The effects of consolidation amongst Japanese water. utilities: A hedonic cost function analysis

Transcription

1 The effects of consoldaton amongst Japanese water utltes: A hedonc cost functon analyss by TAKUYA URAKAMI * and DAVID PARKER ** Cranfeld School of Management Cranfeld Unversty MK43 0AL UK [Abstract]: In many parts of the world water s suppled by very small, local undertakngs. In recent years there has been a move to consoldaton of these utltes n a number of countres. Ths paper looks at the economc effects of consoldaton of Japanese water utltes n the perod usng translog cost functons wth a hedonc output specfcaton. The results clarfy what factors have been most affected n terms of the cost structure of the water utltes after consoldaton. Overall, the fndng s that consoldaton has had some benefcal mpact on cost effectveness, but that the result s surprsngly lmted. Ths appears to be because cost savngs from an mprovement n the use of scarce water resources has been offset by extra expendture on supplyng water to areas wth lower populaton densty. [JEL Classfcaton]: L95, L11 [Key Words]: Water utltes, Consoldaton, Hedonc cost functon * Assocate Professor at Faculty of Busness Admnstraton of Knk Unversty, Japan and Vstng Research Fellow of Cranfeld School of Management, UK ** Research Professor and Drector of the Centre for Research n Economcs and Fnance, Cranfeld School of Management, UK

2 The effects of consoldaton amongst Japanese water utltes: A hedonc cost functon analyss Abstract In many parts of the world water s suppled by very small, local undertakngs. In recent years there has been a move to consoldaton of these utltes n a number of countres. Ths paper looks at the economc effects of consoldaton of Japanese water utltes n the perod usng translog cost functons wth a hedonc output specfcaton. The results clarfy what factors have been most affected n terms of the cost structure of the water utltes after consoldaton. Overall, the fndng s that consoldaton has had some benefcal mpact on cost effectveness, but that the result s surprsngly lmted. Ths appears to be because cost savngs from an mprovement n the use of scarce water resources has been offset by extra expendture on supplyng water to areas wth lower populaton densty. 1. Introducton In past decades, publc utltes such as electrcty, gas, telecommuncatons and transport have been subject to reforms to mprove ther performance, usually based on prvatzaton, new structures of regulaton and measures to ncrease market lberalzaton. The water supply ndustry has also been affected, although to a smaller degree. A notable reform was the prvatzaton of the water and sewerage ndustry n England and Wales n 1989, whch converted 10 publc corporatons nto 10 publc lmted lablty companes and the shares sold to prvate nvestors. In a number of 1

3 parts of the world there have been experments n contractng-out the management of water utltes to prvate sector companes, although wth mxed results n terms of mproved performance (Krkpatrck, Parker and Zhang, 2006). Elsewhere water and sewerage servces reman publcly-owned and managed, but there have been attempts to consoldate the utltes nto larger bodes wth the am of mprovng economc performance through economes of scale and scope. Tradtonally, water utltes have been local co-operatves or muncpally owned, operatng on a very small scale. Indeed, Van Gnneken and Kngdom (2008) report that the major change n the water sector n the 1990s was not from publc to prvate operaton, but from centralzed to decentralzed publc provson. Decentralsed provson was also domnant n England and Wales untl 1973, when 157 water undertakngs, 1,398 sewerage and sewage dsposal authortes and 29 rver authortes were merged nto 10 regonal water authortes. In the Phlppnes water servces are provded by a patchwork of local government unts (LGUs), water dstrcts, cooperatves, Rural Water and Santaton Agences (RWSAs) and prvate enttes (e.g. real estate developers). There are over 500 water dstrcts many contanng a number of dfferent types of water utltes. The structures n the Phlppnes today and n England and Wales before 1973 are not atypcal of structures across the globe. In recent years there have steps to consoldate provson nto a smaller number of larger bodes n a number of countres wth a vew to achevng economes of scale and scope. However, there has been surprsng lttle analyss of the economc effects. Ths paper deals wth the experences of Japan, where water ndustry consoldaton has been underway especally snce the late 1990s. The paper reports the economc effects of 2

4 consoldaton of Japanese water utltes n the perod , usng translog cost functons wth a hedonc output specfcaton. The results clarfy what factors have been most affected n terms of the cost structure of the water utltes after consoldaton. Overall, the fndng s that consoldaton has had some benefcal mpact on cost effectveness, but that the result s surprsngly lmted. Ths appears to be because cost savngs from an mprovement n the use of scarce water resources has been offset by extra expendture on supplyng water to areas wth lower populaton densty. The paper s structured as follows: frst we summarze recent studes nto economc effcency n water utltes before movng on to brefly descrbe the Japanese water ndustry. The data and cost functons used n our analyss are then reported, followed by the results of the cost functon analyss. The paper concludes by revewng the results n the context of exstng knowledge. Areas for future research are ndcated. 2. Lterature revew There have been a number of studes nto the effects of publc versus prvate ownershp on the performance of water utltes. The frst were undertaken n the USA and provded mxed results, wth some studes suggestng that prvately-owned utltes outperformed publcly-owned ones, and some reportng the complete opposte (e.g. Cran and Zardkooh, 1978; Bruggnk, 1982; Fegenbaum andteeples, 1983). The results appeared to be senstve to both the data used and the modelng of costs of producton. Later, wth the comng of the prvatzaton of water utltes, study has been undertaken 3

