Lessons from power sector reforms for the reform of the Indian urban water sector

Indicus Analytics, An Economics Research Firm
http://indicus.net/Media/index.php

Lessons from power sector reforms for the reform of the
Indian urban water sector

Payal Malik
Tuesday, 18 March 2008 00:00

Although in the larger hydrological picture, the urban consumer's water demand
necessarily competes with that of the rural consumer and the farmer's demand for water
as an input, the management of any given amount of urban water is a problem that can
be sensibly isolated from the larger picture. This partial equilibrium problem was the
object of this study.

If one were to compile two lists, one of the areas of economic management that directly
impinge on the daytoday quality of life of all citizens, and another of the areas in
which misguided policies have resulted in outcomes far short of potential outcomes,
then it is reasonable to conjecture that the electricity and water sectors would have pride
of place in both lists. In both cases, not only were policies followed that were contrary
to good sense as dictated by the science of economics, but more perversely, they
undermined the very political and economic interests whose furtherance was
proclaimed by socialist rhetoric to be the raisondeetre for these policies. Indian
economic policy failures are often charitably excused by the plea that policymakers
were softhearted, but presumably hardheaded. However, an ex ante appraisal of the
economics underlying these policies leads one to believe that they were softheaded,
while the ex post impact on the populace points to hardness of heart. While the
continuance of these policies in the short run may be attributed to naivete and an
ideologically blinkered worldview, or an inability to recognize and repair the
unintended consequences of wellmeaning efforts, their longevity points elsewhere. It is
evident that the political and economic elites coalesced into a nexus that supped at the
high table on the rents created by the misguided policies while placating the electoral
votebanks with a steady diet of socialist rhetoric and some populist crumbs from the
table.

As in every other area of economic policymaking, the populist consensus on socalled
socialist strategies has been sturdy and tenacious enough to withstand all challenges
short of a crisis or voter rebellion. The crisis in the electricity sector stems as much

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from the consumption aspirations of the citizenry as from the demands of factories,
farms and serviceproviders who increasingly have to compete not only among
themselves domestically, but also with the rest of the world. Somewhat differently, the
crisis in the water sector is caused largely by the inability of existing water
management institutions to slake the thirst of consumers. Although in the larger
hydrological picture, the urban consumer's water demand necessarily competes with
that of the rural consumer and the farmer's demand for water as an input, the
management of any given amount of urban water is a problem that can be sensibly
isolated from the larger picture. This partial equilibrium problem was the object of this
study.

Intellectual map of the dirigeste


What did the dirigeste view of the electricity and water sectors amount to?

First, water and electricity are often viewed as ``public goods'', although they do not
have the properties required of public goods. Applying standard definitions, water and
electricity are private goods. This seemingly innocuous error has been used to dictate
inappropriate institutional design, and distort investment and pricing decisions.
However, this error does not stem merely from intellectual lethargy. As in many other
policy problems where the commodity in question is inappropriately labelled a ``public
good'', the reason for this inappropriate categorization is not difficult to see. The
inherent nature of a true public good does not allow straightforward commercial or
economic costbenefit analysis. As such analysis is invariably vitiated by considerations
of externalities and some of the concerned goods being ``merit goods'', the planner or
policymaker has wide latitude and discretion in skewing decisions in a chosen
predestined direction. Thus, by the sleightofhand of simply labelling private goods as
public goods, headroom is created for policy intervention and distortion.

Another peculiar view espoused by radical Greens and anarchists is that water is a
common property resource of the community and its allocation and value cannot,
indeed should not, be determined using the standard economic paradigm. This warm
and fuzzy view may be appropriate for small communities drawing their water from an
unspoilt mountain stream or natural spring, but wholly inappropriate for large urban
areas with treated and piped water. Water treatment and transport are costly activities

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and represent value addition to the raw water. The problem of designing institutions for
the allocation of these costs is no different from that faced in a host of other commodity
markets in which transport depends on a fixed common network.

