english summary

Analysis of the cost structure

of the Italian water industry
Economies of scale, density and scope
Adequate ways to implement the reform of the water and sewerage industry in
Italy, which started a good twelve years ago with the Galli law (36/1994) have
not yet been found.
The report on the state of water and sewerage services presented to Parliament
in 2005 by the CoViRI stated that 87 out 91 Area Authorities had already been
set up to cover 97% of the national population, while integrated water services
had been established in just 43 areas. The situation is still one of transition, even
if particular efforts have been made towards implementation in recent years.
There is lively debate over the adequacy of a regulatory system designed over
a decade ago and based on limited information, which applies largely to a geo-
graphical area and an industry sector that has changed and is still developing
from the viewpoint of technology and resource management.
The water sector in Italy is heavily fragmented and there are large differences in
how services are managed with substantial structural and qualitative deficits. The
Galli Law started the reorganisation of the entire water and sewerage cycle by
putting an end to localisms in pursuit of economies of scale and scope through
vertical and horizontal integration and the creation of operating conditions that
would allow the industry to develop.
The national scenario is still dominated today by huge numbers of small service
operators, many of which are still working in house. Among industrial operators
s still represented by the majority of the public sector service operators while
private sector operators account for just a small proportion of the total, although

Scale economies
AAbsolute
bsolute values
values
1,05
number of consumers
growth direction
1,03

1,00

0,98

0,95
50.000 300.000 550.000 800.000 1.050.000
water delivered, cu.m.

1,05

1,00

0,95 mean point

0,90

0,85
0 30.000.000 60.000.000 90.000.000 120.000.000 150.000.000
water delivered, cu.m.

Source
Source: : Rcalculation
REF on CIPE-MAP
on CIPE-MAP
ef calculations data data


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it is significant in terms of tech-

Costs complementarity and scope economies nology solutions employed. The
high degree of fragmentation
Absolute values (1)
Translog (2) in the industry is due to the ex-
αAαF+αAF -0,03 istence of separate operators
αAαD+αAD -0,05
for the different stages of the
Generalised quadratic function (2) water and sewerage services
2∗α0−αAF−αAD−αDF -0,21
cycle, to the municipal scale
1-(CA+CF+CD)/CAFD
dimensions of water and sew-
-0,07
Source: REF calculation on CIPE-MAP data
erage networks and finally to
(1) Scalar values are calculated in the function mean point. division of the supply among
(2) Scope economies occur when the variable is negative.
large numbers of operators.
The purpose of the study pre-
sented is to analyse the underlying production structure of water and sewerage
services and to find answers to more pressing questions.
Can the Italian water and sewerage industry solve the problems of the techno-
logical, structural and geographical constraints that history has imposed on the
national scenario by employing an appropriate operating model for it? Can the
efficiency degree needed to achieve modern industrial management of these
services be carried out using the regulatory instruments currently available?
More pragmatically, has the reorganisation of the industry generated improved
efficiency, or in other words do the economies of scale and scope on which the
entire reform is based exist?
The answers to these and other questions emerge above all from studying the
production functions of the industry. This is performed in this research by fol-
lowing established methods found in the literature: analysing the dual problem
of cost structures. An estimate of the variable cost of a multi-product function is
modelled by a Translog specification using a system estimator (SURE).
An estimate of the variable cost functions for each service is used to examine the
most significant characteristics, such as whether economies of scale and density
exist. The definition of the concept of economies of scale is not so obvious in the
utilities sector and for services networks in general for the same reason that it is
not simple to identify the output produced. The approach adopted is based on the
vectorial dimension of the output (multi-product function). For example the water
service is considered jointly in terms of the quantity delivered, the consumers
served and the length of the distribution network. As a consequence, economies
of scale also assume a vector nature and are represented as a function of these
three components of output.
The existence of economies of scale is examined using a procedure consisting
of two stages. Firstly a dummy binary variable is included, which identifies the
operators responsible for running the entire water and sewerage (integrated)
cycle, in a specification which represents each service. The purpose of this pro-
cedure is to first of all find out whether gains in efficiency can be achieved from
simultaneous management of more than one service as compared with single
service management. A cost function is then modelled for management of the
entire water and sewerage cycle using a multi-product specification in which the
delivery of each service constitutes an output. Two distinct specifications are
investigated in this second stage: a Small Value Translog Function (SVTF) and
a Generalised Quadratic Function. Both models are needed to simultaneously
maintain single and integrated service operators in the estimate sample because,
as opposed to simple Tanslog functions, they allow the presence of zero outputs.
This requirement is satisfied in the conviction that the information obtained from
both types of operator is equally important to a study of the cost structure of the
water and sewerage industry as a whole.
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 english summary