5 nto the economc consequences. For England and Wales Saal and Parker (2000) fnd mxed results n terms of mproved performance wth reductons n operatng costs offset by hgher captal nvestment. A recent study of water utltes n Afrca by Krkpatrck, Parker and Zhang (2006), comparng prvatzed frms wth non-prvatzed frms, found that there was no clear evdence that prvatzaton dd lead necessarly to hgher performance. What s clear s that prvatzaton n the water sector has proved troublesome for both governments and nvestors. Investors face a hold up problem whch mltates aganst snkng large amounts of nvestment nto what s a captal ntensve busness. Once the nvestment s made, governments, under publc pressure to hold down water prces, may be unwllng to sancton the hgher water blls needed to ensure an adequate return on the nvestment. By contrast, once a water utlty s transferred to prvate ownershp, governments may face consderable dffcultes n regulatng the actvtes adequately to ensure good servces at low cost. Guash (2004, p.34) reports that the water sector s the most prone of all of the utltes to contract renegotaton, wth renegotatng occurrng wthn an average of two years of the ntal contractng. There are cases where water concesson contracts wth the prvate sector have faled fnancally. It s the mxed results of prvatzaton n the water sector that s leadng to renewed nterest n how water provson can be made more effcent whle remanng state owned. Ths usually nvolves a restructurng of the ndustry nto larger unts to gan cost advantages and mprove coverage. In many poorer countres a large proporton of the populaton s currently under-served n terms of clean and safe mans water supples, relyng on ran or rver water, expensve bowsers or, n some cases, llegal connectons. 4

6 Turnng to studes of long-run scale economes (SELR) n the water ndustry based on estmatng cost functons or stochastc cost fronters, sxteen studes are lsted n Table 1. The SELR results for relatvely large scale water utltes show evdence of possble scale dseconomes; for example a result of 0.99 n Brazl (Nauges and van den Berg 2007), 0.92 for Japan (Mzutan and Urakam 2001) and 0.71 to 0.88 n England and Wales (Stone and Webster Consultants 2004; Saal and Parker 2000). Such fgures suggest that water companes can be too large, leadng to dseconomes of scale. The regonal water companes n England and Wales are partcularly large, servng bg geographcal areas and large populatons (for nstance, each day Thames Water supples 2,600 mllon lters of tap water to 8.5 mllon customers and removes and treats 2,800 mllon ltres of sewage for an area coverng 13.5 mllon customers). However, certan other studes have found evdence of slght scale economes, for nstance 1.03 n Brazl and 1.05 n Romana (Nauges and van den Berg 2008); 1.14 and 1.09 for the small water supply companes n England and Wales 1 (Battasso and Cont 2008, Stone and Webster Consultants 2004); and 1.05 n Japan (Urakam, 2007). These results are consstent wth the noton that there are scale economes up to a certan sze, but dseconomes f utltes become too large. Supportng ths concluson are, frstly, studes of medum-szed water utltes, where evdence has been found of scale economes (fgures of 1.58 n Fabbr and Fraquell 2000; 1.15 n Im 2008; 1.16 n Krkpatrck et al 2006; 1.11 n Colomba and 1.16 n Vetnam (both n Nauges and van den Berg 2007, 2008); and 1.23 n Torres and Morrson Paul 2006). Secondly, studes of small water utltes show scale economes (1.07 n Aubert and Reynaud 2005; 1.09 n Flppn et al 2008; 1.17 n Garca et al 2007; 1.26 and 1.21 for Moldovan case n 1 In a number of regonal water company areas n England and Wales, some customers are stll served by local water companes, for hstorcal reasons 5

7 Nauges and van den Berg 2007, 2008). 2 In summary, the results from exstng studes suggest that small water utltes may be able to reduce unt costs by consoldatng wth neghborng utltes nto large unts. However, care needs to be taken to ensure that the consoldatons are not so large that they lead to scale dseconomes. (Table1 here) 3. The Japanese Water Industry In ths study, we add to the lterature by nvestgatng the effectveness of scale expanson amongst Japanese water utltes snce The frst modern water supply system (WSS) was constructed n Yokohama n 1887 and shortly afterwards others were bult. As n other countres, water supples were developed by local companes or muncpaltes and were therefore on a small scale. Japanese WSSs have a goal to supply water servces to the entre populaton of Japan and n 2005 acheved a coverage rato of 97.2%. The geography of Japan s such that wth mountans and a forest area of 65.7%, t s not cost effectve to supply water to small vllages n the mountans. Table 2 shows the trend n the number of WSSs n Japan and the populaton suppled (coverage rato). Under the Water Act WSSs are categorzed nto four types, namely: Large Water Supplers (LWS); Small Water Supplers (SWS); Small Prvate Water Supplers (SPW); and Bulk Water Supplers (BWS). LWS are defned as utltes 2 However, Carca and Tomas (2001) show constant returns to scale (1.00) and Antonol and Flppn (2001) show evdence of scale dseconomes (0.95) 6

