Policy Study

Privatizing Infrastructure

Options for Municipal Water Supply Systems

Executive Summary

Many municipal water-supply systems in the United States face serious problems associated with capital deterioration, deferred maintenance, unreliable water supply, and underpricing of services. In addition, local governments are projected to fall $17 billion short of the estimated $49 billion cost (1993-2000) to comply with the Safe Water Drinking Act amendments.

Because municipal water-supply systems, frequently publicly owned and operated, face little capital-market competition and generally cannot go bankrupt, they lack incentives to operate efficiently. Private systems also face operational and management problems as a result of rate-of-return regulation and unequal tax treatment with publicly owned systems. Rate regulation removes incentives to innovate and adopt least-cost practices. In addition, in contrast to municipally owned systems, privately owned systems pay taxes, do not have wide access to tax-exempt funds, and thus operate at a considerable competitive disadvantage.

Privatization in the form of long-term, competitive-franchise agreements or asset sales, introduces elements of competition that can generate incentives for efficient water-supply system management. France currently uses the franchise model to provide water to over 75 percent of its population. The United Kingdom now provides water to nearly 100 percent of its population through fully privatized watersupply systems. A growing number of other countries-including Argentina, Australia, Chile, and Italy-are turning to similar privatization models to gain private-sector operating expertise and investment.

In the United States, the over 300 operations and maintenance contracts between private operators and municipalities are a form of competitive franchising. These contracts, which generally run for five years, have achieved cost savings of between 20 and 50 percent. Contractual performance and cost guarantees enable municipalities to secure operation’s accountability. Removing state and federal laws that restrict the length of contracts would give private contractors more opportunity to make and finance capital improvements, and hence increase potential cost savings.

Compared to competitive franchise, implementing full privatization would be considerably more difficult, but could yield greater benefits by taking advantage of the stronger incentives associated with private ownership. Moreover, the 1989 sale of Britain’s 10 major public water authorities, for example, had the important advantage of identifying $40 billion in investment needs and arranging for the investment to be financed through private-capital markets and rate increases-not public subsidies.

To remove the need for rate regulation, privatization transactions could be structured so that private companies become wholesalers and not retailers of water services. Problems with “cost-plus” rate regulation could also be addressed by replacing it with price-cap regulation. Used to regulate an increasing number of utility services in both the United Kingdom and the United States, this incentive regulatory approach partially decouples compensation that the utility receives from actual cost incurred by linking changes in the price of the regulated service to changes in the retail price index.

To level the “playing field” in which publicly owned and privately owned systems compete, publicly owned water-supply companies could be transformed into standalone, government-owned enterprises subject to the same tax and regulatory policies as private water companies. Both this transitory phase and full privatization would expand a municipality’s tax base, encourage full-cost pricing, and lead to less reliance on all levels of the government to finance the cost of upgrading facilities and meeting state and federal drinking water regulations.