Local Government Ownership of Water Businesses - Does It Add Value?

Garry Law (1)

Abstract

Local government has not taken up the opportunity to run its water operations as businesses. This paper looks at why this is and discusses some alternative models for the structure of the industry which might encourage a change. The paper argues that local government can play a valuable role in the industry as an owner and a price / service regulator attuned to local needs but for this to work well some reconsideration of the Local Authority Trading Enterprise (LATE) model is needed. More opportunities for competition exist and need to be pursued but these would not be well served by a comprehensive move to regional integrated water businesses.

1. Introduction

Businesses use capital. In using that capital they make a return to the providers of the capital which either exceeds the normal market expectation or falls below it. If they are falling below it, then compared with alternative investments that could have been made, the business is destroying capital.

The question is often asked of a business and particularly of its management by its actual or potential owners. It is not often asked of an owner, if that owner is adding or destroying value (footnote2). However if an owner has resisted putting a business in the form where the question can be answered, then it is a question that can only be put to the owners.

Local government can’t be specific about the value it or its community is getting from its water operations because it simply hasn’t got the operations in a form where it can possibly know . In the circumstance the operations are almost certain to be performing below optimum - they cannot have clear objectives as to what they are optimising.

Given chronic under-pricing of water and sewerage services, the answer to the question in dollar terms must be that councils tolerate a massive destruction of capital in this area, in return for other unquantified benefits.

This paper will review the concepts which have driven corporatisation in the national scene, consider why they have not been taken up at local level in the water industry, consider some alternative structures for the water industry which might reinforce them and alternatively consider some adaptations to the LATE model which might better fit the concepts to the present ownership arrangements and thereby retain the advantages of local electoral accountability.

The alternative structures that will be considered are: ·

2. Status Quo and Corporatisation

2.1 A Reform History

The New Zealand Government put in place a radical reform of New Zealand local government in 1989. In the process of the reform the Government intervened to deal with some issues it saw as strategic for New Zealand’s overall economic performance.

Areas of local government which were fundamentally changed were its involvement in electricity generation and distribution, ports, bus transport, airports and roading services. Local government of its own initiative has tackled things such as abattoirs and milk treatment plants in which it had investment to little obvious public benefit. In this process Government notably left alone a major area of council’s operations, water and sewerage.

One can speculate as to why this was. Perhaps they then saw the sector as being of little importance to the national economic performance. Once government had ceased to make capital assistance grants to local government for water and sewerage, it had no direct financial incentive to seek economies in this area. Perhaps also the tide of adverse public opinion on corporatisations which turned to privatisations and the emotional element the water industry seems to involve, left the government thinking the political pain to economic gain ratio was wrong. In the event the government put into the Local Government Act a provision for forming local authority trading enterprises modelled very closely on the state owned enterprises legislation of a couple of years priority and left it to local government to take the initiative if it chose.

It is now coming up to 9 years since that occurred. It is interesting to review the outcome.

Local government has used the LATE model quite a lot for some of its services. However in the water / sewage area the outcome has been the formation of one LATE on the model of the state corporatisations (footnote 3). This is Metrowater owned by Auckland City Council. The other water LATE, Watercare Services Ltd, was formed under government legislative requirement and in rather peculiar circumstances otherwise and does not count as an example of a voluntary transition. Given the narrowness of the Auckland City Council vote to set up Metrowater and the subsequent reversal of a tax free status it thought it had achieved, it is not unreasonable to suggest the count of water LATEs might equally well be none(footnote 4). Elsewhere in Auckland establishment units in Waitakere and Manukau recommended LATEs be formed but the Councils rejected these after well organised local opposition.

In short, if Government thought its process with its own businesses was a model local government should follow for water and that the logic of this would descend on local government as it did for them, then the outcome is a failure.

There are multiple reasons for this. Some of these relate to circumstances in local government but others relate to the model which was offered. The model can be made to work but it needs special adaptation for this industry. In the absence of intellectual work put in by central government to developing a water industry model, comparable to say the work in the gas or electricity industry, local government has floundered with the issues.

Is the LATE model worth reviving and changing to better fit it to the present industry circumstances, or is a more radical approach to structuring the water industry warranted? To address this we need to look at why the SOE model hasn’t fitted, see if it can be changed to better suit and look at some alternative structures.

