5th Bienial Conference on Regulatory Governance

Regulatory Governance between Global and Local

Barcelona, 25-27 June 2014

Establishing a national regulator on water services in Macedonia: Watch what you wish for
Georgi Hristov1 MBA and Gligorche Vrtanoski2 PhD

Abstract
For the time being there is no a national regulator on water supply and sanitation services in the Republic of
Macedonia. The competences for provision of potable water supply, waste water collection and treatment
are fully under the jurisdiction of municipalities including tariffs setting. Currently, there is bottom-up initiative
by local public water utilities (established and owned by municipalities) for establishing a national regulator
on water services. The paper aims to provide more information to the relevant actors at local and central level
about the challenges they might face in case of such undertaking. It analyzes the incentives that motivate
relevant local actors to endeavor such an initiative by capturing the current state and performance of the
sector through regulatory, institutional and performance analysis. Based on an extensive literature review the
paper reveals some aspects for establishing a national regulator for water services, ex ante. It reveals the
tangled web of complex and very often asymmetric relationships among actors. Ultimately, the presented
analysis should help decision makers to take a better informed policy. It seems that the national regulator is
not a magic panacea for the sector, but also other important features are to be well considered.

I. Introduction
In its narrow interpretation, regulatory structures are created to protect consumers from monopoly
abuse and to provide incentives to firms to maintain efficiency. The wider interpretation that
economics profession adopts “encompasses all forms of state intervention in the economy” (Dal Bó,
2006) and thus it had to specify the determinants of the supply and demand for regulation. The
demand for regulation would be connected primarily to two features of the group of beneficiaries.
First, whether the beneficiary group is large and, second, whether the group has large stakes in
regulation. On the supply side, one would have to pay attention to the machinery that produces
regulation: the public sector, which responds to political pressures.
The term public utilities is usually referred to energy, gas, heat, water supply, telecommunication,
postal services, and waste water and waste management. Those services (particularly in the European
Union) might be also called as services of general interests. In general, utilities bear two main
features: (1) natural monopoly: utilities generally operate as natural monopolies in some segments of
their productive cycle, either at local or at national level, in particular for the presence of network and
sunk costs. Indeed, the utility networks and prohibitive investment requirements create entry barriers,

1 Georgi Hristov is PhD student at Faculty of mechanical engineering in Skopje, Universtity of St. Ciril and Methodious, Macedonia
2 Gligorche Vrtanoski is associate professor at the Faculty of mechanical engineering in Skopje, Universtity of St. Ciril and
Methodious, Macedonia
reduce competition and prevent promotion of national economy through market liberalization and
competition; and (2) public interests: since goods or services provided by public utility firms have
some features of public goods and are connected with relevant externalities, government often
regulates these firms and exerts a strong influence on these organizations to protect consumer
interests.
Feasible institutional solutions for regulation of monopoly and other public utilities has been urgent
and widely discussed issue by the academy. The public utilities regulation system can be formed
according to different principles. The main principle is a choice between institutionally separated
regulators for each type of services and a multi – sector regulator that unites regulation of several
branches. The public utilities regulation model includes option of regulatory structure that is one or
two regulation levels in the country (national and municipal).
European Commission for a long time did not interfere in regulation of public utilities within
territories of EU member states mainly because each state considered public utilities as an exclusive
sphere under their own competence and did not want to allow for any interference. Although starting
with 1990 EC have been systematically and actively dealing with liberalization of services. The most
acute issues is the need to find balance between general services, and opening and protests against
opening the market. It was managed to exclude from EU competition law market liberalization of
water companies and their obligatory privatization. However, EU has stipulated that all costs related
to the services are to be included in the water tariff, hence economical principles affirmed by the
member states say that in case of regulatory tariffs (prices) it is significant that tariffs for each product
is in conformity with its costs.
Currently, there is no a national regulator on water services (supply and sanitation) in the Republic
of Macedonia nor there is enough past experience with regulation3 in general and no sound experience
in water regulatory institutions. The competences for provision of potable water supply, waste water
collection and treatment are fully under the jurisdiction of municipalities (including tariff setting).
Municipalities usually establish and are owners of the utility companies named Communal Public
Enterprise (CPE), which among others, are responsible for water services4. The municipality in the
current structure is owner, policy-maker and regulator, as well as a large wholesale customer through
its own institutions. Due to the natural monopoly characteristics of communal services introduction
of competition is not feasible since new entries would only lead to duplication of fixed costs (Baldwin,
Cave, 1999). Thus, establishing a national regulator seems to be a logical intervention in the current
setting in order to separate these conflicting roles municipalities currently have. Surprisingly, the
initiative is not initiated by the state nor by the municipalities, but the bottom-up initiative comes
from local public water utilities (established and owned by municipalities). There is a simple reason
behind – unwillingness of municipal decision makers to increase water tariffs probably due to
(selfish) political and social reasons. This is the main, if not the only reason, why CPEs even beg for
establishing a national regulator on water services in a hope that the regulator will set the tariffs in
favor of CPEs. The situation looks like a child who hopes that his step-father (state) will take care
better than his natural father (municipality) what, of course, might be true under some circumstances.
Also, the municipalities seem to have nothing against this initiative as the “dirty” and un-popular

3 The Energy Regulatory Commission and Agency for Electronic Communication were recently established mainly due
to EU accession process and aligning national legislation with acquis communautaire

