Water Privatisation and its effects on Customer Satisfaction

One of the often cited reasons that water distribution networks are in public control is because they are considered a natural monopoly (DiLorenzo 1996). A natural monopoly occurs when, "due to the economies of scale of a particular industry, the maximum efficiency of production and distribution is realised through a single supplier" (DiLorenzo 1996: 43).

The high level of investment required to construct water distribution and sanitation networks creates a natural barrier to entry for more than one firm to operate in the same geographic area. Natural monopolies are considered unsuitable for a competitive market because of the duplication of facilities required to service individual customers in the same area (Hart et al. 1997). Natural monopolies exist in most markets for networked services, such as telecommunication, transport (particularly rail and harbours), electricity, gas and water supply (DiLorenzo 1996).

"The most important single central fact about a free market is that no exchange takes place unless both parties benefit."

Milton Friedman

Natural monopolies in water and sanitation services are also widespread because of the so-called diamond-water paradox, expressed by Adam Smith as the Paradox of Value (Robertson and Taylor 1957). This is the assertion that some commodities without value in use, such as diamonds, have a high value in exchange and vice versa, water has a high use value, but demands a low price (Levy 1982). Although water is more critical to survival than diamonds, this is not reflected in pricing.

Water is used for many purposes and in the case of reticulated water supply, the same water is used for drinking, hygiene, gardens and as a transport medium for waste. Economic theory suggests that the price of a product is determined by its marginal utility, i.e. its least important use to a person (Levy 1982). In the case of water, this is reflected in the difference in price between tap water and bottled water. Consumers in Australia are willing to pay more than 1000 times the price of tap water for a bottle of drinking water, although the quality is essentially the same.

The low value of reticulated water implies that providing this type of service generates very low margins for the investor. Significant amounts of assets are required to deliver this service to a customer, but the price that can be commanded is very little. This makes reticulated water and sanitation supply particularly economically uninteresting for private suppliers and is thus dominated by monopolistic publicly owned service providers.

Because of the natural monopoly characteristics of water and sanitation services, privatisation has seen some monopolistic segments in the industry transferred to private operators (Estache et al. 2005). One means by which governments attempt to negate the disadvantages of monopolised state-owned service providers is through regulation. Regulation usually takes the form of market mimicking regimes in which service providers compete with each other through performance benchmarking. In this system, utilities are "forced to compete with a shadow-firm whose performance is determined by average or best practice in the industry" (Braadbaart 2007: 680).

Research in the Netherlands shows that this type of benchmarking enhances economic performance. There is a clear case for yardstick competition (Estache et al. 2005; Tupper and Resende 2004). Yardstick competition is, however, not a sine qua non for performance enhancement. Also, collaborative rather than competitive, benchmarking has a positive effect on utility performance (Braadbaart 2007). Regulation is appropriate if firms have incentives to reduce costs and minimise the level of service provision. The incentive to reduce cost is considered a potential negative consequence of privatisation (Fumagalli et al. 2007). Partly privatised utilities subject to service quality regulation maintain incentives towards high levels of quality (Fumagalli et al. 2007).

Status of Water privatisation in the World

Most water and sanitation service are currently provided by publicly owned organisations (Deichmann and Lall 2007; Estache et al. 2005). However, in several countries around the world different modes and levels of privatisation of water and sanitation services have been implemented. The privatisation of state-owned utility service providers has been most prominent in developing countries because the opportunity cost of maintaining government-owned enterprises over private ownership is higher than in developed countries (Deichmann and Lall 2007).

The privatisation of state-owned utility providers is partially driven by the World Bank. The privatisation conditions of reforms funded by the World Bank is the privatisation of formerly state-owned enterprises (Tsamenyi et al. 2008). Water privatisation is, however, a broad sweeping term that can encompass a range of different models in different parts of the supply chain, which is discussed in more detail below. Broadly speaking, privatisation is part of the supply chain of water and sanitation supply in around 35% of the countries of the developed world and 80% of the countries in the developing world.

Estimates show that nearly half of the urban population in African nations rely on private providers for water service (Auriol and Picard 2008). Research on the efficiency of private operators in this continent shows that they are more cost-efficient and that corruption reduces efficiency and matters more than ownership. However, no significant difference between public and private operators is found once environmental factors have been accounted for (Estache et al. 2005).

