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Today, a large share of the world’s population faces acute water scarcity. According to the World Bank, about 1 billion people do not have access to clean water (see World Bank, 2004, p. 1). Due to the ongoing growth of demand, water shortage will be an increasing problem in the near future. The World Commission on Water estimates that more than 4 billion people — half of the world’s population — will live under conditions of sever water stress by 2025. However, global raw water resources are not scarce. More than two third of the world’s surface consists of water. But 97 percent of this water is seawater and 2 percent is locked up in icecaps. As a result, only 1 percent of the world’s water is easy accessible drinking water. Nevertheless, from an economic perspective the entire water resources can be used, even seawater — it is a matter of treatment and transportation costs. Increasing the efficiency, respectively reducing the costs of water supply may be one of the major opportunities to solve the problem of global water scarcity. However, it is important to note that efficiency of water supply will not only be an issue in regions with acute water scarcity such as Africa, the Middle East and South Asia. Also developed regions such as Europe or Northern America face increasingly water resources challenges. One main issue is the increasing raw water pollution, which raises treatment effort and the related treatment costs. A further issue concerns dropping ground water tables. Many of the world’s major groundwater aquifers are threatened or already permanently damaged by salinization. Using alternative raw water resources as for instance surface water would raise treatment costs significantly.

Between 1900 and 1995 global water consumption rose six-fold, from 920 to 5’500 billion cubic metres, which is more than double the rate of population growth. One can expect that due to the extended use of irrigation systems in the agricultural sector, global industrial growth and changed individual habits, such development will continue in the nearer future. According to the World Commission on Water, the water use will increase by about 50 percent in the next 30 years (see World Bank, 2004, p. 1). The allocation of water use will continue to vary significantly between regions and nations. Today more than 20 percent of the world’s population do not have access to safe drinking water. According to the World Bank approximately one half of the people in the developing world are suffering from a sickness associated with bad water (see World Bank, 2004, p. 1). In contrast, total annual per capita water consumption in the United States amounts to l’900 m. However, consumption varies significantly between industrialised nations. In Luxembourg for instance, per capita consumption amounts to only 160 m. Obviously such differences are mainly driven by differences in the economic structure. In industrialised countries, household water consumption amounts to an average of only 5 percent of total consumption, industrial consumption to 65 percent and agricultural consumption to 30 percent (see OECD, 1999, p. 15). In order to have a more detailed view about water consumption, respectively water demand in industrialised countries, it is worth to analyse these three components of water use more detailed. However, this book focuses on the first component, residential use, and only some parts of the second component, industrial, respectively non-residential use.

Traditionally, network industries such as electricity, telecommunications, railways or water supply are regarded as natural monopolies. The duplication of the networks (railroad system, water pipes etc.) would not be efficient and therefore undesirable. Hence, there is no reason to have several firms engaged in the market, because total output could be produced cheaper within a single firm. For a long time, the existence of natural monopolies and quality concerns among other issues served to justify the absence of direct competition. For that reason in many European countries network services were provided by public enterprises or strongly regulated private firms. However, in the course of privatisation and liberalisation, governments and regulators tried to expand the role of competition. Two main possibilities exist in order to implement effective rivalry into network industries: franchise bidding, called competition the market, and product-market competition, known as competition the market. In the piped water industry, there is far more experience with the former approach. However, due to the capital intensity of water supply competition for the market has severe drawbacks. Hence, the introduction of product-market competition may be a valuable alternative. However, both practical experience and theoretical research about the effects and the efficiency of product-market competition are still very limited in the piped water industry. This Chapter analyses product-market competition within a simple model of interconnection where competition is introduced between vertically integrated neighbouring water suppliers.

Privatisation and liberalisation in the piped water industry are not very popular. Opponents of such processes fear that private companies rather optimise short term profits instead of longterm welfare (see WWF 2003 or BMWi 2001). According to a poll, almost the entire Austrian population defeats any privatisation steps in the piped water sector. The German city of Potsdam retracted the water utility privatisation in 2000 since it feared increasing water and waste water fees (see Schoenbaeck et al. 2003, p. 1 and 391). Also in several Swiss municipalities the public voted against formal privatisation which intended to adjust the water utilities’ legal constitution. The concerns about privatisation and liberalisation might root in the fact that water supply is widely seen as a natural monopoly. Hence, it tends be socially optimal to run a water monopoly as public welfare maximising utility instead of a private profit maximising company. In fact, private participation in Europe is not very developed, water supply is usually provided by municipal authorities (see Schoenbaeck et. al., 2003 or EEB, 2002). Extended subsidies from local governments indicate rather welfare than profit maximisation in the piped water sector (see Gordon-Walker and Marr 2002, p. 31). However, due to recent changes in the European legislation, one can expect an increasing discussion about liberalisation. Before 2000 the European Community (EC) excluded the water industry from its competition law — in contrast to other network utilities such as postal services, gas or electricity. Today, water services are neither explicitly included nor excluded in the EC competition law. Nevertheless, in their report for the attention of the European Commission Gordon-Walker and Marr (2002) argue, “there is considerable scope of application of the EC competition rules to increase competition in the water sector”.