4 Usually, in smaller municipalities all communal services are joined within a single company, i.e. “multi-utility”, while
in larger municipalities communal services are provided separately by several companies.
tariff increase will be done by someone else i.e. the regulator. But, if established, will the regulator
just simply fulfill the tariff increase requirements of local PCEs or they will play their role “to protect
consumers from monopoly abuse and to provide incentives to firms to maintain efficiency” in fully?
The paper argues that both aspects – protect consumers and provide incentives to firms to maintain
efficiency – might turn the way around and instead of tariff increase, lead to increased efficiency and
customer protection and lead to more uniform prices, which of course is the desired social outcome
eventually. Due to existing vast price differences it is obvious that some companies will benefit while
others will be forced to improve their efficiency.
The purpose of this paper is threefold: first, to capture the current state of the public water sector in
Macedonia through regulatory, institutional and performance analysis; second, based on the literature
review to provide evidence on different aspects on regulating water sector with focus on the impact
of privatization (as one of triggers for establishing regulation) over efficiency and service quality;
and third, to help authorities in taking a better informed actions about establishing or not a national
water regulator. The “regulatory capture” phenomenon is also given attention. The scope of the paper
is very broad although contributions focusing on water utility regulation are emphasized.
The paper is structured as follows. The next section gives a brief history and an overview of the water
supply sector in Macedonia through regulatory, institutional and performance analysis of the sector.
Literature review of some academic research and findings regarding different aspects of regulation
and regulatory bodies is given in Section III. It begins with more general review and continues with
more focused one on performance and service quality. Chapter IV discuss and attempts to align the
regulator theory within the Macedonian context. A case study of miss-performing of a current
regulator (City Council) is presented on example of tariff setting. Finally, the concluding remarks are
given in Section V.

II. State of the Water Supply Sector in Macedonia

Background
Following the communism collapse in late 1980s, the Republic of Macedonia like other Central and
Eastern European countries went through the transition process which implied privatization of the
state owned companies. This came as a natural adjustment towards the liberalized market economy
which replaced the former planned economy. Before market liberalization, CPEs were and are still
shielded from competition for a long time due to economic reasons - the status of natural monopoly,
and socio-political reasons – providing access to communal services for all customers. This situation
did not differ much from other European experience which is well documented by Héritier (2001). A
notable distinction from other former communist countries was that water supply services, as in other
parts of former Yugoslavia, were under jurisdiction of local governments (not the state) while state
government used to set regulatory framework and secured most of the capital investments. The post-
1991 period has witnessed dramatic changes in the legal environment and institutional framework in
which municipalities and CPEs operate. Similar changes are witnessed in almost all countries from
former Yugoslavia and these changes generally had unfavorable impacts on the level of communal
infrastructure investments, what is well elaborated by Mrak (1997) for the case of Slovenia.
The water services in Macedonia, as almost everywhere, are provided in a monopolistic local market,
at least for the time being. According to the European Commission (2004), delivery of such service
of public interest must fulfill the principles of: universality, continuity, quality, affordability, as well
as user and consumer protection. Established and owned by municipality, a CPE however operates
as separate legal entity i.e. the employees are not civil servants and their salaries as well as enterprise’s
costs are not part of municipal budget. CPE is govern by Managerial and Supervisory Boards which
members are appointed by the City Council and are responsible for taking strategic decisions, while
day-to-day operations are managed by General Manager appointed by the City Mayor. It is evident
that governing structures owe their position to the Mayor and City Council members, all elected
officials. There is thus no security of tenure. Senior management are also restricted by having their
remuneration tied to public sector pay scales, which leaves no room to apply incentives.
A World Bank (2006) report shows that the problems CPEs encounter today can be divided among
technical and operational (high water losses - usually around 50%, old networks and equipment,
missing investments); commercial and financial problems (low tariffs, no full-cost recovery and low
fee-collection rate); human and institutional problems (overstaffing, politically motivated
employments, unattractive salaries); and environmental problems (only 6 out of 80 municipalities
have waste water treatment plants). Similar situation is also documented by Franks (1999) as an
international phenomenon in many underdeveloped or developing countries. Faced with this
situation, the Ministry of Finance has asked for World Bank support and the “Strategy and Action
Plan for Reform of CPEs with focus on water, sewerage and solid waste management” (ECA, 2008)
which concludes that “the reform of the public communal enterprises is one of the major challenges
facing Macedonia today”.
Institutional setting, price regulation and performance of the Macedonian supply sector
The legal framework for water services is comprehensive. Difficulties arise from the fact that it is
defined by a plethora of laws administered by different ministries, with municipal regulations having
to be compatible with the various laws. For example, standards for drinking water quality are set and
regulated by the Ministry of Health, construction standards by Ministry of Transport and
Communication, environmental standards related to treatment and disposal of sewerage by the
Ministry of the Environment and Physical Planning, while municipal and Ministry of the
Environment inspectorates are responsible for ensuring adherence to the standards. The legislation is
relatively suporting for private sector involvement in the sector through different forms of
privatization (PPP, management or service contracts…)5, however in case of establishing a Joint
Stock Company the private sector is limited to 49% as maximum.
The main regulatory interventions which are required are in the areas of licensing, tariffs and
standards. As to licensing, it is responsibility of the Ministry of the Environment and Physical
Planning, not the municipalities. Tariffs are proposed by CPE and should be approved by the
municipal Council. As already explained, this rarely happens and is the main reason why CPEs ask
for a national regulator. According to the ECA (2008), technical regulation, in the sense of the setting
and enforcement of standards, is in place, but implementation is constrained by weak human capacity
of the authorities and deficient political will for effective implementation of the laws. Economic
regulation is less well developed and even less effective. It embodies the concept that regulation is a
tool for implementing policy (as opposed to formulating policy) and requires outside intervention to
deliver a socially desirable balance between price and quality.