In 1989, Argentina initiated a process of privatising infrastructure services, including water and sanitation (Chisari et al. 1999). Services were privatised because of a need to alleviate the financial burden imposed by public utilities. Before services were privatised, the existing organisations were vertically disintegrated. In the water sector, competition has been introduced through a bidding process. Between 1993 and 1994, privatisation of water distribution resulted in a 4.9% reduction in inputs purchased as a share of total sales. The size of the population served per staff member decreased by 27.6%, i.e. the total number of employees increased.

Water efficiency, measured as distribution losses, improved over this period. Lastly, the cost of water to consumers grew by 5.5 %. Overall, privatisation of utilities in Argentina has increased labour productivity, but higher cost for customers, while lowering cost for the utility providers (Chisari et al. 1999). In Brazil, it was found that there is no significant difference between public and private operators regarding their productivity (Estache et al. 2005).

In 1989, the government sold ten publicly owned water/sanitation companies in England and Wales and established a new, independent sector regulator (van den Berg 1997). The regulator controls both water and sanitation utilities with the aim to protect customers' interests (Seppälä et al. 2004).

Water and sanitation service provision in the Australian state of Victoria is fully in public hands, with many activities outsourced to private partners. All state-owned service providers are regulated by the Essential Services Commission. The Victorian government is currently investigating means to increase private participation in the provision of water and sanitation services through so-called Third Party Access (Essential Services Commission 2009).

The public ownership model has been criticised because of a perception that services provided by these institutions are often inadequate and few utilities are able to recover the full cost as pricing is often politically motivated (Deichmann and Lall 2007). The general argument against public ownership of utility service providers is that public services lack Adam Smith's 'invisible hand' to guide resource allocation based on consumer preferences (Andreassen 1994). The regulator for water and sewerage services in Victoria, Australia has expressed the anticipated advantages of privatisation succinctly (Essential Services Commission 2009: 9, emphasis added):

• More efficient allocation of resources (allocative efficiency);
• Efficiency and productivity improvements, leading to lower costs of providing products and/or services from existing input sources, processes and technologies (productive efficiency);
• Longer term efficiency and productivity improvements, with lower costs and improved service quality arising from new and improved input sources, processes and technologies (dynamic efficiency) and;
• Greater customer choice, with innovative offerings of products and/or services that better reflect customer needs and preferences.

DiLorenzo (1996) argues that the often proclaimed natural monopolies in utility services are an economic fiction and their development was an ex-post rationale for government intervention. There is, according to DiLorenzo (1996), no evidence that a natural monopoly, i.e. one firm achieving lower long-run average total cost than other companies, in the industry thereby establishing a permanent monopoly, ever existed. The existence of economies of scale in water and other public utilities does not necessitate a monopoly because competitive and market forces will naturally regulate an industry (DiLorenzo 1996).

Hart et al. (1997) point out that private suppliers deliver public services at a lower cost than public providers. Public ownership of utilities is generally viewed as generating inefficiencies because of soft budget constraints as governments will subsidise money-losing ventures. Empirical data from the United States shows that publicly owned water utilities had higher costs than their privately owned counterparts (Estache and Rossi 2002). The transfer from public to private ownership is thus often advocated as a solution for the poor economic performance of utility companies (Auriol and Picard 2008). The economic arguments over efficiency in relation to ownership are, however, not conclusive as some research indicates that there are no statistically significant differences in efficiency between water corporations, regardless of their ownership structure (Bakker 2007; Estache and Rossi 2002).

Economic theory suggests that a privately owned monopolist will over-invest in cost reduction if the quality of their service is not regulated (Hart et al. 1997). This decrease in investment can have negative consequences on service quality as investment and service quality are closely related to the provision of utilities. Although it can be shown that both private and public monopolists are equally likely to under-invest in quality enhancements, publicly owned utility providers will deliver a higher quality because there is no managerial incentive to reduce cost (Fumagalli et al. 2007; Hart et al. 1997).

The case for government-owned service provision is generally stronger when cost reductions are likely to reduce service quality, when quality innovations are unimportant, and when corruption in government procurement is a severe problem (Hart et al. 1997). In contrast, the case for water privatisation is stronger when quality reducing cost reductions can be controlled through regulation or by competition (Hart et al. 1997).