Secondly, in line with the philosophy of Sovietstyle planning, which in its purest form
sought to reduce the entire economy to one monolithic enterprise whose technology
was represented by a vast inputoutput table that the planner used for decisionmaking
purposes, electricity and water were viewed as the products of centrally controlled and
very highly vertically and horizontally integrated ``sectors'' run by bureaucrats.
Undoubtedly, the nature of technology involved (e.g., the network nature of the
distribution system) organically forces a degree of horizontal and vertical integration.
However, it stretches credulity to argue that the full integration of the valueaddition
chain with respect to both water and electricity were technologically determined.
Clearly, scant attention was paid to the possibility of using functional distinctions to
disaggregate the valueaddition chain so that appropriate institutions could be designed
for these functionally distinct activities. For instance, it is by now clear and well
accepted that electricity is not the product of a single vertically integrated industry but
consists of at least three functionally distinct activities, namely generation, transmission
and distribution, which admit quite different industry structures and allocation
institutions.

Thirdly, populism reduced prices, literally and figuratively, to ciphers that were
incapable of conveying any useful economic information. As politically determined
prices were divorced from the underlying economic fundamentals of consumer
preferences and production technology, represented by the forces of demand and supply
respectively, they were incapable of serving any useful economic function such as
guiding investment choices, technological choices, or consumption choices. For
instance, apart from legal and institutional barriers to entry, absurdly distorted prices
rule out private investment in most parts of the electricity and water sectors except
when all commercial risks are eliminated by the provision of comprehensive state
guarantees. Distorted pricing of inputs and outputs forces inappropriate choice of
technology and spatial location of production activities. Finally, populist pricing
provides final consumers with no incentive to economize and wisely use electricity and
water, should they be lucky enough to actually get these goods. In short, lower than
``equilibrium'' prices of water and electricity encouraged demand and discouraged
supply, thereby quantityrationing a (substantial) number of potential buyers.


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It is telling that in the popular imagination water tariffs are often referred to as ``taxes''
rather than as ``prices''. This confusion neatly encapsulates a basic flaw in the status
quo and indicates a direction for policy reform. Taxes as an economic category describe
an impost by the state for the purpose of providing public goods or for redistribution of
resources by fiat. Being artificial impositions by the state, they carry information about
the state's moral stance, but little useful information regarding economic values,
preferences, technology, etc. On the other hand, as was stressed by von Hayek, prices
are the lifeblood of the economic system as they incorporate and disseminate vital
economic information with an efficiency that a tax cannot hope to match. So, changing
tariffs from whimsically imposed ``taxes'' to economicallyjustified ``prices'' is a major
part of the reform agenda.

Fourthly, it is a corollary of the above characteristics that, as the management and
pricing of water and electricity eliminated the possibilities of private investment and
curbing demand, using public investment to augment supply was the only way to bridge
the demandsupply gap. This reliance on a single policy instrument resulted in a Soviet
style obsession with building visible ``temples of modern India'' without any effort to
justify them commercially, or efficiently exploiting existing assets, or maintaining and
upgrading existing systems, or finding appropriate alternative technologies instead of
big projects. For instance, in the power industry, the obsession was to build new power
plants rather than improve the woeful PLFs of existing plants, or to eliminate power
theft; in the case of water, the obsession was to augment the amount of water going into
municipal networks, without caring that most of the water simply leaks out of the
network before reaching the consumer. Unfortunately, the statist planning mentality
inevitably reduced the assets created by public investment to ends in themselves. Once
created, these assets usually languish without a determined effort to see that they
deliver the value that the planners expected from them.

Populism implies that it is politically more advantageous to build new assets rather than
do the harder work of maintaining existing ones. After all, a new water treatment plant
or electricity generation plant built with public money is decidedly more visible and
politically bankable than a less visible project to strengthen the distribution network.
Such public investment has a number of other aspects. First, the paucity of public
resources and the myriad demands on these resources for purposes that properly lie in
the state's eminent domain (e.g., the provision of true public goods) mean that the
opportunity cost of these funds is high. Secondly, public investment in projects with
low average revenue implies large implicit subsidies to those who can access the

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resulting outputs. Thirdly, by subsidizing the consumption of the ``lucky'' (and needless
to say, affluent and politically wellconnected) few, public investment has
(inadvertently?) served as a means for significant transfers across economic classes,
albeit of the type purportedly not favored by promoters of populist policies.