5 In terms of Goodman and Loveman’s (1991) definition that “privatization covers a wide range of different activities,
all of which imply a transfer of the provision of goods and services from the public to the private sector”
The areas where the influence of the municipality are most visible to the public are in appointments
(the Supervisory and Managerial Boards and the General Manager) and the setting of tariffs (City
Council approves tariffs proposed by Managerial Board). The Municipal Council also approves the
CPE annual accounts, guarantees any CPE long-term loans (thereby burdening its own debt service
limit and legal sources of payment) and monitors and enforces technical standards. Given the
management blending of the municipality and the CPE, along with separate accounting, banking and
bookkeeping functions, it is evident that CPEs operate neither as independent enterprises nor do they
enjoy the benefits of being an integrated municipal department (without management boards etc.).
Tariffs
ECA (2008) points out that the tariffs are generally too low, with the result that there are insufficient
resources for capital maintenance let alone expansion. This situation leads to deteriorating levels of
service. In the period 1995 - 2005 the prices of communal services have been under state government
control and its determination was subject to political considerations and other macroeconomic goals
which caused the prices to rise slower than the inflation rate (a decrease in real terms). In this way
utilities were not allowed to increase their prices to the full-cost levels and in most cases, tariffs have
only been sufficient to cover current expenditures but not to finance regular maintenance and the
replacement of fixed assets. The Government used to explain such a decision as necessary “to prevent
from monopolistic approach in determining the prices” and “in compliance with the regulations of
the macroeconomic politics” although the water supply and sewerage counted for 0.7% and 0.5%
respectively in the structure of consumer price index at that time.
Methodology for Determination of the Price of Drinking Water was adopted in 2005 as a serious
attempt to change the price setting practice whereby the primary objective of reducing inflation was
to be replaced by cost recovery practices. Price control by the government has been abandoned and
price-setting became the sole responsibility of municipalities. Cost-reflective prices have been
introduced, but there were no incentives for efficiency improvements. The methodology has not been
derived from well formulated policy guidance and is couched in rather general terms, lacking the
necessary specificity6. Eventually, in the absence of an appropriate pricing methodology and
independent regulatory body as well as lack of the skilled professional staff at local level to stimulate
the efficient operation of water utilities and set up adequate prices the situation did not change
considerably by introducing the methodology. In practice, it appeared that few municipalities used
the methodology to prepare their tariff submissions to the City Councils and there were only few
examples of tariff adjustments. Stimulated also by political influence in the governance of utilities,
in certain cases the tariffs were even reduced. Again, this was not done based on sound financial
mechanisms nor performance achievements as the clear performance objectives were, and are still,
missing.
Another interesting issue was, and still is, the big differences in water prices across municipalities.
This arose from the fact that public utilities had very different price levels at the start of the price
control. Some utilities charged prices close to the full-cost level, while prices were well below costs
in others. Hence, the price control created different operating environments for utilities with different
starting positions. Differences in prices between different customer groups also exists. Although price
discrimination between different customer groups (household, industry, institutions) may sometimes

6 Currently there is on-going EU IPA project on “Development of National Water Tariff Study” which aims to elaborate a national
water tariff study for developing economic instruments for a balanced water price system and the management of financially
sustainable water investment projects
be justified by differences in costs, the policy of subsidizing households and thereby addressing social
policy issues seems to be a more plausible explanation. Such social policy causes distorting effects
of low-priced services. It enhances overconsumption and reduces incentives for efficiency since
customers receive misleading signals as to the real value of services.
Performance of the sector
The poor performance of communal utilities is the most critical issue. Although, there are findings
that technical performance lag well behind the financial (Hristov, 2009), one should note that this
does not necessarily mean that the tariffs are well enough to cover the costs. Actually, the accounting
legislation and political interests favor reporting of positive financial results, though on the costs of
regular maintenance, missing investments and depreciation costs.
Recent survey on technical and financial performance of the water supply sector are well summarized
by Ristovski (2014). The figures showed that in 2012 the sector performed well below the
international accepted benchmarks as presented:
 Average consumption of produced water amounts to over 300 liters/person/day (benchmark:
210 l/p/d);
 The average consumption of sold water 130 l/person/day (benchmark: 160 l//);
 Non-revenue water is 44.7% (benchmark: 20%) or 58.9 m³/km/den (benchmark: 20
m³/km/den);
 Average number of pipe breaks in the water supply system is over4 pipe breaks per kilometer
a year (benchmark: 0.5);
 Average number of sewerage blockages is over 6 per kilometer a year (benchmark: 0.1);
 Average fee-collection period is 485 days (benchmark: <90 days);
 Operating cost coverage 1.1 (benchmark: >1.3)
 Number of staff per 1.000 population served is 1,5 (benchmark: 0.5)
Table 1 present comparison of the technical performance of Macedonian water supply sector with
several countries from the region.
Table 1 Performance indicators
Macedonia Albania Serbia Romania Bulgaria Turkey Kosovo
Total water consumption
308 300 304 192
- invoiced (l/per/day)
Total water consumption
128 97 158 153 171 108 125
- production (l/per/day)

Non-revenue water
58,9 73,5 22,3 25,5 42,8 43,4 62,5
(m3/km/day)
Non-revenue water (%) 44,7* 68 38 51 54 59 58