2.2 The State Owned Enterprise (SOE) Model

The fundamental elements of this are: ·

This all had major effects on the businesses, the finances of government and indeed radically changed the role of government. It is a model now applied widely by governments around the world, but not at home, by local government for their water businesses.

2.3 Reform in the Water Industry

Local government of course has not done nothing. It has picked up on many of the business improvement aspects commonly used in commercialising entities and applied them.

One can list many of these; contracting out operations, capital works creation design and management; definition of customer standards; use of customer charters; strategic planning; asset registration; asset management planning; customer support systems and the like. All good stuff, but it has avoided the critical issues which come with actually setting the operation up as a business. This local government has manifestly failed to do with its water operations (footnote 5).

I exclude from this the route that Papakura District has taken. It clearly has addressed the issue and decided water and sewerage is a business it did not want to be in and taken one route to deliver on this conclusion, that of franchising the operation. If one takes the corporatised Australian industry as some sort of bench mark of reform, then the New Zealand industry can be measured against it. Appendix I is a personal evaluation of that, showing the transitions the Australian industry has been making and a comparison, on an arbitrary scale, of the New Zealand progress. It will emphasise the point made above. In some areas the adoption of new ways has been commendable, but overall it is within a different paradigm.

Does the SOE model have some fundamental problems when applied in the water sector?. Reviewing the fundamental points above:

Area

Comment on Local Government Applicability - Particularly Water Businesses

De-regulation for competition. This has not happened. Local government has been left with the public health responsibilities in respect of provision of service, with the taxation powers for the service provision, with the service location and access rights and by-law powers in respect of its own service provision.
Light handed regulation . With a business without effective competition, local government politicians are not prepared to give up service standard and price control. It does not see in the Statement of Corporate Intent (SCI) process as adequate control over this, nor was the SCI designed to take up such regulatory roles.
Removing community service obligations or paying for them explicitly . The concept has been little explored in this sector. Local government fundamentally views the sector as a service, not a business, so the concept of separation does not arise.
Removing financial guarantees . With the chronic under-pricing of water and sewerage services there is a problem here. Normal capital structures reflecting the deprival value of the assets are simply not creatable without massive price changes. Hence some ongoing subsidisation seems to be required. Perversely, because water operations can be strong cash generators some in local government think of them as profitable entities they do not want to lose.
Full tax liability . Full tax liability A critical point. Local government organisational units are not subject to taxation on profits. LATEs are. To use the American phrase, "does a turkey vote for Christmas?"
Narrowing owner representation. The tradition in New Zealand local government is for delegation to committees or officers. The concept of elected local body politicians having cabinet minister-like roles is foreign.
Setting up the business as a separate legal entity. There is a transaction cost here in both establishment and operation which may be a disincentive for smaller councils.
Setting as goal of being a successful business. See above in respect of community service obligations. Without a clear separation of these the concept of a successful business objective is resisted.
Appointing commercial boards to run the businesses. Again while service obligations loom so large politicians are reluctant to let go their control as community representatives. Directors fees are seen as an extra cost.
Removing constraints on the businesses servicing. Central corporate service providers are threatened by this and seek to retain present structures which sustain their business volume and power in conventional council structures. They have far more political access than equivalent State providers in the SOE creation.
Contesting the valuation of the businesses. The considerable task of getting together an asset register and valuing the items on it has undoubtedly been a barrier to progress. Few started the decade with these and even now many are laggards. The contrast between deprival valuations and conventional business valuations based on cash flow, is a further problem.
Leaving market forces to rationalise staffing, cost structures, pricing and capital programmes. There are no competitors, hence there is no market pressure. Electoral accountability leads politicians to want close control on the pricing and capital spend, in detail, not at once removed, or over general levels. Transfer of staff diminishes the size of the jobs of council senior managers. Transfer of staff is resisted by the staff themselves, who use local political influence.
Privatise. Political suicide, given the lack of public sympathy for privatisations but especially when there no competitors to give consumer sovereignty, or regulation to protect customers in the absence of competition.

