Urban water: monopolies in the making?

OPINION

Recently, Tim Hunter wrote an NBR column on Why privatising Watercare is a bad idea. Tim’s article highlighted the issue of how best to finance and manage urban water infrastructure.  

Volumetric charging for water use means councils are able to make a return from their water infrastructure services. This approach means council owned water utilities increasingly resemble other network monopolies such as gas pipelines and local electricity lines companies.

There is an important policy debate to be had around whether the current regulatory environment is best placed to ensure urban water services are provided efficiently and effectively.

Valuable assets
Local authorities collectively own over $10 billion water supply infrastructure. This infrastructure is typically composed of fresh, waste and storm water networks, along with water storage and treatment.

Large sums are spent each year to provide these services. Watercare alone plans to spend $2.2 billion on its fresh and waste water infrastructure over the next decade.

These assets not only have immense value in a commercial sense. They provide essential services as well. Given their significance, it is highly importance that water services are regulated effectively.

User pays
The basis by which councils recover costs for these assets is changing. An increasing number of local authorities are charging for actual metered water usage (mainly for fresh water, but there is also a partly volumetric waste water tariff in Auckland).

The benefits of metered water charging are two-fold.

First, charges encourage the efficient allocation and consumption of scarce water resources. Demand for water, and thereby the demand for water infrastructure, is reduced as a result.

Secondly, charges allow for direct cost-recovery, raising revenue that can be used to maintain and upgrade infrastructure.

Natural monopoly
Tim’s article was driven by recent reports by Cameron Partners and EY on alternative financing sources for Auckland Council. In particular, the EY report identified Watercare as a potential candidate for partial privatisation.

And it’s easy to see why Watercare would be an attractive investment. It has a valuable asset base and annual revenue of around half a billion dollars.

Watercare is also arguably a natural monopoly.

Due to high fixed costs, it is very unlikely that another entity is going due to duplicate Watercare’s networks and compete.

Because of the limited prospect of competition, natural monopolies have less incentive to provide an efficient level of pricing, quality and innovation.

Economic regulation
Part 4 of the Commerce Act is the main tool used to guard against the negative effects of monopolies. This regulation typically consists of:

• Information disclosure to encourage transparency.

• Price or revenue restrictions, which aim to ensure revenue does not exceed costs (including an appropriate return on investment). 

• Quality standards, which aim to ensure services meet key performance levels.

To varying degrees, electricity lines and gas pipelines are subject to these requirements (including companies significantly smaller than Watercare).

Of course, Part 4 is not the only form of economic regulation in New Zealand. The copper network is subject to its own statutory regime, for example.

Checks and balances
Water utilities are currently not subject to utility style-economic regulation like Part 4 or the copper network.

For non-Auckland water services, the current framework relies on councils to regulate price and quality (subject to other requirements, such as the Health Act). While councils can contract out water services for up to 35 years, they must retain: 

• Legal responsibility for providing water services.

• Control over water pricing and water policy.

Overall, the primary check on the quality and efficiency for these water services is political accountability. There is limited commercial imperative to ensure price or operational efficiency.

The Watercare Difference
In contrast, Watercare is specifically mandated by statute to manage its operations efficiently. It must minimise costs whilst maintaining the long-term integrity of its assets.

Watercare also cannot pay a dividend. Any profit must be reinvested into its services.

While the statutory controls on Watercare subject the organisation to enhanced efficiency objectives, there is still no independent regulator assessing the efficiency of its operations. Indeed, potential issues with Watercare’s regulatory model (identified in the EY Report for Auckland Council) include:                                                                                          

• Diminished incentives for operating efficiencies (as there is limited incentive to make a profit).

• Risk of ‘gold plating’ assets (due to the absence of an economic regulator like the Commerce Commission).

Future pressure
Councils are under increasing pressure to both contain rates rises and deliver quality services. It is entirely plausible that there will be a temptation to pursue higher and higher user charges for water, if this means keeping headline rates rises under control whilst maintaining service levels.

This trend will make it increasingly difficult to distinguish water services from local lines companies, which raises the question - is there a reason why one should be subject to independent economic regulation, and the other not?

Moreover, it may well be that operators are currently providing effective and affordable services. However, are we confident that the current regulatory regime will guarantee this going forward?

These are questions worthy of investigation.

Guy Finny is a solicitor at Minter Ellison Rudd Watts