What is to be done?

The solutions of the problems afflicting the water and electricity sectors require
concerted policy responses in a number of directions. As the details of the required
policies have been studied above, it suffices here to place these policies in a broader
intellectual and political context.

First, it needs to be recognized intellectually that both water and electricity are private
goods. A practical corollary is that the consumption of these goods needs to be
accurately metered for each consumer. Treating these goods as ``public'' goods that are
jointly consumed by a community implies a moral hazard problem leading to a tragedy
of the commons. The broad principles governing the design of institutions for the
welfare maximizing provision of private goods are wellunderstood, indeed staple, parts
of the economics literature. These insights are being sharpened at the level of market
microstructure in sophisticated economies; see Wilson (2002). However, in India, the
debate is still at a relatively rudimentary stage as we are still grappling with firstorder
problems of institutional design such as the role of the private sector in these markets,
whether these goods should be allocated via the price mechanism, what should be the
nature of regulatory design and the nature of contracts governing relationships among
the players in these markets. In sophisticated economies, most of these elementary
issues have been dealt with over the past two decades or so and the debate has moved
on to secondorder technical issues, e.g., the design of market microstructure for spot,
futures and option trading in these goods. However, as a latecomer to the party, India
does have the great advantage of being able to learn from the experiences of other
countries and being able to take into account the possible market microstructure issues
even while resolving the firstorder problems.

At this point, however, one encounters an ideological shibboleth that has characterized
Indian policymaking over a long period: a desire to constantly reinvent the wheel.
There is a self serving myth perpetuated by generations of Indian policymakers in
myriad contexts that Indian problems are somehow unique and not amenable to solution
using standard economic science. These assertions are little more than an attempt at

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brand differentiation and the creation of an intellectual local monopoly. In every area of
reforms in India, this assertion has been shown to be spurious. To be sure, there are
historically determined local variations that have to be accommodated, but the broad
architecture of successful policy design does not vary very much. So, the second
essential intellectual reform necessary for successful policy reform is to shelve the
notion of India being an economic curiosum and be willing to learn from international
experiences.

Thirdly, as we know from economic theory and the experiences of other countries,
changes in market design are required. In electricity, it is necessary to disaggregate
functionally and develop markets that are consistent with a functional classification of
valueaddition activities. The electricity sector consists of three distinct commercial
activities: generation, transportation and trade. An analogous classification   is
applicable to the provision of water too: water treatment, transportation and trade.
While some Indian states have gone some way towards implementing this functional
separation in the electricity sector, the water sector has seen no movement.

Electricity is traded at two levels: bulk/wholesale and retail. In the market for bulk
electricity, the generators are the ultimate source of supply and the distributors are the
ultimate source of demand. As in any other market, there can be pure traders who
neither generate electricity nor distribute it to the ultimate consumers. In India, the bulk
electricity market has been strangled by vertically integrating the generation and
distribution businesses in the form of SEBs, with almost no economic room left for
genuine trading activity. Moreover, private generators have been discouraged by
subjecting them to bureaucratic barriers in the form of licensing requirements and
forcing them to sell their output to monopsonist SEBs. Opportunistic rentgouging and
capricious payment behavior by SEBs substantially raises the riskiness of private
investment in generation, thereby rendering many potential projects infructuous. In the
wholesale markets, the SEBs have, with very few exceptions, acted as monopolist
distributors to hapless consumers, with plainly evident disastrous results.

