Regulation under Asymmetric Information in Water Utilities

Abstract

Water utilities are reminiscent of network industries and are characterized by important fixed costs. These factors contribute to a single firm serving an area justifying public intervention on pricing. About one-fourth of U.S. water utilities are private and subject to regulation. Regulators are unlikely to be perfectly informed and regulation is unlikely to be costlessly implemented. These inherent imperfections have led economists to consider the incentive properties of regulatory procedures using the economics of information (see David Baron, 1989). The empirical literature on regulation has focused on evaluating the effects of regulation on prices, firms’ costs, efficiency, and innovation in such sectors as airlines, electricity, and energy, as surveyed by Paul L. Joskow and Nancy L. Rose (1989). Few of these empirical studies rely on the so-called theory of regulation. Regarding the water industry, there is an abundant literature on residential water demand, firms’ cost, and their efficiency, given their public-versusprivate nature. Relying on a model with asymmetric information and a sample of California water utilities, Frank A. Wolak (1994) assesses the consumer welfare loss due to asymmetric information and shows that the model with asymmetric information provides a superior description of the cost and demand data to the model under perfect information. Analyzing pricing for residential water is an important policy issue as the sector recently experienced price increases. The problem is even more acute in California because of a high residential demand for water along with population growth, water scarcity, and the probability of severe droughts. Relying on a new dataset of 32 districts in California over the 1995–2000 period, we analyze regulation of private water utilities. For every district, the California Public Utilities Commission (CPUC) chooses a price for water, an access fee per meter, and a rate of return on capital to satisfy firms’ revenue requirements. We assume that the CPUC is imperfectly informed about firms’ labor efficiency. Following David Besanko (1984) and Wolak (1994), we develop a model in which the firm’s capital is used as a screening variable. In particular, the model has the features of a rate-of-return regulation. We show how the rate of return and the access fee can be determined optimally to control firms’ rents. We then adopt a structural approach to analyze the data. A multistep estimator allows us to estimate the key parameters of the model. The empirical results show price inelasticity, an income effect, slightly decreasing returns to scale, and a concentration of efficient firms. The computation of the optimal rate of return and access fee shows that the CPUC would tend to be cautious by allowing a lower-than-optimal rate and access fee. Relying on the estimated parameters, a first experiment evaluates the cost of asymmetric information. The price would be significantly lower, resulting in a gain of consumer surplus. A second experiment consists of simulating the outcome of an optimal price cap following the Farid Gasmi et al. (2002) model. The price cap became a popular regulatory tool in the 1980s such as for electricity, though the incentives resulting in price cap regulation have been questioned by economists. The counterfactual simulations show a price increase, which results in a significant loss in consumer surplus. The increase in firms’ profit does not, however, counterbalance this loss supporting the relevance of the actual rate-of-return mechanism.