Initiatives to privatise state-owned enterprises are often based on the assumption that in private industry, managers have greater freedom to set a corporate strategy and raise capital as is the case in publicly owned organisations (Andreassen 1994; Fumagalli et al. 2007). Water corporations require incentives to act in the public interest and to ensure that managerial behaviour is disciplined. These incentives can be provided through the introduction of competition (Andreassen 1994; Deichmann and Lall 2007; Fumagalli et al. 2007).

Services delivered by publicly owned institutions are often considered inadequate, few utilities are able to recover full cost and pricing is politically motivated (Deichmann and Lall 2007). One of the main issues identified by proponents of increased private business involvement in the provision of utilities is that publicly owned services are not subject to market forces (Fumagalli et al. 2007). Porter (1990) claims on a macroeconomic level that corporate strategy, industry structure and rivalry and demanding customers will stimulate service providers to focus on the market.

To offer a high level of utility, the public sector must be more marketed oriented, i.e. supply more differentiated services (Andreassen 1994). Privatised energy companies are improving their market position by being more customer oriented and focusing on branding in response to increased competition (Hartmann and Ibáñez 2007). The principal objective of a Marketing Orientation is to provide a long-term profit focus through three behavioural components (Narver and Slater 1990):

• Customer orientation: Understanding customer's needs to be able to create superior value;
• Competitor orientation: Understanding the short and long-term strengths and weaknesses of competitors; and
• Interfunctional coordination: Leveraging collective resources to create value.

There has been strong opposition to the introduction of market forces in water supply. The main argument being that water should be considered a human right and not as a tradeable commodity. Water is regarded as a human right as it is not substitutable and intrinsically linked with other human rights, such as the right to life (Bakker 2007). These arguments do, however, not preclude commercialisation of water supply services because many other human rights are underpinned also by private business involvement, e.g. the right to life and the food industry. Another line of thought used to argue against commercial influences in the supply of water is environmentally grounded.

Private companies are answerable to shareholders that seek profit maximisation and will thus not be able to provide long-term sustainable water supply solutions (Bakker 2007). However, market forces in water services use the scarcity of water as a starting point and enforce that it must be priced at the full economic and environmental cost, rather than political pricing adopted in many jurisdictions. Using market pricing will ensure that water is allocated to its highest value use (Bakker 2007).

The supply of water and sanitation services has a circular supply chain that is deeply connected with the natural environment (Figure 3.1). Water is mostly sourced from rivers, groundwater, or more increasingly, seawater. The so-called 'raw water' can be distributed directly to customers or treated to a higher level of quality, depending on customer preferences. The sanitation supply chain starts with the collection and transportation of wastewater from customers.

The wastewater is treated to a suitable standard and either reincorporated in the natural water cycle or sold to other customers (Figure 3.1). All these activities typically occur within a single organisation with the supply chain only being interrupted by the brief time that the water is being used at the customer's property. The water and sanitation industry particularly, where government-owned, is an example of complete vertical integration. In most cases, water is harvested or created, stored, treated, transported and retailed without the intervention or involvement of external parties.

The supply chain for water and sanitation has some characteristics in common with that of agricultural commodities. Both water and agricultural commodities are harvested at particular times throughout the year that does not necessarily match up with the demands patterns of customers. The weather also plays a critical role in determining the total yield of the harvest. The product must be stored so that demand and supply can be matched. In agriculture, the commodity is stored in silos, and in the water industry, it is stored in tanks, dams, the reticulation network and aquifers.

There is a significant difference between agriculture and water supply chains in the mechanism used to meet consumer demand from the point of storage. Agricultural commodities are shifted in discrete units or bundles via road, rail and marine transport. Water is most commonly supplied continuously to the customer via pipework directly into the customer's house. The service is provided on demand, with no need for order placing or direct intervention from the service provider. The supply chain for water services is entirely dissimilar to other networked utilities, such as electricity or telecommunications in which supply must always equal demand due to: the inability to store electricity in any economically efficient way; and telecommunications being a service in which supply and consumption are concurrent. The logistical problem of water and sanitation supply is to design a distribution network that is able to manage the diurnal demands of customers (Smith 1999).

