divestiture o public water supply is that in Chile and the nited ingdom (Perard 2007). Thesuccessul initial public oering o British Telecom in 1984 encouraged the Thatcher governmentto pursue privatization as a basic economic policy. But instead o retaining the assets o the waterutility in the government while ranchising out the operations and maintenance as the rench did,the British government chose to privatize their assets as well. Britains perceived success encouragedother industrialized countries to divest their state-owned enterprises through public oerings in the1980s. Many other countries though, adopted the renchs mode o contracting out management,operations and maintenance, and customer services, among others, while keeping assets in thepublics hands (Absenergy 2006, Megginson and Netter 2001).

ollowing Britains perceived success, the biggest private water companies (ivendi, Suez, Saur,and Rheinisch-Westlisches Elektrizittswerk [RWE]) entered the water markets o the developingworld beginning in the 1990s. This entry presented several risks or both the public and the privatesector. Two primary risks acing the government were: the risk that services supplied by the privatesector will not meet desired standards and the risks that the cost o services provided by the privatesector will be much higher than that charged by the government. n the other hand, numerous risksbeset private investors, namely, commercial, fnancial, technical, legal and political risks. Commercialrisks involve the ear that the private investors may not be able to recoup their investment andmake a proft. Market-related commercial risks may occur i the demand or services is lower thananticipated. inancial risks relate to currency devaluations and convertibility o local to oreigncurrency, especially when oreign borrowings are used to fnance service provision. Technical riskspertain to the lack o sufcient knowledge about the state o installations; the need or replacement,rehabilitation, and expansion; and the resulting operational risks that installations will not perormas expected. Escalation in construction costs due either to ination or other reasons also posetechnical risks. egal risks occur as a result o contractual disputes. The main political risk isthat the government will expropriate the assets or change policy in the course o implementinga contract. Another political risk stems rom governments reluctance to increase taris beore anelection period (Idelovitch and Ringskog 1995).

6 Historically, water services were initially delivered by private providers in many cities in the nited States, such asHistorically, water services were initially delivered by private providers in many cities in the nited States, such asBoston, New ork, and Philadelphia (Water Science and Technology Board 2002, 2).

7 Two other companies, Saur, part o rances Bouygues construction group; and the erman conglomerate RWE,Two other companies, Saur, part o rances Bouygues construction group; and the erman conglomerate RWE,which acquired leader Thames Water in the nited ingdom in 2000, lead the ranks o international private watercompanies.


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section iii



iven these risks, privatization o WSS in developing economies oten did not involve ullychanging ownership o the utility rom the government to the private sector. Instead, many developinggovernments chose to pursue some intermediate orm o private sector participation. These ormsranged rom tendering or construction contracts in large urban cities to joint ownership o water

utilities.8

Table 2 shows the broad range o options under which developing country governmentsinvolved the private sector in supplying water and sanitation. The options vary, depending on therisks that both the government and the private sector were willing to assume. ption A representswillingness by the government to assume more risks while ption B indicates a decline in the risksthat the public sector preers to address, as this option involves partial private ownership. Boththese options meant to introduce competition in WSS service segments that do not have naturalmonopoly characteristics. ption C signals a shit wherein governments move away rom owningand operating the inrastructure, to regulating the services provided by the private sector. We usethe term private sector participation in this paper to indicate all three options given in Table 2.

8 In its strictest sense, privatization meant the transer o productive assets rom the state to the private sector (ParkerIn its strictest sense, privatization meant the transer o productive assets rom the state to the private sector (Parkerand irkpatrick 2005). But private sector involvement (Webster and Sansom 1999) has acquired various meanings asollows:

Privatization: This term was commonly used toward the end o the 1980s to describe the increase in private involvementmostly reerring to the ull hand-over o assets (or divestiture).Private Sector Participation: Reers to the role that the private sector can play in the delivery o services. Privatesector participation in water supply took many orms that varied basically on the extent to which the responsibilityor capital investment and the burden o commercial risk are shited rom public to private sector.PublicPrivate Partnerships: PPP acknowledges the key role that both the public and private sectors have in serviceprovision. The term has drawn much interest as it emphasizes the need or partnership to maximize the benefts thatboth sectors can contribute.


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tabLe2

formsofPrivate-sectori

nvoLvementin

tHeWater

suPPLya

nd

sanitation

sector

oPtIoNA

oPtIoNb

oPtIoN

C

RIsKs/

AttRIbUtEs

sERVICE

CoNtRACt

MANAGEMENt

CoNtRACt

LEAsE

oR

AFFER

MAGE

CoNCEssIoN

bUILDoPER

AtE

oWN

CoNtRACt

(boot)and

VARIANts

REVERsEboot

JoINt

oWNERsHIP

oRMIXED

CoMPANIEs

DIVEstItUREoR

oUtRIGHtsALE

Assetownership

Publicmajority

Publicmajority

Public

majority

Publicmajority

PrivateandpublicPrivateandpublicPrivateand

public(major)

Private,orprivate

andpublic

Sectoralinvestment,

planning,coordination,

regulation

Parentministry

orseparate

publicauthority

Parentministry

orseparatepublic

authority

Public

authority

negotiatedwith

privateoperator

Publicauthority

negotiatedwith

privateoperator

Noneorpub

lic

authority

Noneorpublic

authority

Noneorpublic

authority

Noneorpublic

authority

Capitalfnancing

(fxedassets)

