The Effects of Institutional Arrangements in Local Water Supply Services in Korea
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The Effects of Institutional Arrangements in Local Water Supply Services in Korea Suho Bae, Ph.D. Graduate School of Governance Sungkyunkwan University, Seoul, Republic of Korea [email protected] Moon-gi Jeong, Ph.D. Graduate School of Governance Sungkyunkwan University, Seoul, Republic of Korea [email protected] Seong-gin Moon, Ph.D. Department of Public Administration Inha University, Incheon, Republic of Korea [email protected] ABSTRACT In Korea, local governments are mainly responsible for providing water supply services to citizens. Since 2004, 15 local governments have contracted this service to Korean Water Resources Corporation (K-Water). This paper examines the effects of the two different institutional arrangements— direct public delivery versus contracting out to K-Water—on cost saving and productivity. To do so, it employs a hybrid cost function approach and uses panel data covering the nine years from 2000 to 2008 in local governments. Empirical findings show mixed evidence on the effects of the two institutional arrangements on cost savings and productivity gains. Water supply costs are significantly lower under contracting out than under direct public delivery. But local water supply systems achieve productivity gains in both institutions, and there are no significant differences in productivity gains between them. Local water supply systems need to further reduce average water supply costs through increasing their size and magnitude. Keywords: water supply services; contracting out; total factor productivity (TFP); economies of scale; factor substitutability. Presented at the Annual Conference of the Association for Public Policy Analysis and Management, May 25-27, 2013 in Shanghai, China. 1 I. Introduction Local service delivery mode and its efficiency have gained continuing attention among scholars and practitioners over several decades. The monopolistic public service delivery by governments has been criticized as inefficient. Thus, as an alternative institutional arrangement, private production including contracting out has been supported to reduce costs and improve productivity. While this line of research was largely conducted in the context of western countries, alternative service delivery mode is also gaining significance in the countries with transitional economies, including South Korea. In particular, water supply services, which are one of crucial services for quality of life at the local level, face challenges from citizens for better quality of water services with lower costs. One of solutions to resolve such challenges is to employ an alternative service arrangement through privatization (or contracting out). In Korea, local governments are mainly responsible for providing water supply and wastewater treatment services to citizens. Since 2004, instead of direct delivery of water supply services, some local governments have slowly adopted another type of institutional arrangement, that is, contracting out to Korean Water Resources Corporation (K-Water), in operating and managing water supply systems and delivering water supply services to their residents.1 Currently, 15 water supply systems among 164 local systems deliver water supply services to their residents under contracting out to K-Water. This paper examines the effects of the two different institutional arrangements – direct public water delivery service versus contracting out to K-Water – on cost saving, productivity, economies of scale, and factor substitutability in delivery of local water supply services in Korea. This study advances the previous research on contracting out and cost 2 savings in water supply services using the Korean case. First, most previous studies primarily focused on U.S. and U.K. data for empirical analysis. Only a few studies examined developing countries including Asian and Pacific countries as well as African countries (e.g., Estache and Rossi, 2002; Jones and Mygind, 2000; Kirkpatrick, Parker, and Zhang, 2006). For example, Estache and Rossi (2002) examined 50 water supply systems in Asian and Pacific countries, and Kirkpatrick et al. (2006) examined 76 water supply systems in African countries. But these cross-country studies could not control for unexplained variations across countries such as water- and sewer-related regulatory frameworks, natural environments, and geographical characteristics. This paper uses data from water supply systems in South Korea, which will help improve the efficiency of empirical estimation and provide a more precise estimate of the effects of public delivery versus contracting out on cost savings and productivity. Second, in empirical estimation, it employs explanatory variables representing service attributes and local characteristics related to water supply services, such as pipe length, water supply capacity, water supply rates, recovery rates of water supply costs from water charges, and population density. This approach also helps improve the efficiency of empirical estimation and provides a more precise estimate of the effects of public delivery versus contracting out for water supply services. Third, it examines differences in productivity between the two institutional arrangements. For a more sophisticated model to explain the relationship between contracting out and cost saving in water supply services, this study employs a hybrid cost function approach to measure total factor productivity (TFP), supply elasticity of cost, return to scale, price elasticity of input demand, and the Morishima elasticity of substitution. For empirical estimation, it uses cross-sectional time-series data covering the nine years from 2000 to 2008 in Korean local governments. 3 In Section II, this paper explains the local water supply systems in Korea and provides an overview of the current literature on privatization and contracting out in provision and delivery of water supply services. Then, Section III presents an empirical model for parameter estimation, along with TFP, supply elasticity of cost, return to scale, price elasticity of input demand, and the Morishima elasticity of substitution. Section IV describes data sources and variables, along with descriptive statistics. Section V presents empirical findings, and Section VI summarizes empirical findings and discusses study limitations. II. Literature Review 1. Privatization of Water Supply Services According to Vickers and Yarrow (1991), privatization can be classified into three types. The first type is “privatization of competitive firms,” which means transferring “state- owned enterprises operating in competitive product markets” to the private sector. The second type is “privatization of monopolies,” which means transferring “state-owned enterprises with substantial market power” to the private sector. The third type is contracting out of public services that were previously financed and delivered by the public sector. In most cases, privatization of water supply services can be categorized as the third type of privatization. Pure privatization means transferring the ownership of physical assets from the public sector to the private sector, while contracting out means that private companies only operate and manage water supply systems while the public sector still maintains the ownership of physical assets (Domberger and Jensen, 1997). According to Vickers and Yarrow (1991), however, since contracting out allows private companies to take profits and financial surplus from service delivery, the transfer of profits to private companies can be 4 also considered as a kind of privatization. Thus, contracting out is not different from privatization. Since the mid-1970s, empirical studies have examined the relationship between privatization or contracting out and cost savings in water supply services. Most previous studies have examined privatization in U.S. and U.K. contexts and provided mixed empirical findings (Bel and Warner, 2008). Some studies have found that costs of water supply services are significantly lower under direct public delivery than under private delivery (e.g., Bhattacharyya, Parker, and Raffie, 1994; Bruggink, 1982; Lynk, 1993; Mann and Mikesell, 1976; Souza, Faria, and Moreira, 2008), while others have suggested the opposite effect (e.g., Crain and Zardkoohi, 1978; Morgan, 1977; Raffie et al., 1993) or have found no significant difference between the two institutional arrangements with respect to cost savings (e.g., Ashton, 2001a, 2001b; Brynes, 1991; Feigenbaum and Teeples, 1983; Fox and Hofler, 1986; Teeples and Glyer, 1987; Bhattacharyya et al., 19952; Saal and Parker, 2000). While an alternative service delivery mode such as contracting out gained great significance for efficient delivery of public services, most findings are at best mixed. This paper attempts to examine the Korean experience of an alternative institutional arrangement for water supply services. Korea, which has a rapidly changing economy, has tried to provide innovative public service delivery systems through privatization or contracting out. This examination of a transitional economy expands the current literature regarding the monopolistic delivery of public services by governments and an alternative service delivery system. 2. Local Water Supply System in Korea 5 Local governments in Korea are mainly responsible for the provision of water supply services. A majority of local governments directly produce and deliver this crucial service to their residents. It is known that water supply systems in small rural local governments are operated