8 where water s suppled to a populaton of over 5,001, whereas SWS are defned as supplers to populatons of between 101 and 5,000. Typcally, SPWs are found n buldngs that are equpped wth holdng water tanks that have a capacty of more than 10m 3 and can receve portable water from large or small water supply systems. By contrast, BWS supply portable water to large or small water supply systems but not to the end user. BWSs play an mportant role n developng water resources and supplyng purfed water to both the LWSs and SWSs, where ther own water resources are nsuffcent to meet demand. (Table 2 here) As the data n Table 2 llustrate, water servces n Japan are provded by a very large number of small WSSs. Even n the case of LWSs, the average number of people suppled s only 73,526. The reason for ths s that the utltes are predomnantly owned by the local governments of ctes, towns and vllages. At the same tme, water charges have been rsng. Fgure 1 shows the tme trend of prce ndces of publc and prvate water utlty rates from 1994 to The prce ndex of water and sewerage servces has ncreased dramatcally, whereas the ndces of other servces have decreased or remaned stable. Urakam (2007) argues that the reason of ths ncrease n water charges s the type of ownershp of water utltes. Generally, publcly-owned water utltes tend to over-estmate future demands, perhaps due to the utltes focus on socal welfare ssues rather than cost-effcency. To make matters worse, a recent declne n water demand due, n part, to the development of water-savng technologes (e.g. water-savng tolet systems and water-savng washng machnes) has led to 7

9 downward pressure on water revenues, whch n turn has led the utltes to rase ther prces. (Fgure 1 here) KIIS (2006) conducted a questonnare survey analyss and concluded that the man reason for the hgh cost structure n the Japanese water ndustry was the hgh percentage of purchased water and deprecaton charges. Therefore, KIIS suggested that water utltes should ether consoldate ther plants or vertcally ntegrate n order to save costs and operate water supply systems more effcently, n other words, become bgger. In a study publshed n 2001, Mzutan and Urakam concluded that the optmal sze of a water supply system n Japan should be 766,000 consumers; whch was more than ten tmes larger than the average sze of even the LWSs (average populaton served 73,526) at that tme. The fgures n Table 3 show that wth a populaton served of between 500,000 and 1 mllon, operatng costs are mnmzed at yen per cubc metre of water. However, only 1.5% of water utltes n Japan serve a populaton of more than 500,000. Ths suggests that there are many scale-neffcent water utltes n Japan. (Table 3 here) In 1999 the Muncpal Merger Law was amended so that local governments could be consoldated nto large authortes (known as the Great Hese Era Consoldaton). Subsequently, many neghborng WSSs have merged or been taken over; for example, 8

10 the number of LWSs fell from 1,958 n 2000 to 1,602 n 2005 (Table 2). Also, the Water Act was amended n 2001 and snce then water utltes have been able to outsource whole operatons, not only to other water utltes, but to prvate companes. Snce 2000 many water utltes have consoldated n response to the above polcy changes wth the total number of utltes fallng from 1,964 n 2000 to 1,572 by However, the consoldaton of local authortes was motvated by poltcal factors and the desre to mprove publc servces n general. It s not axomatc that the local government consoldaton s necessarly leadng to optmally szed water undertakngs. 4. Methodology and Data In Japan almost all of water utltes are owned and operated by local government (99.4% n 2005). 3 Therefore, when we use the word water utltes n ths paper, t means LWSs. LWSs provde potable water and must publsh ndependent accounts. In the cost functon modelng we use data on the water utltes publshed by The Mnstry of Internal Affars and Communcatons n Japan to assess the effects of consoldaton n water provson. 4 Usng ths data, we are able to conduct an analyss of costs of producton before and after-utlty consoldaton. In the modelng we endeavor to mprove on prevous studes, as suggested n Coell et al. (2005), by reallocatng expendtures for purchased servces and outsourcng. The reason for ths adjustment s 3 Unlke the UK water ndustry where large prvate water companes provde not only potable water servces but also sewerage servces, Japanese water utltes provde only potable water servces. Sewerage servces n Japan are provded by the department of local governments

11 that: (1) the overall use of nputs may not n fact have decreased but smply shfted nto another nput expendtures; (2) the ncluson of purchased servces n the other nputs category n cost functons ncreases ts sze. In the case of Japanese water utltes, purchased water (from the BWS) accounts for a hgh percentage of total costs for many water utltes because of nsuffcent own water sources to meet local demand. Furthermore, water utltes have been encouraged n recent years to outsource varous operatons n order to reduce operatng costs. Prevous studes have recognzed that purchased water would affect the cost structure of utltes. However, they have not reallocated the cost, but nstead ncluded a purchased water rato as a control varable n the cost functon. In our study, as dscussed n more detal below, purchased water cost and outsourcng cost are reallocated more approprately. A translog cost functon s selected to model water utlty costs. Ths functonal form was frst derved by Chrstensen et al. (1971, 1973) and many researchers snce have adopted t to estmate cost functons. The functonal form s sad to be second-order flexble because t has parameters provdng a second-order dfferental approxmaton to an arbtrary functon at a sngle pont. If t s thought, for example, that scale elastcty and/or elastcty of substtuton may vary across data ponts, a second-order approxmaton should be preferred (Coell et al 2005). The translog cost functon s specfed as follows: ln C = α + α ln Q α qq q ( ln Q) 2 + β lnw + j j j q β lnw lnw α ln Q lnw + δ t + δ td t 10 k γ ln Z td k k CNSD + η type D TYPE (1)