Mainlymarket-

based

Mainlymarket-

based

Public

Privateoperator

Privateoperator

Public

Public

Private

Currentfnancing

(workingcapital)

Mainlyinternal

revenues

Mainlyinternal

revenues

Privateoperator

Privateoperator

Privateoperator

Public

Privateoperator

Private

(government

maypayor

publicservice

obligations)

perationand

Maintenance

Publicentity

Privateoperator

orspecifc

services(billing)

Privateoperator

Privateoperator

Privateoperator

Privateoperator

Privateoperator

Private

Collectionotari

revenues

Publicentity

Publicentity

Public

entity

Privateoperator

Privateoperator

Privateoperator

Privateoperator

Private

Managerialauthority

Publicentity

Publicentity

Privateoperator

Privateoperator

Private

Private

Privateand

public

Private

Basisoprivateparty

compensation

ixedeebased

onservices

rendered

Basedonservices

andresults

Based

on

results,neto

eepa

idbythe

operat

ororthe

useo

existing

assets

Basedonresults,

netoeepaidby

operatororuse

oexistingassets

Privately

determined

Privatefrmp

ays

annualeeto

publicauthority

equaltoulldebt

serviceoentire

investment

Notavailable

Privately

determined

Typical

duration

essthan5

years,mostly

1

2years

About3to5

years

5

10yearsor

sometimes

8

15years

10

30years

orsometimes

25

30years

10

30years

ong-term

ong-term

Indefnitely(may

belimitedby

license)

Sources:AdaptedromMadh

oo(2007),Davis(2005),NECA(2005),WebsterandSansom

(1999),andIdelovitchandR

ingskog(1995).


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section iii



A. Perrmance PsP in he Wss secr

The perceived merits o PSP in WSS include (i) mobilizing private resource to the sector to meetgrowing investments needs, (ii) competition because o the entry o more investors, (iii) increasedinnovation and efciency, (iv) lower prices, and (iv) universal coverage. The ollowing sectiondiscusses the perormance o PSPs in each o these.

1. Milizain Privae Capial

Private sector participation has been generally touted as the solution to the pressing needsor huge capital investment in water and sanitation that have beset many developing countries,allowing governments to ree resources or other important sectors (Prasad 2006, Davis 2005,and Trebing 2004). In practice however, these goals have been difcult to achieve. Prasad (2006)claims that many o the so-called private investments were not really investments (or greenfeldoperations9), but more o private ows to acquire existing business assets. iven the larger riskor private enterprises, WSS investments owed largely to concession (70.9% o total) rather than

to greenfeld (14.6% o total) projects (see Appendix 3).The lobal Water Partnership estimates total investment needs or new water inrastructure at

$180 billion per year or the period 20002005 (Cosgrove and Rijsberman 2000). Based on recenthistorical data (World Bank PPI database 19902006) total private investment in WSS averaged$3.3 billion per year, i.e., only about 1.8% o the annual investment needs o developing countries.In Asia, the $1.9 billion annual average private investments in water (World Bank PPI database)account or 7.9% o the total fnancing needs o the region.10 Thus, the private sector has notmobilized an adequate amount o resources to meet the needs o the WSS sector as proponents oPSP have anticipated. N Secretary eneral Ban i-Moon raised these concerns during the WorldEconomic orum 2008 in Davos lamenting that only a raction o the 1,000 companies had in act

joined the Ns Water Mandate to increase investments in the water sector (Edgeclie-Johnson

2008).

. Inadequae Cmpeiin

Competition among producers and consumers is the most critical actor that ensures the successomarkets in maximizing social welare. Despite various attempts to introduce competition, the WSSsector continues to be characterized largely as a natural monopoly (Prasad 2006 and 2007, Savedoand Spiller 1999). In principle, competition can be introduced in some areas o water supply suchas supply o bulk water in a multi-reservoir system, billing and metering, construction, replacement,and repair work within water services. The relevant natural monopoly problem largely originatesrom the distribution rather than rom other aspects o water supply. In terms o distribution itis uneconomical to duplicate water and sewerage networks. Competing pipe systems did occur in

9 A greenfeld operation is an investment in a manuacturing, ofce, or other physical company-related structure in anA greenfeld operation is an investment in a manuacturing, ofce, or other physical company-related structure in anarea where no previous acilities exist. In the World Banks Private Project Investment database, greenfeld operationsinclude build-operate-own-transer (BT), BT variants, and reverse BT (included under ption B o Table 2).

10 Total fnancing needs or water supply, sanitation, solid waste management, and slum upgrading in urban areas willbe $25 billion per annum and will reach $50 billion per year i urban roads were included (ADB 2006, 22).


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Canada and in the nited States in the 19th century, and still exist in Hong ong, China whereseawater pipes are used to supply ushing water while other pipes deliver drinking water. However,multi-piping systems are oten too costly or consumers (Cowen and Cowen 1998).