Collection period (days) 485 76 178 87 98 108

Collection rate (%)** 95,7 121 89 112 124 90 70

Operating cost coverage 1,1 0,7 1,2 1,1 1,3 1,3 1,5
* Figure is still estimated as lower than the actual situation due to the small number of evaluated utilities.
** Collection percent does not apply to bills collected in the current year, but cumulatively, from all billing in past years.
Adapted from Ristovski (2014)
The average price of water for 6m³ of consumed water-residential of about 150 denars (2.4 EUR) or
0.4 EUR / m3. It can be concluded that the price of water is relatively low and does not provide
financial stability to utilities and capital investments and in some utilities it does not even cover the
operational costs. Despite this situation, a relatively small number of utilities in the last few years
have used the opportunity to increase the price of water in accordance with the current tariff
methodology. An earlier evidence on sector performance is provided by Hristov (2009) where
comparison between the average financial ratios of Macedonian water companies and from around
the world is presented (Table 5).
Table 2 Comparison of financial ratios (Hristov, 2009)

Financial Southeast Latin

USA Africa Egypt Macedonia
indicators Asia America
1 2 3 4 5 6
1 Current ratio 5,22 NA 1,25 1,3 1,695 3,035
2 Asset turnover 0,162 NA NA NA 0,085 0,221
3 Debt to equity 0,71 NA 0,51 0,47 0,31 0,386
4 Return on sales 0,172 NA NA NA -0,419 0,016
5 Return on equity 0,05 NA -0,01 -0,0385 -0,055 0,004
6 Working ratio 0,76 0,86 0,65 0,75 1,317 0,825
Columns 1-5 adapted from Hassanein and Khalifa’s (2006);