12 where C, total cost; Q, output; W, nput factor prces (=L(labor), K(captal), O(others)); Z k, control varables (k=pw(purchased water rato), DS(populaton densty), CU(capacty utlzaton)); t, a tme trend; D CNSD, a consoldaton dummy varable (after consoldaton: 1, otherwse: 0); D TYPE, a type of water utltes dummy varable (water utltes whch was consoldated durng sample perod: 1, otherwse 0). Followng Saal and Parker (2000), n ths study the functon s modfed to estmate the mpact of consoldaton by removng the t 2 term and replacng t wth td CNSD 5. The model also mposes the followng constrants on the parameters for factor nput prces: β = 1, α = 0, β j = 0, β j = β j. q j In addton, Shepherd s Lemma from equaton (1) s appled to obtan the nput share equaton: S = β + αq lnq + j β lnw j j (2) 5 Generally, the translog cost functon specfed as equaton (1) should nclude nteracton terms for the control varables and tme trend. Below, three models of the translog cost functon - wth nteracton terms for the control varables; wth nteracton terms for the tme trend; and wth nteracton terms for the control varables and tme trend - were estmated. However, some parameters could not satsfy the requrements for parameter restrctons based on economc theory. Therefore, the decson was taken to exclude these from our estmatng cost functons and assume that the control varables and the tme trend affected the water utltes cost structure ndependently from output and nput factor prces. 11

13 where S s nput s share of the cost functon. Snce the sum of all the cost share equatons s unty, one cost share equaton must be deleted for the purpose of estmaton. Obvously, outputs should be approprately defned when estmatng producton functons and/or cost functons, otherwse the results obtaned wll be based. In the case of water ndustry, there are two types of modfcaton that can be adopted. One s to adopt a qualty-adjusted output (Saal and Parker 2000, 2001, Saal et al 2007) and the other s to adopt a hedonc specfcaton of output (Fegenbaum and Teeples 1983; Bhattacharyya et al 1995; Schmt and Bosvert 1997; Mzutan and Urakam 2001). Ths study adopts the latter approach. The hedonc specfcaton for the output measure s defned as follows: lny = lnq + λ m ln X m (3) m where Y, hedonc output; X m, output qualty measures (m = CR (coverage rato), DM (dam rato), UG (underground rato), DP (daly suppled water per person)) 6. Usng ths specfcaton, the translog cost functon (1) and the cost share equaton (2) become: 6 The hedonc specfcaton of output was frst derved by Spady and Fredlaender (1978). In ther paper, an output qualty measure s defned as qualty or attrbute assocated wth the physcal output. Followng ths defnton, Fegenbaum and Teeples (1983) ncluded not only qualty varables but also control varables n ther hedonc output functon, whch s equaton (3) n our paper. More recent studes, such as Bhattacharyya et al (1995) and Mzutan and Urakam (2001), nclude only qualty varables n the hedonc output functon and add control varables nto the cost functon. We adopted both approaches to estmate the cost functons, but were unable to obtan reasonable results from the former approach. 12

14 lnc = α + α lny α YY ( lny ) j Y j 2 + Y β lnw lnw β lnw + α lny lnw j + δ t + δ td t k γ ln Z td k cnsd k + η type D type (4) S = β + αy lny + j β lnw j j (5) To nvestgate how water utlty consoldaton n Japan affects the control varables and output qualty measures, a dummy varable for consoldaton s ncluded wth each parameter. Therefore, equaton (4) and (5) are modfed as follows: lnc = α + α lny α YY ( lny ) j q j 2 + Y β lnw lnw β lnw + α lny lnw j t ( γ k + μk, cnsd Dcnsd ) k + δ t + δ t, cnsd td cnsd + η type ln Z D type k (6) ( μ D ) ln Y = lnq + λ +, ln X (7) m m m cnsd cnsd m In economc theory the cost functon should satsfy the followng condtons: (1) be homogeneous of degree one n nput prces; (2) have symmetry of parameters; (3) have monotoncty n output and nput prces; (4) and the Hessan matrx should be negatve semdefnte (the concavty condton n the cost functon). Usng a translog functonal form, the condtons of (1) and (2) can be mposed on the parameters of nput factor prces before estmaton, and condtons (3) and (4) can be checked after estmaton. 13

15 Condton (3) can be easly checked as output and nput factor coeffcents should be nonnegatve. In the case of condton (4), we need to calculate Hessan matrces and check the followng nequaltes: θ 0 ( L, K, O) (8) = θ θ j θ θ j jj 0 ( j, = L, K, O) (9) 2 C C C C θ, θj = = ( βj + SS j ). Although t s w w w w 2 = 2 2 w w where = { β + S ( S 1) } j j not necessary that the negatve semdefntness of the Hessan matrces should be satsfed at each sample pont, t needs to be satsfed at least at the sample mean pont. 7 We calculate the condtons of the nequaltes (8) and (9) at each sample pont n order to justfy the cost functons used n the estmaton. The measures of economes of scale ( SE ) and Allen-Uzawa partal elastctes of substtuton ( AU ) are calculated as follows: ln C SE = 1 (10) lny AU AU CC = ( L, K, O) (11) C C = CCj = ( j, L, K, O) (12) C C j = j 7 As s well known that the 3 3 Hessan Matrx n ths case would be zero by Euler's Theorem and Shepherd s Lemma. 14