A large portion o the cost o supplying water and collecting sewage is tied up in the

distribution network obscuring the potential or direct product market competition in developingcountries (Shirley and Mnard 2002).11 Installing piped water networks is capital-intensive withinvestments quite large relative to the size o the market. Studies rom the nited States indicatethat the ratio o investments in fxed assets to annual tari revenues o WSS is in the order o10:1 compared to 3:1 or telecommunications and 4:1 or energy. iven the higher ratio in watersupply, it becomes difcult to attract private investors and give them responsibility or fnancinginvestments because the payback period is long (Savedo and Spiller 1999, Idelovitch and Ringskog1995). In Zambia, Craig (2002) ound evidence that breaking large water enterprises into smaller, andindependent units ahead o sale, in order to ensure competition, eventually risks losing economieso scale in production.

The natural monopoly problem also explains why in some parts o atin America and Arica,

there are no known frms that tried to introduce direct product market competition other than watervendors (e.g., aguateros in Panama) and sel supply12(Abidjan and Conakry in Arica). This can bedone on a limited scale though, with customers being supplied by alternatives such as boreholesor large individual reservoirs (Prasad 2006). In a study o 110 water utilities in Arica, irkpatricket al. (2006) ound evidence that the technology o providing water (high fxed costs and locationspecifcity) has severely restricted competition.

iven natural monopoly problems and high sunk costs, rivalry under privatization tends tobe confned to competition or the market or competition to win the contract or concessionagreement. However, bidding or water concessions in developing countries tends to be problematic,oten drawing a small number o participants (irkpatrick et al. 2004) due to high transaction costsand high risks. The number o bidders can also be limited by strict prequalifcation criteria as in

the case o athmandu alley (McIntosh 2003). With a ew bidders, there is signifcant potentialor either actual or tacit collusion that could compromise the bidding process (Cook and Minogue2002). Collusion among private water companies restricts competition and encourages corruption.obina and Hall (1999) related how water concessions in Jakarta were awarded to two consortia in1997Thames Water and Suezboth known to be closely associated with President Suharto. AterSuhartos ouster rom ofce, the two consortia negotiated a new concession with the city councilwithout competitive tender.

11 What explains the lack o experimentation with product market competition in water compared to other inrastructureWhat explains the lack o experimentation with product market competition in water compared to other inrastructureondon Economics (1998) argues that because a greater percentage o the costs in water systems are in thenoncompetitive network than in the potentially competitive areas, the relative efciency gains rom competition aresmall. ondon Economics estimates that a greater percentage o the costs (around 66%) in water systems are in the

noncompetitive network than in the potentially competitive areas (estimated at 34%). This is above that o electricitywhere transmission and distribution account or 60% o the costs and are potentially competitive (Shirley and Mnard2002, Savedo and Spiller 1999).

12 Sel supply is an approach to water supply that concentrates on intervention and management at the household orSel supply is an approach to water supply that concentrates on intervention and management at the household orsmall group level. Those who are unserved with sae water continue to draw their supplies rom sources they haveound or developed themselves using traditional means.


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. Unclear Prducive Efcienc

It is generally expected that PSPs are more efcient compared to public utilities. However,the impacts o private sector involvement on frm-level efciency in the water sector have beenmixed. or both industrialized and developing economies, studies do not robustly support the viewthat water sector PSP has improved frm-level efciency. Studies using econometric estimationso cost unctions, stochastic rontier production unction analysis, and data envelopment analysis(Appendix 4) do not provide conclusive evidence o higher productivity or technical efciency amongPSP water utilities. 20 studies reviewed, only three show concrete evidence on technical efciencyimprovements or cost reductions under PSP. Some caution needs to be exercised here as measurementhas been obscured by the lack o comparable data, poor quality o data, and short time period oranalysis; as well as the act that studies were oten undertaken or the period immediately aterprivatization.13 Moreover, two recent World Bank studies concluded that there is no statisticallysignifcant dierence between the efciency perormance o public and private operators in this(water) sector (Estache et al. 2005, 12). urthermore, Hall and obina (2005) ound evidence thatstrongly suggests there is no systematic intrinsic advantage to private sector operations in terms o

efciency. This lack o clear evidence on frm-level efciency and cost reduction through PSP maybe a maniestation o inherent difculties in creating adequate competition in the WSS sector.

. Pricing Iue

As discussed earlier, political goals oten motivated developing country governments to keepwater taris low. With privatization however, water taris are normally bound to increase as pricesneed to recover the ull cost o providing WSS. While price increases to cover costs do not constitutemarket ailures, inormation ailures tend to accompany the process o tari setting with privateoperators in developing countries. Tari setting is most contentious when negotiating privatizationcontracts. The much-publicized ailure o privatizing water in Cochabamba (Bolivia) was due to acombination o complex political, social, and economic actors, where the doubling o taris in

January 2000 ueled much opposition. Consumers opposed the contract because many elt thatit would have been against their long-term interests. Contracts with the private sector are otenrenegotiated on the basis o tari levels. Some case studies in atin America show that privateoperators are not transparent with regard to the parameters or pricing schemes that they plan toimplement (Clarke et al 2004). Certain studies even blame the incidence o contract renegotiationsto moral hazard problems, which tainted those pursued in Buenos Aires and Manila (Davis 2005). Inthe concession tenders or both cities, frms were required to submit bids with average taris at or

