Economies of scale and scope in the Japanese water industry

Takuya URAKAMI※ , Faculty of Business Administration, Kinki University
Tomoyasu TANAKA, Faculty of Business Administration, Kinki University

Introduction
In the past decades, the effectiveness of privatization and deregulation in the area of public
utility industries such as electricity, gas, water, telecommunication, and transportation havebeen significant interests of researchers worldwide. At the same time, quite a lot of empiricalstudies have been conducted in different industries in different regions. One of the major
focusing points of these studies is to find the existence of natural monopoly because if it
doesn’t exist, monopolistic supply should be no longer allowed and then the market should bedivided as well as competitively supplied by at least two or more companies.
Natural monopoly tends to disappear due to the technology development which not only
decreases average production cost but also reduces minimum efficient scale of production. As
is well known by practitioners and researchers, the technology of water industry has not been
progressed as compared to electricity, gas, telecommunication, and transportation industries
where privatization or deregulation policies have been adopted in many countries.
Furthermore, the water industry has specific characteristics, such as essential commodities oflife, lack of substitute goods, necessities of maintaining high-qualities of purified water and soon. Therefore, water supply services have traditionally been provided by state- or
municipally-owned water utilities and then unmoved to public-turned-private organizations.
In fact, Van Ginneken and Kingdom (2008) reported that the major transition of water utilities
in the 1990s had not been from public to private operation, but from centralized todecentralized public provision.
As far as we know, quite a lot of empirical studies have been conducted worldwide in thewater industry. Most of them have been focusing whether economies of scale and/oreconomies of scope does exist in the industry because, as mentioned above, the commoninterests of regulators and managers of water utilities are in the most efficient scale (scope) ofoperations, not in the ownership changes or other drastic regulatory reforms.
In this study, we try to investigate effectiveness of scale expansion of Japanese waterutilities. The benefits of using data in the Japanese water industry is that almost all of waterutilities in Japan are owned and operated by local governments (99.4% in 2005) and many ofthem have been consolidated since 2000 (total number of water utilities changed from 1,964
in 2000 to 1,572 in 2006), so that we can conduct before- and after-consolidation analysis
about really consolidated water utilities. Furthermore, we can use in-depth operating and1