As presented, the financial indicators of Macedonian companies showed better results than the
Egyptian water/wastewater companies. For instance, current ratio is almost twice bigger than in
Egypt, while it is some 40% lower than in USA. As to the asset turnover ratio, all results are low,
with the Macedonian companies having the highest average ratio (even better than USA). The low
debt to equity ratio for Macedonian companies, probably is a result of the companies’ inability to
obtain long-term external financing due to the difficult and complicated procedures for obtaining
external finance set by the current legislation. It is interesting to note that almost all developing
countries (including Egypt and Macedonia) have lower debt to equity ratios than the USA
water/wastewater utility companies, which may suggest that USA companies have easier access to
the external long-term finances. As to the profitability ratios (return on sales and return on equity),
Macedonian companies stand much better than Egyptian ones (negative returns), while USA
companies showed approximately ten times bigger returns than Macedonian.
Utilizing SERVQUAL model, Hristov (2009) has revealed that the perception of service quality of
Macedonian customers is significantly very low due to big perception-minus-expectation gap. It was
also shown that there is a big understanding gap which is defined as a gap between the customer
expectation and the management perceptions of what these customer expectations are (Parasuraman
et al., 1990; Donnelly et al., 1995). Such an understanding gap, according to Donnelly et al. (1995),
is probably due to inadequate research into customer needs, poor internal communication or
inadequate management structures.
III. Literature Review
Water regulation
Water supply and sanitation services are almost always delivered in a local monopolistic market. The
OECD countries, from one side, put much effort to deregulate more and more markets for the purpose
of bringing benefits to the consumers (lower prices, wider range of services and improved service
quality) because the “invisible hand” will guide the resources allocation based on consumer
preferences (Andreassen, 1994). But from the other side, there is a need for stronger regulation when
such services of public interest are delivered by private companies. In such a case, the role of the
regulator is very important, if not a crucial one, because it must play the role of the missing “invisible
hand” in a monopolistic market. Therefore, one of the main challenges governments face, particularly
in case they decide for privatization, is to provide an efficient regulator which is professional and able
to resist the pressures from private operators and politician interest.
The topics of regulating monopolistic markets and regulatory bodies are very comprehensive and
widely researched. There are many definitions and interpretations of regulation, but for the purposes
of Macedonian water sector, and probably elsewhere, Burwell (2008) defined it as “to ensure that
customers receive the best value service through improved efficiency and improved quality of
services”. Regulation has to balance the needs of various stakeholders, e.g. government, operators,
investors, the environment and, most importantly, customers when the market is not perfect and
cannot deliver the optimum balance between price and quality. It is not always possible to reach
consensus. In trying to reach the appropriate balance the regulator should take guidance from policy
set by government. Burwell (2008) further suggests that it is important to recognize that regulation is
a servant of policy not the setter of policy. Although regulator is enforcing and not setting the policy,
those responsible for regulation can and should be consulted when government develops policy.
In trying to reach this balance the tools of the regulator are pricing, monitoring of performance and
reporting, with pricing being probably the most important regulatory activity. For example, in
England and Wales, the Water Act (1989) obliges OFWAT, the regulator for water and wastewater
services, to set prices on the basis of efficient costs and allowing for a reasonable return on the capital
invested. OFWAT is allowed significant discretion in the interpretation of this obligation. Two key
criteria have often been applied to judge a good system of regulation; one which enables the utility to
raise finance for investment at an acceptable cost; and also provides incentives for efficiency in
operation, pricing, investment and innovation (Newbery 1994). Tariff regulation is only one aspect
of a fully-fledged regulatory system. A typical list of regulatory responsibilities besides tariff setting
would include: licensing, enforcement of standards, monitoring and enforcement of performance,
consumer consultation, publication of information, resolution of disputes, consultation with other
regulatory bodies and advice on policy and standards.
Experience so far has shown that the development of regulatory regimes is a continuous process and
not a one-shot exercise. It has also been the case that, while the structures for regulation initially
established have important implications for the evolution of the future system, political considerations
often lead to compromise solutions that depart from those originally envisaged, for example,
regulatory capture, a theory associated with George Stigler. Regulatory capture happens when a
regulatory agency, formed to act in the public's interest, eventually acts in ways that benefit the
industry it is supposed to be regulating, rather than the public. Dal Bó (2006) work provides a precise
framework to understand how asymmetric information is the source of regulatory discretion making
capture possible. Marra (2007) sustains the thesis that public participation in the capital of a private
firm serves to cope with the typical asymmetric information in the agency relationship between
regulators and regulated. Therefore, the author concluded that mixed enterprises (companies jointly
owned by municipalities and private firms that assume co-responsibility for investments in
infrastructure and service delivery) could significantly reduce the asymmetric information between
regulators and regulated firms. With more information, thus the public authority (as owner/controller
of the regulated firm, but also as member of the regulatory agency) can stimulate the service provider
to cut operating costs and can monitor it more effectively with respect to the fulfilment of contractual
obligations. Much earlier, Laffont and Tirole (1991) developed an agency-theoretic approach to
interest-group politics and showed: (1) the organizational response to the possibility of regulatory
agency politics is to reduce the stakes interest groups have in regulation. (2) The threat of producer
protection leads to low-powered incentive schemes for regulated firms. (3) Consumer politics may
induce uniform pricing by a multiproduct firm. (4) An interest group has more power when its interest
lies in inefficient rather than efficient regulation, where inefficiency is measured by the degree of
informational asymmetry between the regulated industry and the political principal.
Bernard et al. (1999) analyzed the impact of regulatory agencies on the efficiency of publicly-owned
utilities. This might be useful in Macedonian context as there is no privatization yet (though there are
debates), but only the initiative to establish a central regulatory body. Using a principal-agent model
they analyzed allocative and productive efficiencies of a public enterprise in two cases, first, when
public enterprise is directly controlled by government and, second, when some decision power is
transferred from government to public utility commission (regulator). Their findings suggest that the
information rent will be allowed to be greater with a regulator than under direct control and, since
this information rent is positively correlated to output, this will also lead to an increase of output.
There is thus an inherent inefficiency in commission regulation, and the government would never
resort to it if its objective were to maximize welfare. However, this tendency of PUC (public utility
commission) regulation to increase output could prove attractive when the government’s objective
differs from welfare maximization and when the government is not entirely free of its choices for any
reasons, such as constitutional restrictions or trade agreements. Pint (1991) already made comparisons
between a directly controlled public monopoly and a regulated private monopoly and from the results,
it can already be inferred that, under regulation by a regulator, a public enterprise would differ from
a private one not only with respect to allocative efficiency, but also in productive efficiency.
Additionally, a regulator (i) improves the information available to government, but (ii) has interests
of its own that differ from those of the government. Consequently, the regulator would try to benefit
from the information it gathers and would be able to extract an information rent in the same way the
manager does. This could eventually result in coalition between the PUC and the utility, i.e. to create
condition for regulatory capture.
Cliftona et al. (2011) work provides an overview of the three, overarching, ‘waves’ of utility
regulation from the nineteenth century to the present, documenting how, when and why the ways in
which the roles of the state, the market and firms altered over time. The authors are on opinion that
the history of utility was, unfortunately, sidelined or marginalized when economists and policymakers
enthusiastically embraced the question of how to reform the utilities from the 1970s, i.e. the beginning
of the “third way”, which bore much in common with the first wave as regards the increased role of
the domestic and foreign private sector and of market forces. According to Kessieds (2004) with a
view to addressing what had been identified as some of the key problems of utility performance in
the second wave, proponents of reform stressed that new policies were needed to ensure utilities
attained superior performance results, delivered better service quality and choice to users at lower
prices and utility regulation would be supported by policies including privatization, liberalization and
deregulation. But, one fascinating difference though, comparing the first and third stages is that now
it was the public utility enterprises themselves who were the protagonists of this development.
Actually, this is the situation currently in Macedonia where CPEs are promoters for establishing a
national regulatory body.
In the context of EU accession process for Macedonia, it is interested to see the experience of new
member states on the topic of water regulation. One such useful work is done by Jurgelane (2013)
providing evidence on principles and development trends of water services in Latvia. Regulation of
public utilities had been introduced in Latvia in 2001. The available EU funding for Latvia caused
problems in the process of setting the tariffs. Water tariffs started to rise significantly due to the own
financing contribution (30% of project cost) needed for a large investment project funded by the EU
and increase in prices was mostly affected by the increase of administratively regulated prices. To
avoid the threats of uncontrolled growth of inflation, such a chain of impacts makes alterations the
responsibility of PUC has been raised in order to control of the growth of total prices. For the case of
Slovenia, recent findings by Fillipini et al. (2010) present evidence that the lack of proper incentives
to improve performance has resulted in the low Total Factor of Productivity (TFP) growth of
Slovenian public water distribution utilities during period 1997-2003. Cost efficiency estimates
indicate that considerable inefficiencies are present in the public water distribution utilities.
Apparently, the current institutional and regulatory setting of the Slovenian water industry does not
provide sufficient incentives for water utilities to make productivity improvements. Therefore, the
authors suggest the first step towards a good practice in regulation would be “to create an autonomous
and professional regulatory agency to regulate water prices by launching incentive-based price-cap
regulation combined with benchmarking which would aim at improving the performance of water
utilities”. Both, Slovenian and Latvia experiences deserve considerable attention for Macedonian
context due to historical background and similarity particularly with Slovenian water supply sector.
Regulation also has to satisfy the demands of both investors and consumers, which can at times be
conflicting. Consumers generally demand quality service and low prices, whilst investors demand
adequate returns on their stake. Cook (1999) finds that it has been difficult for many developing
countries to build sound regulatory systems with respect to competitive behavior, service obligations
and pricing policy. In contrast, it has been much quicker and easier to privatize utilities, with the
result that monopolies and anti-competitive practices may have become entrenched in many
countries. But, there are conflicting findings whether private sector perform better and more efficient
than public. For instance, Teeples and Glyer (1987); Bhattacharyya et al. (1995) did not find any
significant differences between public and private utility performance, however, findings prevail that
the increased efficiency is due to tightened regulation and not necessarily due to privatization. In this
line are also Cook’s (1999) findings that regulation rather than privatization achieved the largest gains
although he claimed that the regulation is difficult and slow process. Contrary, Parker (1999) finds
the regulators to be non effective. Because it is very often to connect regulation with privatization of
public utilities in order to increase performance and efficiency, eventually improving service quality
at reasonable price, some evidence about performance of both public and private sector and service
quality is presented in the text below.
Water services: Private vs. Public
The establishment of effective regulatory institutions and processes is particularly critical to the
privatization process in the utilities sector. Cook (1999) found that the government ownership does
not contribute to cost recovery and government subsidies and multilateral loans were relied upon to
meet water supply costs. Furthermore, the reason why many developing country governments decided
to restructure their water utilities, according to Cook (1999), was due to both public expenditure cuts
and poor institutional capacity which was unable to keep up with maintenance requirements or cope
with the expansion in demand for water and the increasing need to provide more extensive sewerage
facilities, thus lowering the service quality. Other critics of state-owned (public) enterprises usually
take it for granted that “these enterprises’ insatiable appetite for cash and lack of efficiency,
professionalism etc. is due to inefficiency of their managers and workers” (Andreassen, 1994).
Therefore, privatizing those companies will cure the problem is a common assumption. However,
many authors have confirmed that the simple transfer of ownership from public to private does not
necessarily increase efficiency or improve service quality (Ennis, 2006; Goodman and Loveman,
1991).
Dismal performance of public utilities in developing countries is well-documented (Estache et al.,
2005; Renzetti and Dupont, 2003). According to Idelovitch et al. (1997) the finance of the
water/wastewater utilities exceeds the capabilities of the public sector, thus resulting in poor
performance and low productivity of a significant number of public sector utilities. There are also
opposite findings. For instance, in a very comprehensive research (Madhoo, 2007) targeting both the
developed and developing countries, the author provided the taxonomy of country experiences in
managing their water utilities. Madhoo’s general findings suggest that cost recovery and affordability
emerge as the major building blocks for any reform of water utilities, and that ownership change,
public-private arrangements and international involvement provide a mixed blessing for privatization.
The author suggests that the economic development, institutional quality and performance of water
utility are positively associated with the cost recovery and not with the ownership status. In this line
are also the Masten’s (2007) findings from the US experience as a developed country example. This
is worth to be kept in mind for Macedonian context as many assume that privatization will cure the
problem of companies’ inefficiency. This actually gives support to the observation done by Goodman
and Loveman (1991) more than a decade ago. According to them, the pros and cons of privatization
should be measured against the standards of good management – regardless of ownership. Their final
conclusion in this regard is that the simple transfer of ownership from public to private hands will not
necessarily reduce the cost or enhance the quality of services if (1) private managers do not have
incentives to act in the public interest, which include, but is not limited to efficiency, and (2) if
privatized service or asset is not in a competitive market. In this line, Renzetti and Dupont (2003)
argue that mere privatization would not necessarily lead to better performance, since the water
industry is largely monopolistic. Saal and Parker (2000) suggest that the private managers lack
incentives to make efficient choices due to the presence of regulation and transaction costs, threats of
takeover and bankruptcy.
One very important finding from Madhoo’s (2007) research shows that a higher degree of
privatization increases cost recovery, but it appears that the link between ownership and cost recovery
is a very weak dut to a high extend of government regulation, political interference and consumer
resistance to increasing prices. Additionally, it was shown “that good governance and greater
transparency effectively enhance cost recovery levels” and that “political stability has a positive
impact on cost recovery” as well (p.117). Therefore, Madhoo suggests to consider only partial
privatization measures where the private provider should become an intermediate agency in a public
delivery system.
Robinson (2004) researched how privatization is seen from customer perspective. According to him,
English and Wales’s experiences are examples for successful privatization in terms of easier
procedure for capital rising, reduced politicization in decision making and improved efficiency.
However, Robinson (2004) argues that “from customer viewpoint water privatization and regulation
look much less successful” (p.25). Even after the privatization the market remains monopolistic and
consequently there is still no choice of supplier. At the same time, in most cases charges have risen
significantly. Therefore, one can hardly estimate the real, if any, benefit for the customers after the
privatization, Robinson (2004) concludes.
A performance assessment done by Hassanein and Khalifa (2006) revealed that financial and
operational performance of the public utilities in developing countries lag behind compared to
performance of the USA’s utilities. The main reason, according to authors is due to the low tariffs
which further contribute to the low quality of management, inefficient utilization of water by the
public, which all in all in the end lead to lower quality of service. Therefore, they concluded that
inefficiency is a major trait for the utilities in developing countries and see the raising tariffs and
private sector involvement in the management (and possibly ownership) as the major solutions.
However, the authors questioned the possibility of tariff increase due to political or social reasons.
Service quality
Each company must work effectively and efficiently and this applies for public sector companies as
well. According to Donnelly et al. (1995) “public sector organizations face more difficulties than
those in the private sector in their efforts to improve customer service.” (p.15). The intensive debates
and critics about service quality and efficiency of Macedonian CPEs are documented by World Bank
(2006).
Almost all research concerning the service quality usually investigates it in relations with other topics.
After an extensive literature review, Saravanan and Rao (2007) concluded that service quality is given
significant importance due to its close relationship with customer satisfaction, loyalty, efficiency and
financial performance. Many studies (Lee et al., 2000; Price et al., 1995) utilizing single or multiple
item scale confirmed that customer satisfaction is positively correlated with the level of service
quality delivered by service providers. A meta analysis carried out by Capon et al. (1990) finds a
positive relationship between quality and business performance, while Fornell (1992) documents that
customer satisfaction has a direct impact on an organization’s performance.