Setting as goal of being a successful business See above in respect of community service obligations. Without a clear separation of these the concept of a successful business objective is resisted Appointing commercial boards to run the businesses. Again while service obligations loom so large politicians are reluctant to let go their control as community representatives. Directors fees are seen as an extra cost. Removing constraints on the businesses servicing Central corporate service providers are threatened by this and seek to retain present structures which sustain their business volume and power in conventional council structures. They have far more political access than equivalent State providers in the SOE creation. Contesting the valuation of the businesses The considerable task of getting together an asset register and valuing the items on it has undoubtedly been a barrier to progress. Few started the decade with these and even now many are laggards. The contrast between deprival valuations and conventional business valuations based on cash flow, is a further problem. Leaving market forces to rationalise staffing, cost structures, pricing and capital programmes. There are no competitors, hence there is no market pressure. Electoral accountability leads politicians to want close control on the pricing and capital spend, in detail, not at once removed, or over general levels. Transfer of staff diminishes the size of the jobs of council senior managers. Transfer of staff is resisted by the staff themselves, who use local political influence. Privatise Political suicide, given the lack of public sympathy for privatisations but especially when there no competitors to give consumer sovereignty, or regulation to protect customers in the absence of competition.

It should be clear from this list that there are a good number of barriers which have prevented the adoption of the LATE model in water businesses. Generalising these they are: ·

This is a discouraging scene for one that believes that the gain of corporatisation is well worth the pain. Undoubtedly some gains are being foregone which will only arise in a commercial structure.

2.4 Local Government - Different Needs (footnote 6)

This may seem a rather one sided view of the issue. Local government is different. It is different because it is local. It is its ability to work at a local level which is the key to the difference. The difference is well known to people who work in the area and not always known by people who have worked in commercialising higher levels of government services. All of a local government’s customers see all of the services. They can better judge value for money across the board because they see them all and because the services are more tangible.

Local government customers expect our services to be connected to each other. They expect integrated outcomes - a townscape which works practically and aesthetically, development which is sustainable, services which don’t conflict with each other.

Local government customers hold the councilors accountable for council services in a much more detailed way than at other government level. This is not surprising for it relates to the local character of the services and to representation ratios. The table below shows the representation ratios of different government levels. Residents per representative for different government levels

Government Level Population per Representative
National

30,700

Local (Auckland City)

14,200

Further, local government customers expect their local government to concentrate on servicing their local territory and not operate as entrepreneurs seeking to provide services elsewhere if that is where best advantage obtains. They also believe councils have an obligation to provide service. Legally this is not always the case but the expectation is powerful.

A commercial business wants a number of fundamental things: ·

Trading operations formerly run as government services have had these rules run over them as they have been corporatised or privatised. It is the tests lower on the list that have been drivers for freeing some businesses from government ownership as they will perform better in those areas, free of the restraints of political owners.

These ideas are not as readily applied in local government as they have been elsewhere. The reason is not just parochial interest, or provider capture, though these are factors. It is more from the difference between the levels of government.

If we approach the provision of local government service delivery with the same stance as has applied in other levels of governments we would separate service or product streams into businesses and corporatise them, allowing them to operate as businesses in the ways listed above and importantly interact directly with customers in their own name, servicing and billing them directly and marketing directly to them. How does this fit with the different face of local government? In the table below the crosses represent areas of conflict between the customer expectations of a council and the business wants.

Match Of Business Requirements With Customer Expectations

As can be seen there are many conflicts. The model be made to fit but only with some adaptations to both the LATE model and to the traditional ways in which councils work.

3. An Adapted Model Of Corporatisation

3.1 Reform in the Australian Industry

Australian public sector businesses are undergoing a nation-wide process of reform as a result of the National Competition Policy adopted by the Council of Australian Governments. The key elements of this are: ·

There are some specific reforms for the water industry which come within this. Some of these are: ·

The latter list may be seen as rather prescriptive compared with the first. It reflects a past view of the Federal authorities that the opportunities for competition in the water industry were limited and hence it is only more commercial behaviour that is broadly achievable. There are now a good many in the water industry there who do not share this view.

It may be thought in New Zealand that the Australian industry, having been largely corporatised, might be thinking it was in a more stable period. This is not the case. Its leaders now are people who believe in competition. They are also people who do not like being regulated - they would rather be working in fields where markets set as many of the standards as possible. They are looking over their shoulders at the sorts of more-market approaches which are being taken in the other utilities in Australia and asking "is this applicable to us as well?" There is also a defensive motivation - "if we do not take the initiative here then some of the models used in other utilities might get applied here as well".