It is technologically and economically feasible to make the bulk electricity market
competitive. The following steps are essential for this to happen. First, it is necessary to
bring about a panIndian market by eliminating barriers to movement of electricity. The
strengthening of the national grid is an important technological step in this direction.
Secondly, it is essential to eliminate the SEBs distribution monopolies, which also
automatically does away with the SEBs monopsony status in the bulk market and

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creates a diversified and competitive set of buyers of bulk electricity. Thirdly, it is
necessary to eliminate all unreasonable legal barriers to entry in generation, distribution
and trading of electricity. These changes are essential in order to bring about some
economic rationality to electricity prices by loosening the state's grip on the sector,
improve the quality of service to consumers, and for the longrun, induce investment in
all aspects of the sector without having to offer investors ironclad inefficient state
guarantees that are opaque and therefore subject to unending controversy and litigation.

Thanks to technological improvements, some large urban bulk electricity markets can
be made competitive by allowing multiple distributors to compete for the same set of
customers. Other wholesale markets may not allow multiple suppliers to compete in the
market. In such markets, competition can be in two forms. First, potential distributors
may be forced to compete for the market via an auction of the concession contract.
Secondly, incumbents can be disciplined by the possibility of entry by competitors.
Whatever be the nature of the bulk market, it is important to make the market
contestable by lowering the legal and cost barriers to entry. There are two prerequisites
for these conditions to obtain. One, sensible regulation is required to curb the variety of
rentseeking and entryprevention strategies that the incumbent may employ. Two, it is
necessary to divorce the distribution business from the ownership of the wires because
transportation is the only part of the value addition chain that is a natural monopoly.
Exclusive control of the transportation infrastructure by a distributor is a source of
market power and a means for preventing entry into the distribution business. Even
when a distributor owns the wire network, it is necessary that the regulator enforce a
firewall between the two businesses by requiring open access to the network by all
electricity traders in exchange for a regulated access charge. Apart from providing
efficient transportation to traders, the other task of the electricity carrier is to expand
and maintain the network by making the necessary investments. For this, it is necessary
to provide this entity with a budgetary transfer. There is an extremely rich literature
(use Laffont and Tirole (1993) as a starting point) analyzing the relationship between
the regulator and the firm and we refer the reader to it for details.

Electricity Act goes some way towards providing a legal framework for bringing about
the market structure described above. For instance, the delicensing of electricity
generation, the legal requirement of open access to retail markets and the creation of
independent regulators to oversee consumer interests are very sensible provisions.


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However, mere market design is not enough as the efficient operation of any market
requires it to be embedded in a nurturing system of laws and their effective
enforcement. For instance, laws related to property rights and contract execution need
to take into account not merely broad philosophical aspects of fairness, ``rights'' and
``social justice'', but they should marry these principles sensibly with anticipated
incentive and informational constraints under which any lawenforcement executive
operates. Failure to harness together the law with sound economics has yielded laws in
India that make most contracts not worth the paper on which they are written. It is a
matter of everyday experience for every Indian citizen that contracts are flouted with
impunity and any attempt for redress is drowned in ceaseless litigation. The most
obvious instances of these problems are the very high incidence of electricity theft by
consumers, and more disturbingly, the theft of electricity by many SEBs that callously
exploit their stateowned and legally sanctioned monopsony status to simply not pay for
the electricity or coal that they ``buy''.

Therefore, a fourth essential and practical ingredient for the effective operation of
electricity and water markets is the enactment of appropriate laws and their
enforcement. For instance, Commercial or regulatory contracts specifying price,
quantity, quality, etc., need to be easily enforceable, with enabling legislation and a
judiciary that effectively punishes deviations from the terms of a contract. In the case of
electricity and water markets, a legal and political culture that enables routine and
effective price exaction by sellers is a sine qua non for any market design to work.
Unfortunately, India's legal culture in this respect has been steadily eroded by decades
of politically sponsored loot masquerading as socialist populism.

As we have argued above, Electricity Act provides a legal matrix in which the structure
of electricity markets is brought in line with sound economic principles. Even more
fundamentally, for the first time there is an attempt to fix and protect property rights by
making electricity theft and manipulation of meters a penal offence. It is remarkable
indeed that purloining electricity has not been ``theft'' for so long!