IV. Discussion
In general, the assumption of the CPEs managers is that low tariffs and long-fee collection periods
are the main problems. Thus establishing a national regulator will “help” them to increase the price
and thus solve the problems. However, the paper argues that many other issues should be addressed
like service quality, citizen satisfaction, companies’ efficiency or even the ownership and companies’
reputation or public image… it might be also affordability and ability to pay, all aspects that a
regulator must also deal with. Otherwise, if it happens that the regulator does not play its role of
independent and expertise body to contribute in increasing wealth of the society as whole, and not
the wealth of water companies and managers, than the regulator will not serve the purpose it is
established for. In such a case, long run consequences for the sector will be much worse than the
current situation.
Several analysis has already shown that most of the water utilities in the country do need tariff
increase in order to provide for regular maintenance and investments. It was already shown that
companies hardly cover even the operational costs. But, speaking frankly, overemployment, lack of
 contemporary management practices, politically motivated employment, poor maintenance practices,
weak expertise, etc… will be not be solved simply by tariff increase. Nor the “full cost recovery”
option contribute adequatily in reaching higher societal goals and outpust. On the other side, there
are utilities which already have a “fair” price well above the average price and they would probably
not opt for establishing a national regulator.
Under present arrangements, most regulatory responsibilities lie with the municipality including the
hottest one - tariff setting. It is the PCE’s Management Board proposing the tariff amendments (tariff
decrease is also possible) to the City Council for final approval. PCE is obliged to use the existing
methodology for tariff calculation, which although a too general one, still allows for full cost recovery
calculation. Once the tariff proposal is submitted, the City Council reviews the proposal and takes
decision to approve or reject the proposal. There are only few examples of tariff increase approved
by City Councils in recent years. Also, it is worth noting that in some cases tariffs were decreased.
Symptomatically, tariff decrease usually happens in the pre-election periods. Obviously, the
“regulator’s” (City Council’s) decisions are not based on economic, but political and social principals.
In order to justify this, below is presented a simple but real example of financial figures of a water
supply company that has submitted proposal for tariff increase. Price regulation in a natural monopoly
is presented on the chart below and company’s revenues and costs for three year period are given in
the Table 3.
Table 3
2004 2005 2006
m3/year m3/24h l/s m3/year m3/24h l/s m3/year m3/24h l/s
TOTAL PRODUCED 5.522.905 15.131 175 5.475.409 15.001 173 5.180.510 14.193 164