The physical provision of water and removal of wastewater are the tangible aspects of the service product concept. Supporting, or auxiliary services, as defined by Grönroos (1990), are those which supplement and add value to the core service in order to differentiate one service provider from another. An example of a supporting service that could be provided by a water and sanitation provider s advice on the efficient use of water. Facilitation services are those that assist with the delivery and consumption of the core service (Grönroos 1990). Examples of these are information provision, order taking, billing and payment. All these activities occur in the retail interface between the distribution and consumption of the services (Figure 3).

Vertically integrated monopolistic organisations have little need for supporting services because there is no possibility to differentiate, facilitation services are, however, indispensable. Supporting services can be eliminated and mainly serve a marketing purpose (Grönroos 1990). Due to the natural monopoly nature of water and sanitation distribution networks, service providers are not able to differentiate on quality as the same water or sewage flows through the same pipes. In a privatised and marketised retail situation, providers can only compete in supporting and facilitation services.

Research on the effect of privatisation of water and sanitation utilities mostly focuses on econometric modelling of macroeconomic benefits (Estache et al. 2005; Fumagalli et al. 2007; Picazo-Tadeo et al. 2008) and much less attention has been given to the effects on the levels of customers service (Tsamenyi et al. 2008). Although little research has been undertaken on the relationship between ownership and service quality in water and sanitation services, all networked utility services, such as electricity, gas, telecommunication, water and sanitation can be considered analogous. Firstly, networked utility services are considered a natural monopoly (DiLorenzo 1996) and have traditionally been undertaken by government-owned organisations (Deichmann and Lall 2007). There are also similarities in customer satisfaction determinants between these services, specifically in relation to continuity and quality of supply (Fumagalli et al. 2007; Hartmann and Ibáñez 2007; Seppälä et al. 2004).

Because of the similarities between networked utility services and the paucity of research in the field of marketing water and sanitation services, this review focuses on research undertaken in different areas of utility provision, mainly electricity retailing. The model used in this paper is static in that it does not address the transition from public to private ownership, but compares the pre- and post-privatisation situation.

Customer Satisfaction

The definition of customer satisfaction is a consumer's post-purchase evaluation of the overall service experience and is an affective reaction. Customer satisfaction is pivotal to create a sustainable competitive advantage, specifically in relation to customer loyalty (Lovelock et al. 2007). Two approaches to measuring service quality most commonly used are ex-post Customer Satisfaction Surveys or ex-ante evaluations of customer preferences (Ferrari and Salini 2008). Satisfaction with utility services is largely determined by actual service levels but is also influenced by personal characteristics and by the evaluation of services relative to that of the customer's peers (Deichmann and Lall 2007).

An often cited tool for assessing customer perceptions of service quality is SERVQUAL (Parasuraman et al. 1988). This instrument provides five crucial dimensions of service quality: Reliability, Assurance, Tangibles, Empathy and Responsiveness. The main benefit of SERVQUAL is its ability to examine different service industries such as healthcare, banking, financial services, and education (Nyeck et al. 2007) The SERVQUAL model has also been used in water and sanitation industry (Alegre et al. 2000; Seppälä et al. 2004).

The provision of services is usually dominated by intangibles, i.e. the service itself is not a physical object. The intangibility of services makes them difficult to visualise and evaluate, which highlights the importance of tangibles in the marketing of services (Lovelock et al. 2007). Tangible aspects of water and sanitation provisions are first and foremost any colour or odour issues related to the provided water or the effectiveness of the sanitation. Other tangible elements of water and sanitation service provision are, for example, the image of employees, publication materials, local offices and so on (Parasuraman et al. 1988).

The water and sanitation service provision is, however, dominated by intangible elements as the service is provided with very little interaction between the customer and the service provider. The provision of utility services, such as water and sanitation, can thus be classified as an intangible, low-involvement service (Lovelock 1983). Customers will, therefore, place a lower value on the tangible aspects of the end product and more value in the process of service delivery. As long as the service delivery is consistent and reliable, customers may be willing to pay a higher price (Walsch et al. 2005).

Reliability is the ability of a service provider to perform the promised service dependably and accurately (Parasuraman et al. 1988). The importance of reliability is highlighted by the fact that any major breakdown in utility provision usually becomes national news. Research by Deichmann and Lall (2007) undertaken in Bangalore, India, shows that household satisfaction with a utility's performance is directly related to the number of hours per day water is available.