16 where C = C, C j = C w j, Cj = 2 C w w j. If the calculated result for 2 2 w SE s larger than (less than) one, t means there exsts ncreasng (decreasng) returns to scale. If SE s equal to one, ths means there are constant returns to scale. At the same tme, AU should be non-postve due to the requrements of economc theory, whereas AU j should be postve (negatve) f the two nput factors are substtutes (complementary) n the producton functon. The data used n the analyss were collected from The Yearbook of Publc Frms, (Chhou Koue Kgyo Nenkan, n Japanese), edted by the Research Assocaton of Local Publc Frm Management (Chhou Koue Kgyou Kee Kenkyu Ka). The Yearbook reports quanttatve and fnancal data for all water utltes, except for a small number of prvate water utltes n Japan, whch are therefore excluded from the study. Statstcs on those local authortes that had consoldated or planned to consoldate were obtaned from the web ste of The Mnstry of Internal Affars and Communcatons. 8 The water utltes owned and operated by these local authortes were then sampled from The Yearbook of Publc Frms for the perod 1999 to The consoldaton of water utltes began after 1998 and 2006 was the last year for whch data were avalable when ths study was undertaken. The water utltes that were subject to consoldaton durng ths perod are hereafter referred to as Consoldated Water Utltes (CWUs). In order to compare the performance between consoldated and non-consoldated water utltes after 1998, the water utltes whch were owned and operated by local governments that had not been subject to consoldaton were also sampled. Hereafter, these water utltes are referred to as Non-Consoldated Water

17 Utltes (NWUs). Fnally, water utltes for whch we dd not enough data to estmate cost functons were excluded from the sample. The number of observatons for each year (FY1999 FY2006) s summarzed n Table 4. In summary, the number of observatons was 6,648 for CWUs and 6,304 for NWUs. (Table 4 here) The varables used n the analyss are defned as follows and ther basc statstcs are shown n Table 5 for each type of water utlty: CWU, NWU, and AWU. The AWU (All Water Utltes) category conssts of both CWUs and NWUs. Total cost (C ) s sum of labor cost, captal cost and other nput costs. Therefore, the cost shares of each nput ( S L, S K, S O ) are obtaned by dvdng each nput cost by total cost. However, as mentoned before, f purchased or outsourced servces exst, these cost shares may be nadequate for estmatng cost functons. Therefore, we reallocated purchased water cost and outsourcng cost nto other costs (a detaled explanaton of the procedure s provded n Appendx 1) Basc statstcs for the reallocated cost shares ( S, S, S ) RA L RA K RA O are also provded n Table 5. Output (Q ) s measured as amount of water delvered annually. The nput prce of labor ( W L ) s calculated as annual labor cost per number of employees. The nput prce of captal ( W ) s defned as a rental prce of captal, as suggested by Jorgenson (1963) K and Hall and Jorgenson(1967), WK PI ( r + d) = : where PI s an nvestment goods prce ndex; r s the nterest rate; and d the deprecaton rate. PI was sourced 16

18 from the Corporate Goods Prce Index provded by the Bank of Japan. The nterest rate ( r ) was sourced from the Handbook of Water Works edted by the Japan Water Works Assocaton. The deprecaton rate ( d ) was calculated as annual amount of deprecaton cost based on the prevous year s value of assets subject to deprecaton. 9 In the case of the nput prce of other servces ( W ), all water utltes were assumed to face the same O prces and the domestc corporate goods prce ndex was used as a proxy varable. The prce ndex was sourced from Corporate Servces Prce Index provded by Bank of Japan. Turnng to control varables, three knds of varables were dentfed from the prevous studes of water costs revewed earler whch mght affect the cost structure of water utltes. The frst was the purchased water rato ( Z PW ). Ths was ncluded and obtaned by dvdng the amount of annual purchased water by the total amount of annual water ntake. As dscussed n Urakam (2007), purchased water s one of the man reasons for hgh water prces n Japan. Even f we adequately reallocate purchased water cost nto other costs, as dscussed above, purchased water would reman an mportant factor affectng water utltes cost structures. The second control varable was populaton densty ( Z DS ) because the hgher the densty n general the lower the margnal cost of supplyng addtonal users. Z DS was calculated as the number of water suppled populaton per length of ppelne. The fnal control varable 9 Some water utltes conducted a revaluaton of assets durng the sample perod wth mplcatons for deprecaton. To remove ths complcaton, we adopted the average of the deprecaton rate durng the sample perod. That s to say, n the modelng, we assumed that each water utlty faced a constant average deprecaton rate throughout the sample perod.. 17