The existing organisation of piped water supply in Europe is very heterogeneous. In most countries, water supply is organised on a local level. Historically, the communities are responsible for water supply systems such as treatment and storage facilities or pipe networks since water supply is widely seen as a natural monopoly. In addition, local authorities choose the form of organisation and the permitted degree of private sector participation. Due to these decentralised structures, water supply in most European countries is characterised by a high number of locally operating monopolies. Such local operators often face very different marginal production costs due to differences in production scales and the use of different raw water resources, as for instance surface, ground or spring water (see e.g. Correia and Kraemer 1997). As a result, retail prices vary significantly — even between neighbouring water utilities. The obvious question is how to overcome this puzzling inefficiency. Countries as England and Wales or France introduced a process of privatisation in the water industry. However, as Feigenbaum and Teeples (1983) showed, different ownership structures do not explain efficiency differentials in communal water supply. That means, the pure changing of ownership structures does not necessarily enhance the efficiency of water supply. Rather such process has to be combined with further measures. , there are three ways to improve productive efficiency: concentration, competition or increased trade (see also Ludin et. al., p. 3). In fact, there has been a progressive concentration process in countries such as Belgium or the Netherlands. However, in most other countries concentration is not a feasible opportunity, due to political, legal or geographical restrictions.

Due to extensive shares of fixed costs, network industries such as electricity, gas, railways or water are widely seen as natural monopolies. In such case, it is cost minimising and therefore socially wanted when only one single firm serves the entire market. Usually these services are rendered by public enterprises or strongly regulated private companies. Harold Demsetz (1968) proposed franchise bidding as an alternative to regulation. He argued that auctioning the rights to a natural monopoly would lead to a similar outcome as regulation, but at lower costs. In fact, franchise bidding has often been used in practice. Even though, there is only some experience in the water sector — mainly from France. The success of the auctioning model in the French water sector is assessed ambivalent since competition at the re-auctioning stage is only minor intensive. However, in theory the main criticism of Demsetz’ proposal rather concerns investment incentives than competition intensity. It was Oliver Williamson (1976), who pointed out the problem of long-term specific investments. If the life-time of specific assets exceeds the contract length and transferring the ownership of assets is difficult, the franchisee faces a serious hold-up problem. As a result, re-auctioning a natural monopoly undermines investment incentives. The hold-up problem tends to be stronger in sectors where investment is very specific, long term oriented and hardly to evaluate by a third party. One can assume that investment in the capital-intensive water sector exactly corresponds to these characteristics. Water pipes have technological lifetimes up to 100 or more years and they can not be dug out and used elsewhere. Additionally, investment into the underground network can hardly be monitored by a third party.

In practice, introducing competition in the piped water sector tends to be difficult. Both, competition and competition the market have several drawbacks due to the water market’s specificities. Nevertheless, we can not conclude that competition in the water industry is not useful or possible to apply. The non-existence of competition tends to be an inferior situation – even when the monopoly is driven by public authorities. Experience in practice shows that public water supply does not necessarily secures efficient and high-quality water supply. In both, developed and less-developed countries many governments started to introduce privatisation due to a lack of financial resources or due to a lack of know-how. Privatisation is therefore widely seen as a way to overcome the of public services. However, it is important to note that privatisation itself is not expected to be a superior alternative. For good reasons, one might be even more concerned about private monopolies. Privatisation has to be accompanied by the introduction of competition. In any sector, competition tends to foster technical progress, to increase efficiency and to lower retail prices. Even when water market’s specificities make competition less intense or more complex to apply, it may be useful to introduce at least some degree of competition. However, it is necessary to count for these specificities when applying a competition scheme and when defining the relevant regulatory framework. Regulation has to ensure high quality of supply, high connection rates, efficiency by the use of economies of scale and affordable retail tariffs.