Water losses and optimal network investments: Price regulation effects with municipalization and privatization

Abstract

Abstract We analyze optimal investments, to reduce water losses, in a regulated water industry, with perfectly inelastic demand and private information about local investment efficiency. We compare the public and private ownership cases, both subject to the same regulatory (revenue cap) mechanism. The theoretical analysis is supported by a calibration and simulation exercise. The incentive to invest is affected by ownership, financial structure and revenue cap. Overinvestment results in private firms as the cost of capital is accounted differently. In public firms: (i) the effect of the revenue cap is diluted and investments distortions with respect to a benevolent social planner are negligible; (ii) information rents are valued according to the marginal cost of public funds; (iii) the distortionary taxation and a price inelastic demand drive local politicians to maximize water revenues to finance investments and to increase municipal fiscal gains. Price differences result from differences in ownership and financial structure.