13 The potential problems in all empirical work in privatization include the lack o data and bad data, omitted variables,The potential problems in all empirical work in privatization include the lack o data and bad data, omitted variables,endogeneity, and selection bias. The two most pronounced difculties are determining the appropriate set o comparison

frms or benchmarks, especially in developing economies with limited private sectors, and the undamental reasons whycertain frms are government-owned. Thus, it is difcult to evaluate the eects o government where the ownershipstructure itsel, which includes both political and perormance goals, is endogenous to the system. Moreover, someo the studies that assess the impact o privatization oten combined both industrialized and developing economies,producing results that may be unreliable (Megginson and Netter 2001, 332). Assessing the impact o privatization isdifcult due to a number o methodological problems including the lack o a counteractual, difculty in identiyingbenchmarks to assess perormance, complexity in doing general equilibrium model analysis, danger o short-runperormance improvement, and unclear basis or causality (Parker and irkpatrick 2005, 51516). ther limitationsinclude the small sample size, poor quality o data, and shorter time rames or analysis (Clarke et al. 2004, 4).


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below levels previously charged by the government.14 Davis (2005) argues that companies tend topledge unrealistic tari reductions during the bidding, expecting to renegotiate these clauses oncethe contract is awarded. Many governments oten agree to new demands by the private frm giventhe high political and fnancial costs o canceling a contract and initiating a new bidding process.

These problems are common in developing countries where governments capacity to negotiatecontracts with experienced multinational frms as well as to regulate their operations is weak.

5. Lw Cverage

ne o the important expectations o PSP is that the private sector brings resources toinvest in the WSS sector so that coverage can be increased.However, increasing water coverage indeveloping economies has been difcult to achieve under PSP or two reasons. n the demand side,water users in some countries are not willing to pay cost-recovering taris, partly because peopleare not aware o the health benefts owing rom reliable supply o water.15 In these countries,eective strategies to sensitize the public on key issues such as paying or water, raising hygieneawareness, reducing vandalism and misusing acilities are rarely developed beore launching the PSP

(WP Arica 2003). or example van den Berg et. al. (2006) show that all the main assumptionsmade in designing a PSP in Sri anka are unrealistic. Culture can also constrain demand where orinstance, it proved difcult to impose cost-recovery taris given the culture o nonpayment amongthose living in the black townships in South Arica (Budds 2000).

n the supply side, private suppliers aim to make a proft and hence, they will invest onlywhere they expect to make a proft. Thereore, the poorest clients are inevitably neglected. Concernsabound that PSP could hurt the poor in at least two ways. irst, introducing PSP may make crosssubsidies difcult and encourage private frms to cream skim or cherry pick, i.e., serve the mostproftable customers and ignore the unproftable ones (i.e., poor and rural consumers). This ledprivate water companies in the Peoples Republic o ChinaSuez and eoliato operate largelywithin or near the wealthier residential and industrial centers (Mcee 2007). Second, large costs in

water supply orce private operators to recoup their investment by charging high connection costs,which the poor cannot aord (Savedo and Spiller 1999). or instance in Buenos Aires, customers inthe poorest regions were asked to contribute almost 20% o their income to get water connections(Estache et al. 2000). Thus, in the absence o properly targeted saety nets, it is likely that thepoor may be excluded rom WSS services.

Rural areas have been neglected or the most part. It is costly or the private sector (andgovernment) using conventional technology to supply water to rural areas, where the populationdensity is low and users are widely dispersed. A World Bank study on improving rural water supply

14 In the case o Buenos Aires, the winning frm oered to set average taris 27% lower than the rate charged by theIn the case o Buenos Aires, the winning frm oered to set average taris 27% lower than the rate charged by thepublic utility. In Manila, which was divided into two service areas with separate concession agreements, the winningfrms pledged to reduce average taris by 2643% (Davis 2005).

15 This is common among low-income settlements o Cte dIvoire, Nigeria, and Zambia where communities are not ullyThis is common among low-income settlements o Cte dIvoire, Nigeria, and Zambia where communities are not ullyinormed on a wide range o issues (e.g., planning and design, operation and maintenance o a water utility) and/orinappropriate inormation channels/messages are used to reach them (WP Arica 2003).


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section iii



in Nusa Tenggara Barat, Indonesia showed that installing a large-scale piped system can cost fveto ten times more than rural wells and simple gravity-ed piped systems.16

Small scale independent providers17 (SSIPs) that recent literature has classifed under privatizationhave taken on the task o supplying water to rural areas in some developing economies, as is

common in atin America and Arica. However, SSIPs cannot exploit the same economies o scalethat large water utilities enjoy orcing them to charge by as much as our to ten times the usualrate. Hence, SSIPs have oten been branded as exploitative and at times, evidence does suggestthat they earn excessive rents (Davis 2005, 150). or reasons cited above, private capital in thewater sector became subsequently concentrated in urban areas given their larger investment needs,higher population density, and high revenue potential.

FIGURE 2PRIVATE INVOLVEMENT IN WATER AND SEWERAGE PROJECTS

(19902005)

High income (0%)

Low income (1%)

Upper middleincome (56%)

Low middleincome (43%)

Source: Madhoo (2007).

