Private firms can quickly become inefficient and wasteful when sheltered from competitive market forces. That being said, in many cases water privatization can improve infrastructure, lower costs and provide residents with the clean, safe water they expect.
After the Flint, MI water crisis earlier this year, some suggested that the city should privatize its municipal water service. This suggestion was met with criticism and arguments that privatization fails to improve quality or decrease costs. Others simply don’t like the idea of a private company having anything to do with the production of one of life’s necessities. But the private production of water and sewage services is often advantageous for consumers and taxpayers, and it’s more common than many people realize.
Before we discuss the pros and cons of privatization, it’s necessary to specify what privatization entails. In her work on common pool resources, Nobel Prize winner Elinor Ostrom defines providers as anyone who arranges for the provision of a good or service. Producers, meanwhile, are anyone who constructs, repairs or takes actions that ensure the long-term survival of the product. Often they are one and the same, but not always. Under many privatization agreements a water company becomes the producer—being responsible for infrastructure upgrades, repairs and daily water production—while the municipality remains the provider and ultimate owner of the infrastructure.
Privatization in the United States
In their recently released 2016 Annual Privatization Report, the Reason Foundation provides some insightful survey data from the Public Works Financing annual water partnerships survey. First, the size of the water/wastewater outsourcing market was $2.2 billion dollars in 2015, up 5% from 2014. More than 2,000 water facilities operate under some sort of public-private partnership, including those in some large cities such as Milwaukee and Tampa.
Nearly all of the municipalities currently using a private water company are satisfied with the service they are receiving. From 2006 to 2015, 2,529 municipal contract renewals came up and 90% were renewed, as shown in the table below.
More generally, there is no compelling economic reason for local governments to be the sole producer of water. Harvard Economist Andrei Schleifer has written extensively on private vs. public ownership, and one of his key points is that public ownership may be preferable to private ownership when there are significant opportunities for deteriorations in quality that cannot be adequately avoided via contracting.
As an example of this Mr. Shleifer cites prisons. In order to increase profits, private prison operators may replace highly trained, expensive prison guards with poorly trained, cheaper guards who mistreat prisoners. This deterioration in quality is hard to prevent with a contract since it is difficult to specify the proper training in words and difficult to ensure that the guards consistently act in accordance with the appropriate standards.
Water, however, does not meet this criterion. First, water quality is relatively easy to contract for; simply specify the allowable amount of the various contaminants. Water quality is also relatively easy to monitor, and compared to prisons there are more people interested and capable of monitoring it—consumers, government officials, media and watchdog groups.
A public-private partnership has several benefits versus a completely public system. First, private firms often operate in many different jurisdictions, which means they have more experience and are able to institute best practices based on their accumulated knowledge.
Second, there is more oversight. The firm has an incentive to provide the specified water quality in order to maintain their business with the city and to avoid being sued for breach of contract. Local government officials can easily monitor the firm since they only need to focus on water quality and availability. If either the government or the firm fail to do their job, the other entity can alert residents.
Third, private companies are often better situated to maintain the infrastructure than public ownership, and public choice analysis helps explain why. Under complete government ownership, rate increases are a political decision rather than a business decision. There is a strong incentive for government officials to keep rates low, especially during election years, since rate increases rarely lead to votes.
Moreover, it’s difficult for politicians to commit to making necessary infrastructure improvements since the deterioration of a city’s water infrastructure is a long process that’s hard for the average voter to notice. A politician can get more votes by allocating tax dollars to conspicuous things like additional policemen or shiny, new fire trucks—it’s hard to trot out a new water main at a campaign rally.
Low rates may satisfy consumers in the short run, but they often lead to neglected capital improvements. A report released last year by the American Water Works Association estimated that America’s water infrastructure needs $1 trillion of investment over the next 25 years, or $40 billion per year!
Some opponents of water privatization note that it sometimes results in rate increases rather than the decreases often touted by its proponents. The evidence on whether rates rise or fall is mixed, but considering the underinvestment over the last several decades, some rate increases are inevitable, regardless of public or private provision. In fact, many municipalities, especially smaller ones, are engaging in some sort of privatization in order to ensure that their infrastructure complies with stricter environmental and testing regulations.
The importance of competition
Municipalities that privatize their water systems can enter into short or long term contracts, and each has its pros and cons. Short-term contracts increase competition since firms will have to compete more often for the right to manage the water system. The drawback is that firms will be less willing to invest in costly infrastructure improvements since shorter contracts mean less time to recoup the large, upfront costs.
Alternatively, long-term contracts provide firms with an incentive to invest but decrease the benefits of more frequent competition. Entering into a long-term contract may require more diligent oversight on the part of city officials since the firm will not be subjected to the same level of competition.
If a city only wants a firm to operate the water system while it retains the responsibility for infrastructure improvements, then a short-term contract is more appropriate. If a city lacks the expertise or cannot afford to make the necessary infrastructure improvements, then a long term contract will likely be required.
City officials and residents need to remember that privatization itself is not a panacea. The key to effective privatization is maintaining competition. Private firms can quickly become inefficient and wasteful when sheltered from competitive market forces. That being said, in many cases water privatization can improve infrastructure, lower costs and provide residents with the clean, safe water they expect.