accounting data provided online by The Ministry of Internal Affairs and Communications(http://www.soumu.go.jp/c-zaisei/kouei.html) which enables us to investigate whether or not
economies of scale and/or economies of scope exist in the Japanese water industry.
The structure of the paper is as follows after the introduction. In the first section, we will
give an overview of the water industry in Japan, some background to aid in understanding thereasons of high cost structures and the brief history of WSSs’ consolidation. In the second
section, the methodology for the cost models will be explained. In this section, we addresssome modifications of the cost function models. Third, we will show estimation results andanalyze what factors have been affected from consolidations. Finally, we will summarize ourresults in a conclusion.
The Japanese Water Industry
The Number of Water Supply Systems
Since the first modern water supply system (WSS) was constructed in Yokohama in 1887,
WSSs have been expanded throughout of Japan. WSSs are categorized into four types by theWater Act: Large Water Supply (LWS); Small Water Supply (SWS); Small Private Water
Supply (SPW); and Bulk Water Supply (BWS). LWS is defined as the system wherein water
is to be supplied to an estimated population of over 5,001, whereas SWS is defined as thesystem in which water is to be supplied to an estimated population between 101 and 5,000.
SPW refers to the water supply system in buildings that are equipped with holding water tanks
that have a capacity of more than 10m3 and can receive portable water from large/small watersupply systems. On the contrary, BWS is defined as the water supply systems that supply
portable water to large/small water supply systems and not to the end user1.
It is worth mentioning that water services have been supplied by a large number of small
WSSs. Even in the case of LWSs, the average number of water supplied population is only
73,526. The reason is that WSSs have generally been owned by the local governments ofcities, towns and villages. This is mainly because the local governments are considered toplay an important role in the prevention of water-borne infectious diseases and fire expansions(fire expansions are the result of the popularity of wooden houses being built in Japan) whichwere thought as big disasters at the time when modern water supply systems became to berequired.
Water Supply Cost
The price index of water and sewerage services has increased dramatically in recent years.
In our later analysis, we sample the observations from LWSs because only LWSs provide
potable water under the regulation of independent accounting systems. Therefore, when weuse the word ‘water utilities’ in this paper, it means LWSs.
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Urakami (2007) pointed out that the reason of this dramatic increase of water utility rate wasdue to three factors – the type of ownership of water utilities, a lack of competition due toderegulation issues, and the number of water utilities. As mentioned above, almost all ofJapanese water utilities are owned and operated by local governments. Generally,
publicly-owned water utilities tend to over-estimate future demands, perhaps due to theutilities’ focus on social welfare issues rather than cost-efficiency. To make matters worse,
recent decline of water demand due to the development of water-saving technologies (e.g.
water-saving toilet systems, water-saving washing machines, etc.) as well as change of life
style (e.g. eating out more often, taking a shower instead of taking a bath, etc.) led to thereduction of water revenue – resulting in increased water prices.
Drastic regulatory reforms have been undertaken in public utility industries in Japan, suchas electricity and gas (liberalization of market entry), transportation (deregulation ofsupply-and-demand balancing), and telecommunication (breakup and privatization). On thecontrary, in the case of the Japanese water industry, such kinds of deregulations have not beenpromoted. That is because, as mentioned above, water industry has specific characteristics,
such as essential commodities of life, lack of substitute goods, necessities of maintaining
high-qualities of purified water and so on. As a result, natural monopoly has remained in thewater industry so that competition has not been promoted.
Not only researchers but also practitioners have recognized that the scale disadvantages doexist in the Japanese water industry. KIIS (2006) conducted a questionnaire survey analysis
and concluded that the main reasons of high cost structure of Japanese water industry werehigh percentage of purchased water cost and depreciation cost. Therefore KIIS suggested thatwater utilities should consolidate their plants or vertically integrate water intake-purification
only companies and water-delivery only companies in order to save costs and operate watersupply systems more efficiently. On the other hand, Mizutani and Urakami (2001)
concluded that the optimal size of a water supply system should be 766,000 consumers; which
is more than ten times larger than the average size of LWSs (73,526). However, thepercentage of number of water utilities whose size of water supplied population is more than
500 thousands, is only 1.5%. This indicates that there must be so many cost-ineffective water
utilities in Japan.
Methodology
Composite Cost Function
Traditional functional forms such as Cobb-Douglas and Translog have been used to estimate
economies of scale and/or economies of scope. However, if some parts of observations
include zero outputs; these functional forms would be inadequate because they have
log-quadratic structures for output variables. To tackle this problem, researchers have applieda Box-Cox transformation to the Translog model (which is well known as Generalized3Translog); however question does arise even in this case: whether zero should be treated thesame as nonzero data or whether zero represents a discrete corporate decision from othervariations in the variable levels. (Greene 2008, pp.296-297) Therefore, in this study, aComposite cost function is selected as a cost model of water utilities. (the details were omittedin this resume version)
Data
All of the data used in the analysis was collected from the Annual Statistics of Local PublicCorporations, (Chihou Kouei Kigyo Nenkan, in Japanese) edited by the Research Associationof Local Public Firm Management (Chihou Kouei Kigyou Keiei Kenkyu Kai, in Japanese),and the Statistics of Water Works (Suido Tokei, in Japanese) edited by the Japan Water Works
Association (Nihon Suidou Kyokai, in Japanese).
(Variables used in this analysis were omitted in this resume version)
Estimation Results
The estimation methods are the SUR (Seemingly Unrelated Regression) for a total costfunction with input share equations. Before estimation, all variables except for time trend anddummy variables are normalized by sample means. The estimation results are shown in Table
3. The goodness-of-fit is acceptably high and the first-order coefficients of output and input
factor prices show the correct signs and are statistically significant at 1% level.
The estimated coefficients of time trend shows negative sign and is statistically significant
at 1% level. On the other hand, the estimated coefficients of cross term of consolidation
dummy variable with time trend shows negative sign and is statistically significant at 1%level. Our result also shows water utilities’ consolidation has a negative impact on cost
reduction during sample periods, however it is quite smallFurthermore, the estimated coefficient of a type of water utilities dummy variable shows
negative sign and is statistically significant at 1% level; however the extend is surprisingly
small. It suggests that consolidated water utilities are 2.0% more cost effective thannon-consolidated water utilities.
As for the estimation results of economies of scale and economies of scope are also shownin Table 3. The estimation results overall economies of scale show 1.020, indicating that there
are economies of scale for Japanese water utilities, evaluated at sample mean points. In
addition, estimation results of economies of scope show 0.534 for consolidated water utilities
after water utilities’ consolidation and 0.530 for non-consolidated water utilities. This
indicates that, in both cases, there are economies of scope for water delivery and water
purification so that Japanese water utilities could achieve cost savings from vertical
integration.
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Conclusion
The primary purpose of this study has been to investigate the existence of economies of scaleand economies of scope in the Japanese water industry. This analysis relates world-wideinterest about the optimal scale of water supply systems and optimal scope of services thatwater utilities provide.
The obtained results from our analysis are that there exist overall economies of scale forJapanese water utilities, as well as Japanese water utilities could achieve cost savings fromjoint operation between water delivery and water purification. These indicate that not only
horizontal but also vertical scale expansion could lead to cost savings.
One another result we obtained from our analysis is that water utilities’ consolidation has
had beneficial impacts on cost effectiveness, but that is quite restricted. Almost eight years
have passed since the beginning of local governments’ consolidation, however large part ofCWUs have been consolidated only for two or three years. It is easily thought that theeffectiveness of consolidation in short time periods would be restrictive, so that we think weshould continue to analyze the effectiveness of consolidations in the future.