The remaining three parameters in the SERVQUAL model are directly related to the behaviour of staff. Responsiveness encompasses the willingness of staff to help customers and provide prompt service. Assurance is the ability of employees to inspire trust and confidence and empathy relates to the caring and individualised attention a firm provides to customers (Parasuraman et al. 1988).

The core water and sanitation services are delivered at arm's length as they are provided directly on the customer's premises. Supporting and facilitating services, however, rely mostly on direct interaction between staff of the organisation and the customer.

In subsequent work, Zeithaml et al. (1993), developed a model (Figure 4.1) to assess the nature and determinants of customer expectations of service. The conceptual model specifies three different types of service expectations: desired service, adequate service and predicted service. Based on this model, five potential gaps in service provision have been identified, of which three are discussed below.

Gap 1 - Customer expectations and management's perception of these.

The difference between the customer's expectation of service and management's perception of these expectations is the first gap defined by Zeithaml et al. (1993). In a publicly owned corporation, management's perception of customer expectations are mostly not market driven, but politically motivated, as will be discussed below.

Gap 2 - Establish the right service quality standards.

The actual service quality standards are the second possible source of service gaps. Public utilities are homogeneous and do not reflect different the demand characteristics of customers (Andreassen 1994; Seppälä et al. 2004). Andreassen (1994) discussed factors that affect business customer satisfaction in privatised state-owned enterprises and found that heterogeneity among the users of public services is reflected in different demand characteristics and that consequently, various segments of users have significantly varying levels of satisfaction. The defining distinction between publicly and privately owned water and sanitation service providers is that the latter is driven by market forces and will thus be more sensitive to segmentation of their customer service offering.

Gap 3 - Meeting service provision standards.

As far as meeting the actual service standards, research generally indicates that there is no distinguishing difference between privately and publicly owned service providers (Fumagalli et al. 2007; Estache et al. 2005). The extant research on this topic is, however, focused on meeting the primary service standards, such as continuity and quality of supply, ignoring the supplementary services (Picazo-Tadeo et al. 2008; Tsamenyi et al. 2008).

Customer Behaviour

An interesting aspect of utility services provision is that consumer behaviour can affect the quality of service delivery (Fumagalli et al. 2007). In water and sanitation, this is illustrated by the imposition of usage limitations in the form of water restrictions in many Australian states. Loyalty is a critical aspect of customer behaviour and a key parameter in creating a financially profitable relationship over time (Lovelock et al. 2007) and is generally considered a more effective business strategy than attempting to acquire new customers as the latter is much more expensive (Hartmann and Ibáñez 2007).

Due to the ubiquity of government-owned monopolies in the provision of water and sanitation services, customer loyalty has not played a role of importance in managerial considerations. The natural monopolistic nature of utility services provides a large barrier to access for a competitive market to emerge and changing providers is thus not a viable option for the customer (Deichmann and Lall 2007). However, experience in areas where service provision is open to competition shows that after privatisation and the introduction of a competitive market, most consumers will not be very willing to change (Hartmann and Ibáñez 2007). In Germany, electricity consumers have been reluctant to exercise choice and few private electricity customers have switched energy suppliers (Walsch et al. 2005).

According to Hart et al. (1997), a market open to consumer choice in which the customer can assess the service quality, a privatised provider is rewarded for quality-enhancing efforts through repeat purchase by customers. The relationship is, however, more complicated. Several approaches to customer loyalty have been proposed in the literature. Gee et al. (2008) introduce the concept of polygamous customers that are loyal to several brands. In the provision of most utility services, polygamous purchasing behaviour cannot occur because of infrastructure constraints and the natural monopoly, i.e. each house can only have one water and sanitation connection. Brand switching can, however, arise in a situation where the retail function has been privatised, as is commonly the case in telecommunications and the energy market.

Jones and Sasser (1995) provide a model to predict the switching behaviour of customers in a privatised water and sanitation retail market. Common sense would dictate that the relationship between satisfaction and loyalty is linear; the more satisfied a customer is, the more likely they will remain loyal. The relationship is, however, dependent upon the level of competition in the market. For water and sanitation services in a situation of natural monopoly, either privatised or in public hands, the relationship between customer loyalty and satisfaction (Figure 4, top curve) is not relevant as the only choice customers have is either to purchase or not purchase the service. The more competitive a market becomes, the more sensitive customers will be to switching and managing customer satisfaction will not be sufficient to ensure customer loyalty.