Private investments also appeared to have benefted the relatively wealthier countries as the

risks associated with water projects in less developed countries are high (Davis 2005; Budds andMcranahan 2003; World Bank 2004,170). igure 2 shows that or the period 19902005, upper-middle-income countries captured 56% o the total investment o $46.2 billion and lower middleincome countries getting 43%, while the lowest income countries received only 1% o total privateinvestments. During this period, private investment owed largely to Argentina (27.5% o totalconcession unds), Malaysia (20.6%), and Philippines (19.6%) (Madhoo 2007). atin America beneftedlargely rom private ows given their higher levels o household income, economic and politicalstability, and perceived government commitment to market liberalization, which is avorable toprivate investments. Sub-Saharan Arica (SSA) captured the smallest volume o investments (aboutless than 0.2%), most o which were described as a widespread ailure. By 2003, only 5% o the

16 The average fnancial incremental cost or installing a large-scale water piped system costs Rp1,197 per cubic meter,The average fnancial incremental cost or installing a large-scale water piped system costs Rp1,197 per cubic meter,rehabilitating a large-scale piped system is Rp526, versus Rp89 or rural wells and Rp96 or simple-piped systems(Perkins 1994).

17 SSIPs are essentially private sector entrepreneurs who supply water such as vendors who use carts, bicycles, or polesSSIPs are essentially private sector entrepreneurs who supply water such as vendors who use carts, bicycles, or polesto carry containers o water to customers; kiosks or standpipe operators; tanker truck delivery persons; and householdsthat sell water rom their private connections to neighbors. SSIPs sell water to households (oten the poorest) thatare usually unconnected to existing piped systems, and households wishing to augment their existing supply.


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worlds population was being served by the ormal private sector (World Bank 2004, irkpatricket al. 2004, and Budds and Mcranahan 2003). To date, private fnancing in water supply andsanitation account or less than 10% o total inrastructure investments in developing countries(World Bank 2007).

b. Nrm r succeul PsP in Develping Ecnmie

As discussed in the previous section, PSP in the WSS sector has neither created adequatecompetition that can drive down costs and prices, nor has it mobilized large amounts o resourcesto the sector and increase coverage. Nevertheless, some PSPs succeeded in eectively deliveringWSS. Experience has shown some preconditions or success. rom the supply side, an enablingbusiness environment, innovative schemes or product market competition, an eective regulatorymechanism and contract enorcement, and strong institutional actors are behind successul PSPsin the WSS sector. Similarly rom the demand side, adequate willingness to pay or improved WSSservice, easibility o metering,18 cost-recovery taris, and context-specifc measures had to bemet to ensure success.

C. suppl-side Cndiin

1. Plic and Iniuinal Envirnmen

Private sector participation has made more progress in high-income and middle-incomecountries, but has ailed considerably in low-income developing countries. Success in the wealthiercountries is attributed to an investment climate that is conducive to private capital and reduces therisks associated with operating water systems. In developing countries, private sector participationis easier to launch and more likely to produce positive results under a market-riendly policyenvironment and where the government has ample capacity to regulate. Such an environment

is characterized by the existence o competitive product markets or other goods, organized andcompetitive labor markets, mature capital markets, competitive managerial labor markets; togetherwith institutionalized management training, well-defned property rights, good business ethics,and good governance. PSP launched in developing countries with these enabling characteristicshave shown noticeable success. Privatization succeeded in Chile, Mexico, New Zealand, and nitedingdom as these were accompanied by reorms to open markets, removed price and exchangerate distortions, and encouraged ree entry (World Bank 1992). The 2002 Water Resource aw inChina introduced a user-pay system where water user is charged based on the actual amount oconsumption, reducing the commercial risks or private operators (Mcee 2007). That paved theway or introducing PSPs in the PRC.

. Innvaive Meaure Creae Cmpeiin

iews about what constitutes a natural monopoly in utilities have changed radically in recentyears. In developing economies, competition has been stied by the lack o any eort to addressthe natural monopoly problems in the water sector. The solution to this problem is to isolate thenatural monopoly elements. While this has been done in the gas and telecommunication sectors,

18 Water values should be high enough to justiy the cost o metering.Water values should be high enough to justiy the cost o metering.


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this has not largely been done19 nor tested in the WSS sector. The literature suggests three ways oimproving productive efciency in the water sector namely concentration, trading water rights, andcompetition. In industrialized countries, the latter two are more widely practiced. While concentration(also reerred to as town agglomeration20) has been adapted in the developed economies such as

Belgium, Italy, and Netherlands, this is not always easible in other countries (especially developingeconomies) due to political, legal, and/or geographical restrictions. Water trading has been done butmainly in agriculture and more oten to address seasonal demand (oellmi and Meister 2005).

Competition can be achieved either through competition or the market (i.e., through biddingo contracts as discussed earlier) or through direct product competition. In industrialized economies,direct product competition has been done through three basic channels: inset appointments, borderline competition, and common carriage. Inset appointment in England, Italy, and Wales enable thelicensees to allow new entrants to supply customers in a defned geographical area. Border linecompetition such as in Poland and Czechoslovakia allows customers (usually large customers) thatare located at the border o a supply area to purchase water rom an existing neighboring utility.Common carriage (recently adopted in England) is a model o interconnection, wherein two or morerival companies render water services in the same area and customers are ree to choose their watersupplier. In such a model, ormer monopolists connect their water networks in order to allow eachother access to their distribution pipessimilar to telecommunication or electricitybased onaccess pricing. However, there are difculties associated with common carriage including limitationso mixing dierent water qualities,21 extensive coordination requirements or the exchange otreated water, diseconomies o scale due to pumping requirements, and quality losses over longdistances that can signifcantly limit the exchange o water between utilities. iven these difculties,efciencies may be achieved only at the regional or local level. At this stage, the potential orcommon carriage to induce competition is still unclear given high transport costs and high fxedcosts in the water sector (oellmi and Meister 2005, ECD 2004).