Even as one deplores political populism, it is undeniable that there are significant
distributional concerns regarding both electricity and water, but especially the latter. In
a democracy, it is appropriate that the political process and the constitution should
define the ends that the state should strive towards. However, most problems admit a
number of solutions and it is the policymaker's job to pick the one that achieves the
mandated goal most efficaciously. For instance, suppose the political process mandates

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a specified amount of ``access to water and electricity'' by the ``poor''. This outcome
can be achieved by forcing utilities, for all practical purposes, to give away these goods
for free, or by directly transferring purchasing power to the poor without distorting
prices for this purpose. Clearly, the Indian state has chosen the decidedly inferior
former course. The reasons are not difficult to find.

With a decrepit fiscal system, it is politically and fiscally expedient in the shortrun to
allow utilities to lose money through underpricing and theft, rather than bear the
subsidy burden directly and transparently. Moreover, price distortions can be used to
buy off powerful constituencies, such as farmers, with favors of cheap power.
Naturally, the only real beneficiaries of these giveaways are the large farmers who
have pumpsets to run in the first place. Even for them, this stratagem has limited
benefit as the tyranny of doubleentry bookkeeping rules out any more than a token
amount of electricity supply at the absurd prices promised by politicians.

One may wonder how this Mad Hatter's tea party, with ``Jam yesterday and jam
tomorrow but never jam today'', is sustained. This has been done by the sleightofhand
of confusing ends and means: instead of a clear objective of providing welldefined
amounts of water and electricity to the poor, with subsidized prices as just one of the
possible means, the politicians have managed to shift the goalposts and framed low
prices as an end in itself! In both cases, the state has attempted to address distributional
concerns via a high degree of de jure price discrimination and crosssubsidy. Of course,
the pattern of de facto price discrimination is not congruent with the de jure pattern. By
imposing wedges between marginal cost and de facto prices, the system imposes
significant deadweight welfare losses on society. Furthermore, de jure price
discrimination motivated by politics defeats any attempt at sensible ex ante economic
calculus, e.g., what is the right amount to produce, by what means, by whom, who
should consume the output. However, the ex post effects are easily discerned. As the
prices do not convey appropriate economic signals, there is a mismatch between
demand and supply across all the various artificially created segments of the markets. In
every segment, there is excess demand, indicating that the price is below the
equilibrium level. The effective price received by the supplier is the realized revenue
per unit of output. The persistent supply deficit points to this incentive being inadequate
to induce investment and augment supply to meet the demand.

One reason for the parallax between de jure and de facto prices is the rampant
corruption that enables many consumers to undermine the attempted market

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segmentation. For instance, a wellentrenched system of bribes allows households and
industries with high electricity loads to masquerade as those with low loads and to
manipulate their meters.

Another reason is the ``coping cost'' imposed on a consumer by the endemic scarcity of
water and electricity. As this cost is particularly onerous for the poor, the result is a
significantly regressive distortion of true economic prices, especially of water; in the
case of electricity, the poor cope by simply doing without it, which does not impose a
monetary coping cost but does impose significant costs by reducing the effective length
of a day for the poor. High coping cost have also brought about a de facto market
segmentation of a particularly inefficient and socially invidious kind: industry and the
affluent have simply seceded from the decrepit public system by setting up a parallel
private system. This islanding strategy not only undermines the price discrimination
attempted by the state, but more seriously, it reduces the stake of the affluent segment
of the market in sustaining and improving the public system. By impeding the
expansion of the public system, the islanding strategy also sustains and reinforces the
socioeconomic wedge between those ``inside the system'' and those ``outside looking
in''. Thus, the policy undermines and defeats the very objectives it is purportedly
designed to serve.

So, the fifth policy reform required is to replace the opaque system of price
discrimination with a transparent system of direct budgetary transfers to welltargeted
groups of consumers, e.g., a voucherbased system of transfers.