TOTAL INVOICED (m3) 3.037.598 3.011.475 2.849.281

TOTALL REVENUE ($US) 911.279 903.442 854.784

TOTALL COSTS ($US) 1.265.252 1.215.821 1.200.218

Adapted from Hristov (2007)

Average Obviously, the company produces

Total Cost
financial lost in three consequent years,
thus reviewing the water price and
PRICE (denars/m3)

Demand
establishing a real, cost recovery and
Unregulated
price
profit securing price, seems to be, at
Pa

Pd
least, economically correct. Currently,
C
the price of m3 water for home users is
Pc
B* 0.3 US$ and the company does not
receive any subsidies from a general
Pb
B
Marginal
fund. Using the Methodology, the
MCa
A Cost
company calculated and proposed to
Qa Qc Qd Qb the City Council a new price of 0.48
0
Marginal
Revenue US$/m3. The advantage they have as
QUANTITY (water produced m3/year (month) monopolists, and also allowed by the
Law is price discrimination, which in
this case is applied on households and businesses. The businesses currently pay 0.46 US$/m3.
Respectively, the new proposed price is 0.7 US$/m3. To simplify the analysis it concentrates only on
the households’ price.
The chart presents the curves of demand, average total cost, marginal revenue and marginal cost for
the case of natural monopoly. The natural monopoly’s demand curve is identical to the market
demand curve for the product; it confronts a downward-sloping ATC curve; MC is always less than
ATC; and marginal revenue is always less then price7 (demand). The profit maximization rule remains
unchanged – produces the rate of output where marginal revenue equals marginal cost (Schiller,
2006).
ATC never reaches its naturally U shape, because the production capacity is much bigger than the
demand (300 l/s vs. 180 l/s), which suggests that the capacity costs are very high due to the “always
ready to serve policy”. In such a case, Fristoe et al. (1971), when analyzing the allocation of cost in
water pricing, suggested that (i) “average cost pricing likely would be the most practicable policy for
a publicly-owned water utility”, and (ii) price would be set at Pa. Obviously, without regulation (City
Council) the company will charge at point Pa. If regulation forces the production at MCa, or at Pb
(price equal to marginal cost – the consumers would get optimal use of water produced), it would
bankrupt the organization - the marginal cost is always smaller than ATC and therefore it produces a
loss (B-B*) on every m3 water produced.
Now, the City Council set the price at Pc, i.e. at point C where the demand is satisfied and the
production costs are covered. But, “to determine water prices simply by allocating the costs ignores
the interrelation between costs and prices” (Fristoe et al, 1971). Firstly, the average consumption is
far away from the demand represented at C, and secondly, the normal profit is not included at point
C. So, if water is to be priced at Pc, the subsidy from the government is a must in the amount Qb
multiplied by (B-B*). Otherwise, including some normal profit in the price moves the price from Pc.
With simple mathematics, comparing yearly productions and costs, several points from MC, MR and
ATC curves can be determined:
MC03-04 = ΔTC03-04/ΔQ03-04 = (1265252-1215821)/(5522905-5475409)=1.041
MR03-04 = ΔTR03-04/ ΔQ03-04 = (911279-903442)/(3037598-3011475) = 0.3