The prospects that third party access might open are receiving particular attention. The potential for of competing businesses for retailing and provision of local reticulation (this being part of potential third party access) are particular threats. The threat that the large electricity and telecommunication utilities pose in the retailing area is recognised. There is the potential for these opportunities to be opened up entirely through third party access rules independent of any industry structure considerations. Australia then is not only a step ahead of New Zealand in water industry reform, it is potentially going even further.

3.2 Competition

In considering the structure of the industry the potential for competition is a good place to start. Firstly enhancing competition should enhance innovation and in the pursuit of better customer service quality and value. Where there is competition the need for regulation of close political control can be readily foregone. Where are there new opportunities for competition in the industry? The service can be disaggregated as follows:

In some circumstances separation of the bulk services is not a consideration.

Different businesses operate in different sectors. Watercare and the Wellington Regional Council only operate in 6 and 7. Metrowater operates primarily in 1, 2 and 3. United Water in Papakura operates 1, 3, 4 and 5. In Australia, Melbourne Water is 6 & 7 while the retail businesses there each cover the remainder. In Brisbane the water business unit, Brisbane Water, covers 3 to 7. The Council retains the others. Sydney Water Corporation does everything, while contracting out parts of 5. In Adelaide SA Water covers 1, 2 and the ownership function of 6 and 7, while United Water covers the remainder.

Clearly different industry structures are possible with different allocations of these roles.

At the most fundamental disaggregation, what are the opportunities for competition?:

Element

Potential for Competition

1. Customer Interface Considerable. Providers need a call centre, a billing system and a system for handling the interface to the providers, particularly in respect of customer service problems. Many utilities have these. The multi-utility looms. However this is a small part of total costs.Where there is potential for customer service providers to deal directly with competing providers of element 7, the scope expands considerably.
2. Retail Network Owner Potential for ownership competition at first installation in larger additions to systems but becomes a monopoly beyond that. Some customers may have the ability to bypass to bulk reticulation. Yardstick competition only in the larger scene
3. Retail Network Manager (Facility Management) Potential for competition. Would need reasonably long contracts for start-up cost to be worth while. Potential for competition. Would need reasonably long contracts for start-up cost to be worth while.
4. Retail Network Operator Potential already demonstrated.
5. Retail Network Maintainer Potential already demonstrated.
6. Bulk Reticulation Provider (where applicable) (footnote 10) Essentially a monopoly. There can be some potential competition at the margins where some customers may have the ability to bypass, or have own sources.
7. Bulk Treatment / Source / Disposal Service Provider (where applicable) Some potential for DBO BOO BOOT type competition on large new works, but this is a rare opportunity. There may be some potential for splitting up businesses to create competition but network flexibility is often low, and community tolerance of redundancy necessary for real competition untested. Retailer own sources is a potential area.

A model for having competing retailers is the mobile phone access providers which have competed for business in New Zealand. The real potential is for providers who sell more than one utility service and apply the same customer interface skills over all of them.

It might be thought there is little opportunity for different retailers to differentiate the service. It is all the same water the customer gets. This is a rather engineering oriented view of the world. Can water service be differentiated? The following shows some potential areas of differentiation.

Basics: ·

Add Ons: ·

A green purchasing option already happens in Australia in the energy sector. Some customers pay more to support purchase of wind generated power. The benefit is not local. A retailer operating across several disconnected sewerage schemes could still potentially offer opportunity to support more advanced practices provided one of the systems offers the opportunity. Environmentally aware customers, thinking globally, may still purchase even if the benefit is not local.

A major consequence of third party access is the pressure it puts on the reticulation provider to have access prices which are very strictly cost reflective. Any cross-subsidisation is an opportunity for a retailer to "cherry pick" the overcharged.

Local government may see itself as being the provider of right in respect of retail services. This is a narrow view. It may be more true of the reticulation provision but it is not true at all of the retail function.

Local government has some powerful advantages as a retailer in: ·

However these will need to be worked on if they are to be realised as advantages in a competitive market. A summation of this is that there are opportunities for competition beyond those currently operated. However they do need some different concepts of structure of the industry to be considered. The creation of third party opportunities is a potentially very powerful driver of change. New Zealand could do well to look at a similar regime as Australia.

