Economic regulation of the water supply industry in the UK: a game theoretic consideration of the implications for responding to drought risk

Abstract

Droughts have tested the water supply companies in UK over the past decade. This paper employs game theoretic modelling to test hypotheses regarding the implications of price cap regulation for resource and supply security. We present an empirical analysis of drought management by ten water companies in UK as a basis for formulating formal games. These games are estimated. The game between the economic regulator and water companies as they negotiate the price cap, indicates that a high price-cap, low capital investment pattern (a variation of the Averch-Johnson effect) is optimal behaviour. The game between water companies as they compete with one another under "comparative competition" indicates that it is optimal for some companies to focus on operational-intensive strategies, and for others to focus on capital-intensive strategies, leading to further additional hypotheses concerning resource and supply security, the viability of bulk water trading and the structure of the water industry.