The Economics of Water Nationalisation

Here is a suggested answer to a 25 mark question on the economics of water nationalisation.

Question:

Evaluate the argument that the interests of consumers would be better served by returning the UK water industry to state ownership. Use appropriate diagrammatic analysis in your answer (25 marks)

Point 1

One argument for nationalisation is that it would then allow the regional water utilities to operate more in the public interest with lower water bills for households which then increases their economic welfare. This is because nationalisation involves a transfer of ownership from private to public sector. As a result, state-owned utilities can run with different objectives. Instead of aiming to maximise profits and returns for shareholders (Extract B says that Thames Water has paid out £2 billion in dividends in ten years) a public sector utility might switch from profit maximisation to pricing closer to an allocatively efficient price equal to marginal cost. This is shown in my analysis diagram. Consequently, lower water bills for households increase their consumer surplus and effectively increases their real incomes. This might be particularly relevant to millions of households on low incomes who struggle to meet bills and save at the same time. Nationalisation might therefore be in the best interests of consumers.

Point 1 Evaluation

A counter argument to this is that state-owned water utilities would be likely to make less profit than if in the private sector. This is partly because prices would probably be lower relative to the average and marginal cost of supply. But also because, without the discipline of shareholders and stock markets, there is the risk of X-inefficiencies due to to the lack of competition in the industry. If profits are lower, then there will be less profit to reinvest into the water supply network e.g. to reduce leakage rates and improve water quality. Extract B says that Thames Water “has invested more than £1bn in expanding and improving its treatment works.” Lower profits also reduces the corporation tax revenue that the government might expect to generate each year.

Point 2

A second argument for taking water back into state ownership 30 years after privatisation is that the industry is essentially a natural monopoly and as such is not suitable for the usual types of competition between rival suppliers. Natural monopolies in the state sector can achieve economies of scale leading to big gains in productive efficiency and value for money for taxpayers. With a natural monopoly the total fixed costs of operating the water supply network (from reservoirs to ”dedicated pipe networks” and treatment of waste water) are huge. This means that the average fixed cost and average total cost of supply will fall as more households and businesses are connected to the network. As a result, long run average cost will fall due to internal economies of scale. This means that, if water is in the public sector, average household bills can be kept relatively low and the industry can benefit from higher levels of capital investment funded by government, who can borrow £ billions at lower long term interest rates than the private sector. Investment is important in cutting leakages and therefore helping to address growing problems of water scarcity as the population grows.

Point 2 Evaluation

In evaluation, the ownership of a business or industry is only one factor influencing its performance and the impact on customers. It is important to judge businesses on a case by case basis. Some water utilities have performed better than others in keeping their costs low and investing to increase supply capacity. It also depends on how an industry is managed and regulated. Providing the regulator OFWAT is prepared to use their powers when setting prices and fining (e.g. Extract B mentions that “in 2017 Thames Water was fined £20m for releasing raw sewage into the Thames) then the sector can improve meeting the changing needs of households and businesses. A good example is the billions of £s being invested building the new London super-sewer.

Final reasoned comment / evaluation

Overall, I would argue that the case for nationalizing the water industry should be made on economic rather than political grounds. The natural monopoly aspect of the industry suggests that genuine price competition is unlikely. Extract A contrasts water privatisation with electricity and gas. This points to state ownership based on social objectives as convincing. However, I argue that the powers of the industry regulator OFWAT – acting as a surrogate for competition – should be strengthened. They need to avoid allegations of regulatory capture and maintain tough price regulation and higher standards of service year on year so that water utilities meet their environmental targets. Households and businesses want a reliable and clean water supply at an affordable price. A well regulated private sector can achieve this best in the long run.