19 ncluded was capacty utlzaton ( Z CU ). Ths was calculated as the amount of average daly water suppled water per maxmum capacty to supply water. The modelng also ncludes varables to reflect the qualty of servce suppled. It s to be expected that provdng hgher qualty servces rases costs. Four varables were adopted. Frst, the coverage rato ( X CR ): ths was obtaned by dvdng number of water suppled populaton by number of total populaton. Second, the dam rato ( X DM ): ths was defned as the amount of water-ntake by dam per total water-ntake. Thrd, the underground rato ( X UG ): ths was defned as amount of underground water-ntake per total water-ntake. The dam and underground ratos wll reflect dfferences n water supply costs resultng from above ground or below ground water resources. Fnally, the daly suppled water per person ( X DP ): ths was calculated as the amount of water suppled daly per number of populaton wth access to the water supples. Ths varable also acts as a proxy for the amount of water suppled to ndustry and commerce. Gven that the per capta consumpton of potable water s almost the same among all households, varatons n X DP can be taken to represent the percentage of non-household consumpton of water In our dataset, Z PW, X DM and X UG take zero for some parts of observatons. To avod numercal errors n estmatng translog cost functon, there are two knds of modfcatons: one s a Box-Cox transformaton and the other s substtutng small value for zero (e.g. Cowng and Holtmann 1983). The former approach s well known as a generalzed translog cost functon approach when output varables have zero observatons. In ths case, as suggested by Greene, a queston does arse n the Box-Cox transformaton: whether zero should be treated the same as nonzero data or whether zero represents a dscrete corporate decson from other varatons n the varable levels (Greene 2008, pp ). In our study, followng Cowng and Holtmann (1983), we adopt a smple approach substtutng a small value (10-6 ) for zero observatons. Ths avods serous nformaton loss from removng zero observatons from our sample. 18

20 (Table 5 here) 5. The Estmaton Results Translog cost functons were estmated for each type of water utlty n Japan n the sample perod, The estmaton methods used were the SUR (Seemngly Unrelated Regresson) for all cost models wth nput share equatons. Before estmaton, all explanatory varables except for tme trend and dummy varables were normalzed by sample means. As a frst step, n order to check that the cost reallocatons undertaken were effectve, we estmated two cost functon models: one an hedonc cost functon wth cost-reallocaton and the other an cost functon wthout cost-reallocaton. In ths case, a statstcal test could not be appled. Instead, we calculated concavty condtons, as defned n nequaltes (8) and (9) above. The calculaton results shown n Table 6 ndcate that cost-reallocatons led to sgnfcant mprovements n the cost models. The percentage of the number of water utltes satsfyng the concavty condtons n the case of the wth-cost-reallocated model was at least 40% hgher than when usng the wthout-cost-reallocaton model. Therefore, we concluded that the cost-reallocaton model should be preferred when estmatng the cost functons. (Table 6 here) We also performed statstcal tests for a hedonc output specfcaton, as defned n equaton (3), and for the consoldaton dummy varables on the control varables and 19

21 output qualty measures, as adopted n equatons (6) and (7). The results of log-lkelhood (LR) statstcs are shown n Table 7. The null hypotheses that all parameters of output qualty measures are jontly equal to zero ( λ = 0 ) for all categores of water utltes are rejected at the 1% level of sgnfcance. Therefore, a cost functon wth a hedonc output specfcaton s preferred to a wthout-hedonc-specfcaton model. However, the null hypotheses that all of the parameters of the dummy varables on the control varables and output qualty measures are jontly equal to zero ( 0 μ, μ 0 k, cnsd = m, cnsd = ) for AWUs and CWUs are also m rejected at the 1% level of sgnfcance. As a result, n order to nvestgate the effectveness of water utltes consoldaton n terms of reducng costs, as well as to clarfy what factors have been affected n the cost structure of water utltes by consoldaton, we used consoldaton dummy varables on the control varables and output qualty measures. (Table 7 here) The estmaton results are shown n Table 8. The goodness-of-ft n these regressons s acceptably hgh for each model. The frst-order coeffcents of output and nput factor prces ( α Y, β L, β K and β O ) show the expected sgns and are statstcally sgnfcant at the 1% level. The estmated cost models meet the requred propertes such as monotoncty condtons and concavty condtons at the sample mean ponts. (Table 8 here) 20

22 As for second order coeffcents, almost all of them show the same sgns for the AWUs, CWUs and NWUs, and are statstcally sgnfcant. However, the coeffcent estmates of the cross term of output and nput factor prce of other servces ( α YO ) show dfferent sgns between the CWUs and NWUs ( for CWUs and for NWUs). Ths suggests that consoldaton of water utltes consoldatons mght have led to a cost reducton for other servces. The estmated coeffcents for the tme trend ( δ ) for the AWUs and CWUs have postve sgns and are statstcally sgnfcant at the 1% level, whereas that for NWUs has a negatve sgn but s statstcally nsgnfcant. Ths suggests that costs have actually been rsng over tme n the case of the CWUs. However, the estmated coeffcent for the cross term of the consoldaton dummy varable wth the tme trend ( t δ t, cnsd ) for the AWUs and CWUs s statstcally sgnfcant at the 1% level and has a negatve sgn. Ths result s consstent wth a regulaton effect (as found by Saal and Parker, 2000). In terms of drectly lookng at the effects of consoldaton amongst Japanese water utltes snce the late 1990s, our results suggest that consoldaton has led to some cost reducton. The estmated coeffcent on the dummy varable for the type of water utlty ( δ type ) has a negatve sgn and s statstcally sgnfcant at 1% level. But the result s surprsngly small. It suggests that CWUs are about 1.8% more cost effectve than NWUs. 21