Regulation and contracting


Our discussion so far has touched upon some aspects of the regulator's job, e.g., price
and quality regulation, ensuring open access to the market, inducing investment, etc.
Given the Indian policymakers’ newfound faith in ``regulators’’ as a panacea for all
problems, it is important to delineate the regulator's role and the limits on his ability to
bring about desired outcomes.

With respect to the scope of useful regulatory activity, one needs to state the obvious: a
regulator has no legitimate economic role in a market where competition can ensure
firstbest outcomes by means of conventional commercial contracts. The demand for
regulators in such markets is silly at best or an attempt to reintroduce state interference

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at worst. All that such markets require are wellfunctioning judicial and executive
institutions for contract enforcement, prevention of market collusion and antitrust
activities, etc. However, the regulator is of crucial importance in a noncompetitive
market where a firm has the power to exact rents. Here, a regulator is charged to act as
society's fiduciary to provide incentives to the firm to act in the social interest,
howsoever this social mandate is defined. The regulator’s interaction with the firms is
governed by the contracts between these entities and the regulator’s fiduciary
responsibility to pursue the social mandate. Once they frame the regulator’s mandate,
the state actors lose their ability to interfere with this interaction on a daytoday basis.

The potential benefits of regulation are wellunderstood. If the regulator has complete
information, and the regulated firm's actions can be monitored perfectly, and the firm's
actions are contractible, then the regulator can achieve the first best outcome by
eliminating the firm's rent, i.e., reducing the firm's return to its opportunity cost.
However, in a regulatory setting with asymmetric information, the regulator cannot
achieve the first best outcome as it must compromise between the competing
requirements to limit the firm's rent while ensuring that the firm's incentive
compatibility condition is satisfied in the presence of private information. It is a staple
result of the regulation literature that this tradeoff forces the regulator to optimally
compromise between the twin objectives, thereby leaving some rent for some types of
the regulated firm; see Laffont and Tirole (1993).

As the regulator is the state’s fiduciary, it is important to delineate the appropriate
means and degree of control exercised by the state over the regulator. In this regard, it
is vital that the political system provide a clear objective and mandate to a regulator.
The regulator should have the legal basis and the incentives to pursue his mandate free
of daytoday political interference. For this, it is important that the process of hiring
andfiring regulators be extremely transparent and open to judicial and public scrutiny.
Needless to say, very high standards of probity, knowledge, insight and good
judgement should be prerequisites for a person to be hired to the regulator’s office.
Equally, very strong evidence of the violation of these standards should need to be
presented in order to fire an incumbent regulator. The regulator’s daytoday
functioning should be disciplined not by the executive but by the judiciary in the light
of the regulator's legal mandate, relevant caselaw and precedents.

It is sometimes argued that the regulator can be dispensed with and the relationship
between the state and the firm can be governed directly by a contract. This is possible if

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one can draw up a complete contract, i.e., provide for every possible eventuality that
might arise. That being practically impossible, a regulator is required for the quasi
judicial task of interpreting the social mandate and providing direction in states of the
world not foreseen by the contract. In the absence of a regulator, even trivial conflicts
caused by contract incompleteness would end up in the court's lap.

The regulation of markets with stateowned participants poses peculiar political
economic problems.

First, the regulator’s independence is especially crucial in markets where private and
stateowned firms may coexist and compete. Without independence, there is
insufficient institutional distance between a regulator and a stateowned firm, especially
when there is no firewall between the state actors and the regulator. As both are
manifestations of the state, it is not credible that a feeble regulator will be impartial and
evenhanded. Regulatory capture by stateowned firms is a very real threat, as has been
the case in the power sector. In markets that were hitherto the preserves of the public
sector and which are only now being opened up to private participation, potential
private entrants have a justifiable fear of being exploited and treated capriciously by the
state once they bear the sunk costs  and enter the market. The only way to allay such
fears is to set up strong independent regulators who can withstand the inevitable
political pressures to play favourites with the public sector incumbent. However,
creation and sustenance of independent regulatory institutions requires a substantial
degree of political and judicial maturity. Ultimately, the state actors have to forbear
routine interference in areas that they have considered to be a part of their eminent
domain. The Indian political class has hitherto been unwilling to part with this fiefdom.
Legitimate mandated regulatory functions are routinely compromised by the issuance of
opportunistic “policy” directives.

