Dr. Scott Reid, Associate Director Stone & Webster Consultants Tennyson House

1. Investigation into evidence for economies of scale in the water and sewerage industry in England and WalesPresentation of FindingsWater UK City Conference, 21st January 2004 Dr. Scott Reid, Associate Director Stone & Webster Consultants Tennyson House 159-165 Great Portland Street London W1W 5PA +44(0) 207 907 0600

2. Overview • The brief • The existence and evidence for economies of scale in the England and Wales water and sewerage industry. • The impact of mergers on economies of scale. • Trends in scale economies over time, in particular in relation to changing standards and related investments/assets. • Extended to look at economies of scope in the light of chosen methodology • Outline of approach • Main findings • The full report www.ofwat.gov.uk

3. Our study framework • Water companies “produce” multiple outputs • Relevant to how economies of scale is defined and measured • Relevant also to whether economies of scale is what matters • Baumol (1977) - key concept is whether costs are sub-additive • “Scale economies are neither necessary nor sufficient for sub-additivity” • Other dimension is scope economies across different outputs • indivisible inputs, cost complementarity in production

4. Multiple outputs Customer services Sludge treatment & disposal Service function Wastewater and sludge Water distribution treatment Water collection & Wastewater collection & treatment conveyance WoCs WaSCs

5. Definitions and measurement • Economies of scale • defined as change in outputs for a given change in inputs • can be measured by inverse of % change in costs from 1% change in outputs • > 1 = economies of scale • < 1 = diseconomies of scale • Economies of scope • exist if joint production of multiple outputs costs less than separate production • sharing of indivisible inputs across different “products” • cost complementarity in production

6. Water Supply Volumes of water delivered also control for changes in water quality over sample period Number of water connections served Sewerage service Equivalent population served Measure of loads treated also control for rising treatment standards Number of sewerage connections Output definitions

7. Data • Most of the data from Ofwat’s Annual Returns (costs, outputs, capital stocks) • Some “external” sources to measures input prices (labour and energy) and measures of output quality • Looking at the 1992-93 to 2002-03 period • captures most of the post 1989 consolidations • Data set allows industry structure to change • controls for any rationalisation in inputs following actual mergers / take-overs (e.g. capital stocks, labour inputs) • controls for any change in input prices following actual mergers / take-overs (e.g. cost of capital)

8. How we measured economies of scale • Scale measure defined by % change in costs for same % change in volumes/loads and connections • Estimates derived from estimated cost functions • operating cost models, controlling for • Outputs, price of variable inputs, capital stock, operating environment, measures of quality • total cost models, controlling for • outputs, price of all inputs (including capital), operating environment, measures of quality • Estimates evaluated for average size firm in the sample

9. How we measured economies of scope • Horizontal scope economies from integration of water supply and sewerage • % difference in costs associated with integration vs. separation • Vertical scope economies from integration of water production and distribution • % difference in costs associated with integration vs. separation • Measures derived from same cost models as scale estimates

10. Main findings - 1 • Long-run diseconomies of scale observed for WaSCs, but evidence that this is declining

11. Main findings - 2 • Long run constant returns to scale not rejected for water only companies • estimates suggest small economies of scale, but not different statistically to 1 • opex models: • estimate for average WoC = 1.06 (se = 0.11) • total cost models: • estimate for average WoC = 1.11 (se = 0.09)

12. Main findings - 3 • Horizontal integration of water supply and sewerage associated with overall diseconomies of scope

13. Main findings - 4 • Some evidence of scope economies from vertical integration of water production and distribution • By contrast diseconomies of scope associated with vertical integration of sewerage service functions • Direct relevance to competition agenda and Water Act 2003

14. Main findings - 5 • Examined whether data on companies that had been subject to merger with other water companies supported a “shift” in the underlying cost function for that sub-sample • Evidence of: • % change in costs associated with change in outputs is lower for merger companies • % scope economies are higher for merger companies • BUT CANNOT REJECT DIFFERENCES EQUAL ZERO • Statistical insignificance might reflect • insufficient “merger” observations • differences between the mergers

15. Stone & Webster interpretations • Industry structure • Current structure not optimal on economic criteria • Privatisation preserved the inherited RWA structure from 1973 Act • 1973 structure motivated by benefits of integrated river basin management • But 1989 Act separated environmental planning function without re-assessment of the optimal scale and scope of RWA operations • Merger policy • difficult to see case for further consolidation in context of present industry structure of WaSCs and WoCs • But different patterns of ownership might be justified under a different organisation of water supply and sewerage services • Market competition • vertical separation of water supply would lose benefits from economies of scope