. Eecive Regular Mechanim and Cnrac Enrcemen

When direct product competition is not easible, the regulatory mechanism is expected toprovide incentive or competition and ensure socially desirable outcomes. iven that the privatesectors main motive is proft, regulatory mechanisms have a greater role to play under PSP. But asdiscussed earlier, a more eective regulatory ramework is absent in the low-income countries. Evenwhere rules and guidelines or competition did exist, they were poorly implemented (Cook 2002).

19 There are isolated instances o parallel piped water systems that can be ound in some arid areas, where one systemdelivers pure water or direct human consumption and the other delivers lower quality or reclaimed water or suchuses as ushing toilets or watering gardens. Thus, some competition even in delivery, based on quality dierentiationand price, can be ound, indicating that reormers ought to consider whether their water system really is a ubiquitousnatural monopoly (Noll et al. 2000).

20 The 1994 alli aw mandated that all existing water service suppliers should be consolidated into water sectormanagement areas, based on hydrographical sub-basins (optimum territorial areas, reerred to as TAs), to bedefned by the 20 regional governments within six months. The process was delayed however, due to strong politicalresistance to aggregate and to objections by inuential vested interests, particularly private operators who, beorethe alli aw, managed roughly 5% o Italys water and wastewater services (ingdom 2005, 8).

21 Mixing dierent water qualities raises the possibility o leaching and corrosion o pipes, sedimentation, suspension oMixing dierent water qualities raises the possibility o leaching and corrosion o pipes, sedimentation, suspension oparticles, and microbial quality. These can also happen when there is a need to pump water or long distances (oellmiand Meister 2005).


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In a number o case studies o water privatization in atin America,22 Shirley and Mnard (2002)observed that a regulatory contract with a private operator could most likely succeed under threeconditions: (i) inormation asymmetries between regulator and utility are reduced; (ii) incentivesare provided to motivate the utility to comply with the contracts goals; and (iii) both parties

provide credible signals o their commitment to abide by the contract, and credible enorcementis in place.

Inormation asymmetry can be reduced by introducing competition (e.g., product marketcompetition, competition or the market, and yardstick competition) and by monitoring. Althoughproduct market competition is rare in water, the regulator can use competitive bidding or theranchise to operate the system, and yardstick competition to augment the inormation base.ardstick competition, such as that pursued in Wales, was quite problematic as utilities operateunder various circumstances that are oten not comparable. More sophisticated as well as pragmaticregulatory mechanisms such as the ogelsanginsinger mechanism can be used to avoid inormationasymmetry (see Train 1997 or details).

There is emerging evidence that in seeking contracts with the private sector, transparent

tendering and inormation disclosure yields better conditions or consumers. Shirley and Mnard(2002) described how competitive bidding was eectively employed in Buenos Aires. irms revealedmore inormation whereby the proposed water taris reected the bidders assessment o investmentas well as operating costs. nder Argentinas contract, the governments commitment to sustainull convertibility (o returns) at a fxed rate reduced the risks associated with exchange ratedevaluation (Cook 1999). In Cambodia, Webster and Sansom (1999) ound that contracts with localprivate operators required them to explicitly provide ull coverage in their respective or designatedareas.

The regulatory mechanism should include eective incentives to induce the private sectorto reveal more inormation and not to act opportunistically. Incentives oten take the orm osetting specifc targets, sharing risks and rewards, or price regulation. Prior to privatizing in 2003,

the Metropolitan Waterworks Authority in Thailand streamlined its manpower and installed a keyperormance indicator system to evaluate work efciency and control expenditure, resulting in profts40.3% above-target (McIntosh 2003). In Senegal, the government based the remuneration o theprivate operator on the efciency o the network (measured by lower unaccounted-or-water, andhigher billing and collection efciency), and operator contributions to capital expenditures (NECA2005). In a publicprivate partnership or water services in Colombia, the management ee or theoperator was linked to revenues creating an incentive to improve billing and collections, as wellas to reduce leaks and to expand services (World Bank 2006b).

Commitment o the government to eectively enorce the contract and resolve disputes playsa critical role in successul PSP. Such mechanisms should also include penalties or reneging onthe contract, including fnes, oreiture o bonds, and revocation o the contract. or instance,

the contract with the water operator in Santiago could be revoked or nonperormance and thecompany could be sued by consumers or ailure to provide adequate service (Shirley and Mnard2002). Commitment is deemed to be stronger, particularly on the part o developing governments,when there are strong institutional actors that ensure good governance and eective regulation.

22 The case studies include privatization contracts o dierent orms ranging rom management contracts to concessionsThe case studies include privatization contracts o dierent orms ranging rom management contracts to concessionsin Buenos Aires (Argentina); ima (Peru); Mexico City (Mexico); to urban water supply in Chile, Abidjan (Cte dIvoire),and Conakry (uinea).