Figure 1 Number of Water Supply Systems

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Table 3 Estimation Results
Variable

Estimate

SE

Variable

Estimate

SEConstant

0.017

0.001

wL  wO-0.067

0.004

y DEL

0.762

0.015

wK  wE-0.001

0.002

y PUR

0.161

0.014

wK  wE-0.047

0.006

y DEL  y DEL

0.032

0.005

wE  wO

0.006

0.002

y PUR  y PUR

0.031

0.006

Z POPNET-0.1340.008

y DEL  y PUR-0.0330.006

Z CAPUTL-0.3560.026

y DEL  wL

-0.0820.003

Z COVRAT-0.0870.022

y DEL  wK-0.091

0.016

Z DAYWAT-0.5410.014

y DEL  wE

0.000

0.009

ZUNDWAT-0.1160.009

y DEL  wO

0.1720.020

Z PURWAT

0.614

0.024

y PUR  wL

0.045

0.001

Z HIGHPU

0.104

0.011

y PUR  wK-0.119

0.014

t-0.014

0.002

y PUR  wE

0.026

0.009

tDCon

0.011

0.002

y PUR  wO

0.047

0.017

DType-0.020

0.007

wL

0.206

0.003

SE DEL

0.811

0.015

wK

0.482

0.004

SE PUR

0.170

0.015

wE

0.083

0.003

SE

1.020

0.001

wO

0.229

0.010

0.534

0.006

wL  wL

0.109

0.004

0.5300.005

wK  wK

0.086

0.005

R square (total cost)0.938

w E  wE

0.000

0.001

R square (labor cost)

0.279

wO  wO

0.108

0.009

R square (capital cost)

0.373

wL  wK-0.038

0.003

R square (enegy cost)

0.294

wL  wE-0.005

0.001

SC withdummy
SC without

dummy

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