23 Turnng to the control varables, the estmated coeffcents for purchased water ( γ ) pw for the AWUs, CWUs and NWUs are statstcally sgnfcant at the 1% level and have postve sgns. At the same tme, the cross term coeffcent of purchased water wth the consoldaton dummy ( μ pw, cnsd ) has a negatve sgn (although t s statstcally sgnfcant at the 1% level only n the case of the AWUs). These results ndcate that a hgh percentage of purchased water leads to an ncrease n costs compared to smply explotng own resources (of 1.6%~2.2% per annum), and that the trend growth rate for ths cost was 25% lower after water utltes consoldated. Ths suggests that consoldated utltes may have more purchasng power when t comes to negotatng contracts wth the BWS, or they may reduce what s known as purchase responsblty, whch has been an mportant cost burden. 11 Ths suggests that consoldated utltes may have more purchasng power when t comes to negotatng contracts wth the BWS. On the other hand, the coeffcent estmates for populaton densty ( utlzaton ( γ cu γ ds ) and capacty ) show negatve sgns. These results ndcate that hgh populaton densty and hgh capacty utlzaton have had a postve mpact on cost savngs (16%~19% and 26% per annum, respectvely). Furthermore, the cross term coeffcent 11 In Japan, BWS conssts of Prefecture owned (44.1%); Cty, Town, or Vllage owned (2.0%); and Cooperatve owned (53.9%) utltes. Cooperatve owned BWS have been set up by some local governments whose water utltes do not have suffcent own water sources to meet demand. In ths case, water utltes have to purchase an assgned share of purfed water from BWS. Ths system s called n Japan purchase responsblty and the assgned share s defned dependng on each local authorty s ownershp share n the BWS. The concept of purchase responsblty has been crtczed because the assgned share has been mantaned even where the demand for water has been decreasng. Ths has, therefore, been an mportant cost burden for some water utltes. 22

24 estmates of populaton densty wth the consoldaton dummy varable ( μ ds, cnsd ) for CWUs have a postve sgn (statstcally sgnfcant at the 5% level), ndcatng that cost savngs from hgh populaton densty were offset by the effects of water utltes consoldatng. The trend rate of declne n cost was 20% lower. Ths s probably best explaned by the fact that n Japan sometmes water utltes have had to merge wth smaller and more poorly equpped neghborng utltes wth low populaton densty. Ths has mpacted n terms of reducng any cost advantages from consoldaton. As for the estmated results for the output qualty measures, the estmated coeffcents for the coverage rato ( λ ), the underground water rato ( cr λ ug ), the daly suppled water per person ( λ dp ), and the dam water rato ( λ dm ) had the expected sgns and all were statstcally sgnfcant at the 1 % level. Equally, the cross term coeffcent estmates for the consoldaton dummy varable wth qualty measures showed nterestng results. Frst, the nteracton term wth the coverage rato ( μ cr, cnsd ) had a postve sgn (statstcally sgnfcant at the 1% level), ndcatng that a hgh coverage rato has contrbuted to cost reducton, but the cost reducton s 87% lower after water utltes consoldated. Second, the nteracton term wth the dam water rato ( μ dm, cnsd ) had a negatve sgn (agan, statstcally sgnfcant at the 1% level). In other words, whle a dependence on dam water was found to rase costs, consoldaton of water utltes tended to amelorate ths effect. Dam water was less of a cost burden for consoldated water utltes, probably because they are able to share out the cost of buldng and mantanng dams over a larger customer base. Fnally, the dummy on the daly water 23

25 suppled per person varable ( μ dp, cnsd ) also had a negatve sgn and was statstcally sgnfcant. Ths suggests that consoldaton n the ndustry has led to cost savngs n terms of water supply per head. The case for consoldaton of water utltes, around the world, s based on economes of scale. Therefore, we estmated the scale effects between 1990 and 2006 n Japan. The results and Allen-Uzawa partal elaststes of substtuton are shown n Table 9. The results suggest that there are economes of scale for all types of water utltes n Japan, evaluated at sample mean ponts. In order to check tme seres and output level varatons n economes of scale (SE), we calculated SE for dfferent tme perods and dfferent output levels. The results are gven n Table 10. They show that there s no obvous dfference n SE between AWUs and CWUs and n both cases SE has been decreasng snce (Tables 9 and 10 here) As for the Allen-Uzawa partal elaststes of substtuton, the estmaton results of AU LL, AU KK and AU OO for all types of water utltes have a negatve sgn and are statstcally sgnfcant at 1% level. Ths ndcates that the results satsfy the requrements of economc theory. Furthermore, AU LK and AU KO have postve sgns (also statstcally sgnfcant at the 1% level), ndcatng that labor and captal as well as captal and other nputs are cost complements. By contrast, AU LO has a negatve sgn for the AWUs and CWUs and a postve sgn for the NWUs. But n all cases these results 24