The sample employed is composed of approximately 330 elementary cross

sectional observations based on the tariff structures in force as required by the
recent CIPE-NARS (consultative nucleus for the implementation of guidelines
for the regulation of public utilities services) regulations. The sample consists
of a heterogeneous collection of realities ranging from operational units which
distribute approximately 132 thousand c.m. (1st decile) to units delivering 15
million cu.m. of water per year (10th decile). The set of variables contained in the
Chambers Statistics Archive on the Water and Sewerage Sector (Archivio statistico
Camerale sul Settore Idrico-ACSI) is particularly detailed and allows satisfactory
empirical counterparts to the economic values considered in microeconomic
theory to be constructed.
The estimates obtained for water services are very robust, at least as far as the
fundamental variables are concerned. An average value of 0,93 emerged for
diseconomies of scale in our sample. A value of 1 for this property corresponds
to complete diseconomies of scale. In practical terms the result implies that a
10% increase in the operating scale would increase variable unit costs by 0,7%.
An increase in the operational scale must be interpreted in this respect as an
identical percentage increase in the quantity of water delivered, the number of
consumers served and the length of the distribution network. If the concept is
forced a little, this theoretical exercise can be considered the same as the much
more concrete reality of a “merger” between two geographically adjacent opera-
tors with similar overall characteristics.
A very different result is found for economies of density, a measurement obtained
by increasing the proportion of water delivered and consumers served while
holding the length of the network constant. In practical terms this is the same
as increasing the degree of urbanisation in a given geographical consumer area.
In this case an increase of 10% lowers the variable unit costs by 2,2%. This is
hardly surprising because since it does not require any increase in the distribu-
tion network, the total variable cost increases less, relatively.
The translogarithm formula was chosen, however, because it allows economies
of scale to be studied as a function of increases in the dimension of each output
and also the effect of its composition to be assessed. The function obtained for
water services in particular lies on a four dimensional hyper plane because its
output is three dimensional. Two of the outputs, the number of consumers and
the length of the distribution network, must be held constant leaving the volume
delivered free to vary in order to represent the function on a more practical two
dimensional plane. A fairly flat curve is obtained for high volumes, which gives
low economies of scale for very low volumes and then drops very sharply into
the diseconomies zone.
Evaluation of economies of scale cannot be achieved without considereing all the
dimensional variables. This aspect is investigated by plotting a bundle of curves
on the same plane for different numbers of consumers. Two main conclusions
were drawn from these curves. Firstly, there are clear economies of density.
The curve moves upwards as the number of consumers raises, so the level of
delivered water beyond which it falls back into diseconomies of scale increases
but less than proportionally. The second conclusion concerns the physical rela-
tionships between the values: there must be a consistent relationship between
the volumes delivered and the numbers of consumers served. On average each
operator delivers approximately 200-500 cu.m. per year to each consumption
point. Consequently an average number of consumers should generally consume
a quantity of drinking water which would bring it, according to the curve plotted,
into the diseconomies zone. The conclusion drawn is that a normal operator does
not make any savings on costs from increasing the consumer base served.
The economies of scope analysed in the cost structure of each service revealed
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the chance to make gains in efficiency from the management of sewer and
sewage treatment services in addition to drinking water supply services. These
savings amount to around 7% .
The complementarity of the costs of different services was evaluated using a
common method of analysis: the Small Value Translog Function for integrated
service operators. Complementarity between water supply and sewer and water
supply and water treatment services was found. Evaluation of the third combina-
tion, sewer and water treatment, would have made little sense in reality.
Finally the Generalised Quadratic specification indicates whether the total cost
incurred from integrated operation is greater or less than single service opera-
tor provision. The result showed a saving of approximately 7% from integrated
operation. This result assumes greater reliability when it is considered that it is
similar to that obtained using the previous methodology.
To conclude, the results obtained are in line with those encountered in most of
the literature. Low diseconomies of scale exist in the water services industry, but
it enjoys good economies of density. Joint management of these characteristics
may lead to gains in efficiency. Substantial economies are obtained in integrated
management of the water and sewerage cycle, to a greater extent from vertical
integration of services because of cost complementarity between water supply
and water treatment services.

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