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Probity is crucial in ensuring successul PSP. To achieve this, the regulator needs to be shieldedrom political intererence (Cook 1999). Credible regulatory rameworks exist where the operatorhas some autonomy rom the executive branch, arms-length relationships between governmentsand public water agencies, and cordial relationships between government and private investors as

in Argentina and Brazil (Savedo and Spiller 1999). Among those studied by the World Bank inatin America, Santiagos regulator was powerul, independent, politically insulated, and guided bydetailed laws that let little room or abuse (Shirley and Mnard 2002). Moreover, the governmentneeds to support a regulatory environment that is transparent, consistent, and accountable (Cook1999) to ensure the success o the PSP.

. Demand side Meaure

While the oregoing suggests a host o supply-side conditions should be in place or PSP to besuccessul, certain demand-side conditions should be simultaneously met to ensure success. Theseconditions include easibility o metering, adequate willingness to pay, cost recovering taris, andcertain context-specifc actors.

Metering ollows the user-pay principle whereby a consumer pays or the amount o water he/she consumes. However, the water values should be high enough or metering to be economicallyeasible. The need to recover costs is universally accepted. However, assessment o willingnessto pay and the publics preerence or private sector provision o WSS, and the participatoryassessments on easibility o tari increases, should precede the introduction o PSP. PSP that hadpaid attention to these demand aspects and had considered price elasticity in revenue predictionshas perormed better.

Tailoring the provision o WSS according to local circumstances can help make the serviceacceptable to the customers. or instance, water multinationals partner with local private operatorsin Cambodia, Colombia, Paraguay, Philippines, and ganda, given that the locals have a betterunderstanding o the market (Triche et al. 2006). Durban Metro Water in South Arica dierentiates

its water service by oering the poor (approximately 30% o the total 3 million) a choice o waterconnection: ull pressure high tank or low tank each with dierent connection charges andmonthly taris. Water kiosks are available or those who are not willing to pay or piped water, asare standpipes rom which water is sold at an aordable rate (Webster and Sansom 1999). Temporaryconnections can be tapped in Haiti and Burkina aso to address the needs o slum areas (WP Arica2003). Appropriate involvement o the community and civil society organizations in designing thePSP systems also has enhanced the acceptance o PSP among local communities.

D. Len Learned: Privae secr Paricipain

The poor perormance o the public water utilities provided the impetus or PSP in the WSS

sector. As shown in the previous section, however, PSP in the WSS sector in developing countrieshas oten allen short o expectations. PSP succeeded when (i) enabling policy and institutionswere in place; (ii) innovative approaches are used to create competition; (iii) eective regulatorymechanisms and contract enorcements are easible; (iv) there is eective demand or improved WSS;(vi) innovative and exible approaches are used to suit the local conditions; and (vii) transparentand participatory consultative process precede the privatization process.


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The experiences o the private sector in supplying household water in developing economiesoer valuable lessons. irst, privatization has largely ailed in developing economies becauseeorts to privatize were oten expedited without sufcient orethought, analytical work and publicconsultation. The need to meet conditions or aid and debt relie, rather than the merits o reorm,

drove some developing governments to involve the private sector in WSS services. Many o thesecountries undertook privatization even i the necessary policy, legal, and political institutions werenot yet in place (Almansi et al. 2003, Bayliss 2002, and Cook 1999).

Second, PSP as a strategy achieved a modicum o success in industrialized economies. Developedcountries beneft rom mature capital markets with stock exchanges, venture capitalists, banks andother fnance institutes, a well-unctioning legal system that protects private property rights, andconventional standards o business behavior (business ethics) that acilitate market exchanges.In developing countries however, many o these institutions remain weak or are nonexistent. orinstance, in many developing economies, there is a paucity o liquid capital markets to acilitateshare trading, and a shortage o institutions that can curb rent seeking by the private sector (Parkerand irkpatrick 2005).

Third, experience has shown that a pure change in the structure o ownershiprom beinggovernment to private ownershipdoes not necessarily enhance the efciency o supplying WSS.essons rom studies o PSP show that lack o competition is generally more important than ownershipitsel in explaining the perormance o PSP in the WSS sector (irkpatrick et al. 2006). Thereore,the process o privatization has to be complemented with measures that will provide incentives orcompetition. ourth, PSP is largely motivated by proft, it is most likely or the private sector toavoid the poor areas and rural markets (ECD 2004) in the absence o supplementary measures bythe government to ensure inclusiveness.

In the main, PSP is not a panacea or all the problems in the WSS sector as some developmentpractitioners had thought in the early 1990s. PSP produces good results under certain circumstances.Thereore, selective application o PSP in the WSS sector is imperative. The lessons point out

that synergy between the public sector (in setting the rules o the game; eective contractenorcement; and eective regulatory mechanism) and the private sector (innovative ways toreduce cost and increase efciency, ethical conduct o business, and corporate social responsibility)will eventually determine socially optimal outcomes o PSP in the WSS sector. When the enablingbusiness environment and policy and regulatory measures are largely not in place, reorming thepublic utilities should be given due consideration. Public sector reorms to reduce nonmarket ailuresserve as a viable alternative or PSP under certain circumstances, as well as a platorm or utureinvolvement o the private sector.

