There are no close substitutes. The product cannot be stored or easily transferred from one customer to another. The service is most efficient if produced by a single firm. Firms are characterized by declining marginal costs, high capital costs and high initial fixed costs. The natural monopoly may be temporary or permanent.
Externality is the second form of market failure.
In this case one must compare private costs to public costs. The costs are unintended and not compensated. Pollution is an example. Alternatives to regulation in these instances are private lawsuits, taxes and subsidies. Equity is the third form of market failure that justifies regulation.