Secondly, it has been argued that regulation is a means for disciplining and improving
the performance of staterun utilities. This seems true in principle as one might expect
stateowned firms to respond to incentives in the same way as private firms. Indian
political reality, however, destroys this apparent parity. The regulator's ability to bring
about desired outcomes depends on the regulated entity's sensitivity to financial
incentives in the form of tariffs, transfers, penalties, etc. Historically, Indian state
owned entities have been motivated by myriad considerations, many of the non
commercial and nonfinancial kind. These considerations have been used as an alibi for
poor commercial and financial performance by the managers of these entities and the

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political class that oversees and exploits these entities. The alibis of the ``social
responsibility'' variety are routinely seized upon by the political class to open the public
purse to provide openended nonperformancerelated subsidies to the stateowned
entities. Consequently, these entities face very soft budget constraints and are unlikely
to respond to regulatory incentives in nearly the same way as private firms might be
expected to respond. So, regulation per se cannot be expected to improve significantly
the performance of stateowned firms in the absence of substantive internal reform of
these firms themselves.

The only way to have good regulatory outcomes when stateowned utilities are
involved is to transform them into “private” firms, either via sale of equity and loss of
direct state control, or by maintaining control but stripping away their government
department character: have similar employment policies, have similar managerial and
labor incentives, credibly deny them openended budgetary handouts and empower
management to make commercially sensible decisions. Although the Indian state has
failed to credibly implement the second route time and again, commitment to this route
is piously intoned by elements of the Indian polity every time straightforward
privatization is proposed, the political class is clearly loath to part with the milch cow
fattened over decades. For instance, a red herring regularly tossed into this debate is
that instead of privatizing stateowned utilities, it is sufficient to “corporatize” them.
While the change of legal status from government department to corporation is a
necessary first step for reform, it will not by itself necessarily subject the organizations
to external market discipline or force them to create internal systems of accountability.
The settingup of good internal and external incentive structures is of paramount
importance for a wellfunctioning utility and the Indian state is yet to demonstrate its
ability to set up such institutions.   In the absence of credible state initiatives in this
respect, privatization of a number of activities is the only realistic solution of the
problem.

In conclusion, the prescription for successful reform of Indian urban utilities can be
summed up in the following simple mantra: (a) introduction of competition in the
provision of services wherever possible, (b) independent regulation of providers where
competition is infeasible,  (c) introduction of meaningful user charges, (d) subsidies to
the poor via direct transfers rather than via price distortion, (e) either the privatization
of utilities, or of various functions, or at the very least, a substantial overhaul of the
internal and external incentive structures that govern the utilities. The general thrust of
these reforms is a shift from a bureaucraticallymanaged commandandcontrol system

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that pays scant attention to incentive issues to a system that is based as far as feasible
on marketdetermined incentives. Successful transition is complicated as it requires
parallel reforms in many interlinked areas such as labor and financial markets,
organizational forms, corporate governance, etc. Experts recommend various
institutional features that are needed if markets are to satisfactorily determine prices and
patterns of investment in the area of urban utilities. In our study, we give particular
attention to regulation as one such institutional feature. Yet, and here is the rub, the
creation of these institutions and the implementation of complementary reforms is in
the hands of the very political class that stands to lose the most from these changes.
Slow and hesitant attempts to untangle the mess are under way in the face of pressure
from the stakeholders. However, the strengthening of these weak institutions requires a
statesman to rise above myopic political interests and cut the Gordian knot. In terms of
the contest for control, the vested interests who stand to lose from reforms are already
organized within the firm and the state, and have direct influence and control over
decisionmaking. In order to counter and overcome these vested interests, reformers
need to build potent coalitions for reform if the reforms are to succeed.
This essay is the summary of the findings of a project done by the author for WSP-
SA, World Bank

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