3.3 Fixing the LATE Model for Water Businesses

A local government potentially has five different relationships with a service business that it owns: ·

The first two are not of concern here. The last three tend to be considered in terms of the SCI of the business. However this is an inadequate tool for the purpose. It is oriented towards the investor interest as it was conceived of as a tool for businesses operating in competitive markets. The council has a legitimate role beyond being an investor, in determining the service area of a water business, in determining its base customer responsiveness and its base service standards. There is no market to determine these. I believe these issues are best addressed in a parallel document to the SCI - a service agreement. This will be like a customer contract in some regards. What it is doing though is keeping the fundamental customer contract as being between the council and the customer - not the business and the customer.

It is for the council to set and monitor this agreement. Most importantly it needs to maintain an energetic public stance that this is the role it continues to take. The business has not been given a licence to set its own service standards. To do this service regulation effectively there must be a resource available to council outside the resources of the business. In larger councils this requirement may need to have its own specialist staff. Alternatively, consulting resources could be looked at, for what would be a task with a seasonal peak.

The council also needs to be the moderator of prices. It can do this through the same agreement.

Where the council requires the business to do something it would not do by its own commercial choice in the way of pricing, or determining a service area or a service standard above the norm, then the council needs to be told the cost by the business and make its own decision as to fund it or not. It is only by being this explicit that pricing cross-subsidies will be exposed and challenged as to their need. Council is quite entitled to have services provided by the business for social ends. It is only with this sort of separation that it will ever know the cost of them and be able to best prioritise its expenditure. If these community service obligations are submerged within a business unit they will never be seen. If they are dealt with entirely through an SCI there is the risk they will be traded for under-performance on new investment (footnote 11) rather than the cost made explicit.

Councils should also look to get cost reflective pricing signals from the business. It may do this best if it asks the business to operate with an accounting separation between its retailing function and it pipes business. Further, it should be challenging the business to look at the possibility of just concentrating on the capital investment side of the business and look to contract out its facilities management.

None of this requires any change to legislation. What is needed is just the concept that a business with market power, like a water business, is going to be regulated by council through more than just monitoring its financial performance. It is the council that will continue to be the party that represents the disempowered customers on matters of price, access to service and service standards. If councils do this well and sell it to their constituents they may avoid the current suspicion of corporatisations and be able to sell the advantages.

What does need Government action, is the lack of legislative powers for commercial entities in the water business. At the moment only councils have them and they are unnecessarily coercive. This needs urgent attention to remove those from councils that are unnecessary or anti-competitive.

Further I believe Government would do well to look at promoting a regime which opened third party access as a right in the water industry. It could well have magical effects in removing the price distortions which a century of political pricing have left us with.

4. Franchising

This is a somewhat neglected alternative. While we have looked at the SOE model, the Australian corporatisations and the England / Wales transition of corporatised Water Boards, succeeded by privatised companies, we have rather failed to notice that the scale of the ownership structures of these is not local - they are much larger units of government than local government in New Zealand. The mechanisms those States have adopted using price and service regulators, customer councils, of requiring customer charters and public reporting against them, are devices which are created to increase accountability of the businesses, because the owning (or regulating in the case of the UK) unit of government is only weakly accountable electorally for the particular service.

In contrast the French model of franchises (noting that there are several different sorts) is a model particularly adapted to local government, for in France as here the infrastructure is typically local government owned. Commentators on the French industry often note the close relationship between the franchisee and the mayor of the franchising local government. Others comment on the accountability the mayor has to the constituents for the larger picture aspects of the service. France noticeably lacks the sorts of powerful utility regulators which are found in Britain and the USA. These become the centre of much utility and consumer group attention, to the dis-benefit of customer focus by the utility. It is ironic that the French water companies, who have been rather demonised here as representing the face of privatisation on the British model, in fact work at home in an industry highly attuned to local government ownership and needs.

Papakura is a model which many will be watching with interest. Listening to industry buzz suggests they achieved a very competitive price, perhaps with a reasonable dash of first mover advantage in the preparedness of the bidders to win this foothold at some cost to normal margins.

However, as demonstrated above, a franchise is a bundling of a series of elements which are potentially contestable individually. Bundling them means some potential competitors are excluded. It also tends to push the term of the franchise towards that needed by the element where a long term is needed to recoup investment. In short, it favours long term contracts with the problems they have of meeting changing circumstances, getting new elements competitively priced and where old elements are discontinued, having them exchanged for fair price reduction.

New Zealand local governments have a suspicion of long term contracts. Not many have a management culture well attuned to long term relationship management across contractual boundaries and the risks this entails. These are undoubtedly considerable barriers.

5. Larger Industry Units