26 are not statstcally sgnfcant. 6. Conclusons The prmary purpose of ths study has been to nvestgate the effectveness of water utlty consoldaton wth partcular respect to Japan. In addton, the results have helped clarfy the sort of factors whch mght affect the cost structure of water utltes after consoldaton. The analyss s relevant n the context of current world-wde nterest n the optmal scale of water supply systems and optmal scope of servces that water utltes provde. Japan has been used as a case study because there are a lot of small water utltes n the Japanese water ndustry, almost all of them are owned and operated by local government. At the same tme, there has been a move towards consoldaton of the ndustry snce the late 1990s. Ths has been assocated wth consoldaton of local authortes, under what s known as the Great Hese Era Consoldaton. The effects have been consdered usng translog cost functons wth a hedonc output specfcaton. The results suggest that water utlty consoldaton has had some benefcal mpacts n terms of costs of producton, but the extent has been surprsngly small, gven the expectaton that larger utltes would be more effcent. Water utlty consoldaton has slowed cost ncreases down, but ts mpact has been only between around 0.3%~2% per annum. The reason for ths appears to be that, although problems of scarcty of water resources (reflected n the costs of purchasng water and a relance on a hgh percentage of water from dams) has mproved snce consoldaton, other problems have arsen. In 25

27 partcular, consoldaton wth small, poorly equpped and especally low populaton densty water utltes seems to have rased overall supply costs. Almost eght years have passed snce the begnnng of local government and therefore water supply consoldaton n Japan. However, a large number of CWUs have been consoldated only for two or three years (see Table 4), therefore t s possble that our results under-estmate the longer-term benefts of consoldaton. Perhaps the dffcultes faced by absorbng poorly equpped and low populaton densty utltes may be addressed over tme. It would be useful to repeat our study at a later date when a longer perod of data are avalable. Another possble lmtaton of our study les n the fact that we have been concerned wth the effect of utlty consoldaton on cost performance. It s possble that other benefts of mergers may not be reflected n the results, such as mproved bllng and meterng and mproved servces to partcular groups n socety, such as the poor. Further research could usefully nvestgate any such effects. Nevertheless, our results provde a useful nsght nto the potental cost reductons from consoldatng the water ndustry nto larger supply unts where currently supples are provded on a very small scale. The results suggest that there may be some cost savngs, although overly-enthusastc expectatons of effcency mprovements may be unwarranted. Appendx 1 Cost Reallocaton In the cost functon model specfed as equaton (1), we defned total cost as the sum of labor cost (CL ), captal cost (CK ), and other cost (CO ). 26

28 C = CL + CK + CO (A.1) However, as suggested n Coell et al. (2005, pp ), f expendtures for purchased servces and outsourcngs exst, two problems mght arse: (1) the overall use of nput factors may not have decreased, but have shfted nto another nput expendtures; (2) the ncluson of purchased servces n the other nput category ncreases the sze of the other nput. In the case of Japanese water utltes, purchased water accounts for a hgh percentage of total cost because many utltes do not have suffcent water resources to meet ther own demands. Furthermore, n recent years water utltes have been encouraged by government to mprove ther effcency by resortng more to outsourcng varous servces. Therefore, n ths study three steps have been taken to reallocate costs: (1) dvde CO nto three parts, namely: S1 CS (outsourcng cost), S1 CW (purchased water cost), and S1 CO (other costs); (2) to reallocatecs S1, based on the KIIS(2006) survey ; and (3) reallocatecw systems. S1, based on the cost structure of bulk water supply CO conssts of energy costs, repar costs, chemcal costs, outsourcng costs, purchased water costs, and other costs. From the above dscusson, we thnk outsourcng costs and purchased water cost are best reallocated nto other costs. So frstly we dvdeco nto three parts and then equaton (3) becomes: C = CL + CK + CS + CW + CO S1 S1 S1 (A.2) 27

29 Accordng to the questonnare survey results n KIIS (2006), outsourcng amongst Japanese water utltes s manly planned for labor-ntensve operatons (see Fgure A-1). Based on ths fndng, outsourcng costs are reallocated nto labor costs S1 S 2 ( CL + CS = CL ) and equaton (A.2) then becomes: C = CL + CK + CW + CO S 2 S1 S1 (A.3) (Fgure A-1 here.) If water utltes do not have suffcent water resources to meet ther own demands, they have to purchase purfed water from bulk water supply systems (BWS) or other water utltes. Ths means that water utltes have to pay for purfed water but do not have to pay for purfcaton actvtes. The prncple of the water tarff settng of BWSs s based on full cost recovery, so that the purchased water cost could be reallocated dependng on the cost shares of BWS. The cost equaton of BWS s as follows: BWS BWS BWS BWS C = CL + CK + CS + CO BWS (A.4) In order to obtan cost shares, we dvded both sdes of (A.4) byc BWS, then BWS BWS BWS 1 = SL + SK + SO (A.5) SL = CL + CS C, BWS BWS BWS BWS where ( ) BWS BWS BWS SK = CK C, BWS BWS BWS and SO = CO C. The cost of water utltes could then be reallocated, as 28

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