IV. PUttING LEssoNs to PRACtICE

Despite its limited success in developing countries, PSPs play a potentially important role in

the WSS sector. Selective and well-planned application o PSP under suitable circumstances is thekey to success. auging rom the experiences surveyed by this paper, the ollowing steps oer auseul general guide in introducing PSP in the water sector.

(i) Conduct participatory assessments and rigorous demand analysis. Rigorous analysis oneective demand is critical to understand the easibility o recovering costs and thepotential or proft. The size o the market and willingness to pay or improved services


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Putting Lessonsto Practice


are critical inormation to assess the easibility o PSP. Conjoint analysis to understand thedemand or service attributes is complementary to the demand assessment (see unatilakeet al. 2006 or details). In-depth tari analysis that takes into account the eect oprice elasticity on revenues is indispensable. These analyses should be undertaken in a

participatory and transparent manner to ensure public support or PSP.(ii) Examine the existence o an investor-riendly business, policy, and institutional environment.

The right climate begins with an overall broad ramework that spells out the policiesneeded to entice private investment. Maturity o capital markets and fnancial institutes,the capacity o the legal system to protect private property rights, standards o behavioro the private sector (business ethics), and the level o governance and law enorcementshould be properly assessed beore launching PSP in the WSS sector (ADB 2002).

(iii) Study pro-poor service delivery options. As clearly evident, there is a greater chancethat the poorest segments o the society may not be serviced by the private sector. In-depth analysis on the easibility o the pro-poor service delivery should accompany PSPdesigns.

(iv) Use a gradual and stepwise approach. In involving the private sector, a stepwise approachcan be undertaken beginning with a simple arrangement such as a management contract.This allows the so-called test the waters approach beore launching bigger and complicatedschemes. Implementing privatization in phases can also help in determining and selectingthe most appropriate option to involve the private sector. In countries where there ismistrust on the private sector, this stepwise approach helps in gaining public supporteventually determining the political will or PSP-related reorms in the WSS sector.

(v) Broaden the inormation base on risks. Beore entering into any contract, both thegovernment and water utilities should obtain expert advice. Best practices in riskmanagement include careul identifcation, analysis, and ranking o risks by an expertteam beore competitive tendering.

(vi) Establish an eective regulatory body. An eective regulatory ramework must be in placeor PSP to succeed in the WSS sector. Transparency, public awareness, and public relationsare benefcial to regulatory mechanisms. An incentive-based regulatory approach thatreduces inormation asymmetry should be given priority. The capacity o the regulatorybody should be enhanced to ensure eective contract enorcement.

(vii) Tari reorms. There should be an agreement between the government and the privatesector over appropriate tari structures and tari-setting mechanisms. Sound economicsin water management demands that water should be provided at air and reasonable ratesand that proposed rate increases be linked with agreed improvements in services.

(viii) Good relations between the governments and private operators. A synergistic relationship

between the public agencies and the private sector should be ostered.(ix) Consider alternative reorms in the sector. I the enabling business environment is weak,

reorms or the public utility must be considered. Rushing into privatization in developingeconomies, when enabling conditions are not in place, will not only lead to ailures butalso reduce the political will or uture PSP. n the other hand, suitable public sector


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reorms will enhance the perormance o existing water utilities and pave the way orthe uture PSP.

It should be noted that there is no blueprint or introducing PSP in WSS sector. It is essentialto understand and study vigorously the context under which the PSP is introduced including the

culture, political structure, and legal and regulatory ramework o the investment site.

V. CoNCLUDING REMARKs

Private sector participation in WSS as a strategic policy has gained reasonable progress in higherand middle-income countries, although the experiences in the poorest developing countries are notencouraging. pscaling this process in developing countries without thoroughly understanding thelocal contexts under which the private sector can operate can result in ailures. When applied inright environments, PSP can produce socially desirable outcomes. More specifcally, a change in thestructure o ownership (rom government- to private-owned) is not sufcient to make PSP work;rather the presence o an enabling environment that harnesses competition is necessary or success.Conditions under which the private water supplier can be more efcient include an innovativeapproach to competition, eective regulation, good governance and contract enorcement, andsufcient eective demand. Ensuring that these necessary conditions prevail in the developingeconomy is a must beore any PSP in the WSS sector.

Experience has also shown that privatization is not a one size fts all solution or the problemso poorly perorming public water utilities. Thereore, selective application o PSP in the WSS sectorbacked by rigorous prior assessment o its easibility is imperative. When prevailing conditions arenot suitable or introducing PSP, reorming the public utility should be given due consideration asa viable alternative. Such reorms should minimize/prevent nonmarket ailures by enhancing internaland external accountability, customer orientation, and autonomy. In addition, a more independentregulator is critical to making water operations more efcient since sel-regulation is a questionablepreposition. The public and private sectors are interdependent. A well-perorming public sector is a

necessary condition or the success o PSP in the WSS sector. Thereore public sector reorms shouldnot be overlooked in the process o engaging private investors in the water sector.


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aPPendix


APPENDIX 1

MARKEt AND NoNMARKEt FAILUREs: tHE RoLE oF tHE PUbLIC sECtoR

nderstanding the success o the market mechanism may be the best way to comprehend market ailures.Toward this end, the success o the market can be measured using the concept o economic efciency or

Pareto optimality.23 iven resource endowments, technology, and preerences, an economy is said to haveach

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