Walsch et al. (2005) confirmed the findings of Jones and Sasser (1995) and found that customer satisfaction by itself did not have a significant effect on switching intentions of customers from German energy suppliers. The intangibility and heterogeneity of utility services make the interpretation of brands as promised to the customer of particular importance (Hartmann and Ibáñez 2007). The loyalty of residential customers in the energy market depends as much on brand image as on switching cost and satisfaction (Andreassen 1994; Hartmann and Ibáñez 2007). The research by Walsch et al. (2005) indicated that monetary and non-monetary switching cost, risk aversion and lack of transparency in the market are major determinants of the high levels of customer loyalty they found. The market for services can be segmented into 'loyals', 'habituals', 'switchers' and 'multi branders', expressed in the Diamond of Loyalty (Lovelock et al. 2007):

• Loyals have the highest profit potential and have an active preference for the brand with a strong emotional connection. They also see a high perceived risk in switching brands.
• Habituals are passive loyals through inertia. They are behaviourally, but not attitudinal loyal and are passive brand advocates. They are susceptible to switching when there is a service failure or through competitor's promotional deals. Their retention is mostly based on convenience and switching costs.
• Multi branders have a small repertoire of service brands and actively search based on quality and price. They have little involvement in the brand and often seek variety for its sake.
• Switchers are characterised by a broad portfolio of brands and are sensitive to price promotions and have a low perceived risk of switching.

In summary, service marketing theory (Jones and Sasser 1995; Lovelock et al. 2007) and research in the retail of utilities (Hartmann and Ibáñez 2007; Walker and Johnson 2005) show that a correlation exists between customer satisfaction and customer loyalty. There is, however, no direct causality between satisfaction and loyalty as other confounding variables, such as customer psychology and brand image, are at play.

Given the experience in some privatised utility markets (Hartmann and Ibáñez 2007; Walker and Johnson 2005), most customers could possibly be classified as either Loyals or Habituals. The implications for managers is that managing customer satisfaction will not be sufficient to stimulate loyalty, as shown by Jones and Sasser (1995). The central question to be asked is whether the existence of loyalty segmentation as confirmed by Walsch et al. (2005) for electricity retail in Germany, as exists in water and sanitation retailing.

The past decades, water and sanitation service providers have been privatised in several jurisdictions around the world. The motivation for this wave of reform is predominantly based on econometric considerations. Evidence on the effectiveness of privatisation is mixed but point towards there being no significant economic difference. The research on this topic has been widely myopic of the marketing implications of privatisation. Also, the environmental complexity and the myriad of confounding variables, in particular, differences in legislation around the globe, frustrate the possibility of drawing firm conclusions.

A review of the extant literature on the privatisation of utility services and services marketing theory shows managerial behaviour as a possible independent variable influencing customer satisfaction as described in the relational model in figure 5.1.

The transition from publicly- to a privately-owned provision of water and sanitation services has been driven by a quest for improved efficiency, demonstrated by the recent wave of water privatisation of most networked utility services. In many countries around the world, there is already significant private investment in the provision of water and sanitation services, but the impact of privatisation on the level of customer service has been widely ignored.

It is argued that a change of ownership structure in the provision of retailing services significantly improves the behaviour of managers that are responsible for the interfunctional coordination of the service organisation. As described in the conceptual model, this has a direct impact on all at least three dimensions of the SERVQUAL service provision model: Responsiveness, Assurance and Empathy. The consequent change in service quality acts to influence customer satisfaction and in turn altering customers' loyalty behaviours.

The proposed model, though based on germane secondary research, has been developed under the assumption that networked services such as telecommunications, transport and energy are analogous to water and sanitation services. It is proposed that future research is undertaken to focus on testing this model, specifically within water and sanitation service provision. Given the upcoming changes to the contestable provision of services in the Victorian water and sanitation sector recommended by the Essential Services Commission, the ideal industry environment exists to test the model. In doing so, this model may provide insights into how the industry may transition to a free-market model in which each of the parties involved in the transaction described by Milton Friedman in the epigraph will receive maximum benefit.

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