MC04-05 = (1215821-1200218)/(5475409-5180510)=0.053
MR04-05 =(903442-854784)/(3011475-2849281) = 0.29

ATC03 = TC03/Q03 = 1265252/3037598 = 0.42 > 0.3 (water selling price)

ATC04 = TC04/Q04 = 1215821/3011475 = 0.40 > 0.3
ATC05 = TC05/Q05 = 1200218/2849281 = 0.42 > 0.3
ATCs are bigger than the current price in the analyzed period! Also the MR is equal to the price which
is not in accordance with the theory for natural monopolies. Using the Methodology, the company
has calculated and requested by the City Council an increase of the water price for 60%, which in
economical terms seems reasonable, but probably not in political terms. Moncur and Pollock (1988)
explain that due to the absence of competitive market pressure there are “strong political incentives
to hold down water price”, which in this case is very true. The end result is that instead of preventing
market failure with the government intervention, we faced a “government failure” - well explained
by supporters of public choice theory that government effectively corrects market failures. For

7 Marginal revenue equals price in competitive market

example, they argue that if government action is required, it should take place at the local level
whenever possible. However, it seems that political influence even on local level is too high.
Two other possibilities how the regulator could regulate the behavior of natural monopoly are profit
regulation and/or output regulation. Both have some advantages, but also disadvantages. For instance,
profit regulation may “force” the companies to so called bloated cost, while output regulation
(producing at Qd, which obviously would not satisfy the needs for profit), could force the company
to cut the cost in order to keep some profit. Therefore the company will not have enough for plant
and equipment maintenance, resulting in reduced water or service quality.
If there is no clear distinction between the daily political interests and the society’s long term
economics interests, none of the theory proved methods can be applied. Speaking about government
intervention on the energy market, Schiller (2006, p.67) concludes: “The greatest risk for the economy
tomorrow is that political impatience today may slow the market adjustments needed to bring energy
markets into equilibrium.”
Burwell (2008) has proposed several regulatory structures which might be considered for Macedonia
in the overall process for transformation of local public enterprises8. Those are (1) Independent
national regulator for the sector, (2) Multi sector regulator, (3) Advisory body, and (4) Regulatory
rules. All have their respective advantages and disadvantages and should be well considered by all
stakeholders if the process for establishing national regulator is launched. ECA (2008) presents
evidence that population is supportive for a change in the way prices are determined. It was suggested
that prices should be determined in a way which reduces the influence of the municipality and that a
national regulatory committee might be the solution to this problem. However, the strategy suggest
that implementing regulation via a national body (committee) could be a long-term option for
Macedonia or might be an intermediate solution that could later be a precursor to the formation of a
stand-alone water regulatory agency. In either case, professionalism and autonomy from day-to-day
political pressures would be essential.

V. Concluding remarks
This paper was meant as a contribution to the ongoing debate about establishing or not a national
regulator for local public water supply enterprises in Macedonia. It has never aimed to suggest yes or
no for such undertaking nor what regulatory system and model (if any) are to be implemented. The
main purpose was to stimulate further discussion among relevant decision makers by providing
evidence on different aspects on regulating water sector. The focus was given on presenting some
aspects of regulatory commission, impact on privatization, and service quality and tariffs (being the
main triggers for launching regulatory debate). The main intention was to frame others’ regulation
experience within country context to the extent possible and not to elaborate any of the regulatory
aspects in sufficient details.
As presented, currently there are no real boundaries nor clear distinction between policy making,
service delivery and control by the municipalities. CPEs are captive to its founder. As a result, there
is little autonomy and accountability on the part of the service providers and decisions are frequently

8Regulation Discussion Paper (for the needs of Strategy and Action Plan for Reform of Communal Services Enterprises
with focus on Water, Sewerage and Solid Waste Management)
driven by political considerations rather than principles of sound business management and economic
efficiency. If water prices are to be determined in a way which reduces the influence of the
municipality, then a national regulator might be the solution.
The literature reviewed suggested that (1) it has been difficult for many developing countries to build
sound regulatory systems with respect to competitive behavior, service obligations and pricing policy,
(2) private sector not necessarily perform better than public and increased efficiency might be due to
tightened regulation and not necessarily due to privatization, (3) implementing regulation via a stand-
alone water regulatory agency should be long term option for Macedonia (professionalism and
autonomy from day-to-day political pressures would be essential), (4) although pricing structures can
deliver improved performance, further regulatory oversight with respect to performance monitoring
and reporting is required, (5) development of regulatory regimes is a continuous process and
successful regulatory design needs to address problems relating to different aspects like service
quality, affordability, information asymmetry, capture… and not only pricing.
The paper suggests that for Macedonia, it is useful to use experience of former Yugoslav countries
now being EU members due to similar historical and contextual characteristic. Following Slovenian
experience might be a good choice due to similar starting point and current sector performance.
Finally, the paper flags a silent warning mainly to communal public enterprises that, contrary to their
expectation, a sound regulator would (probably) not serve their needs only (as tariff increase is
currently), but even more attention is expected to be given on general outputs and societal wealth. In
such circumstances, companies’ efficiency (or non-efficiency) and performance will be duly
explored. For example, paper argues that price-cap mechanisms as a means of increasing the
productive efficiency of regulated monopoly enterprises would provide for better financial results,
but it does not necessary mean more cash nor increased tariffs. Another issue is “one size fits all”
approach. It would be even harder for a national regulator than the City Council (current regulator)
to tailor tariffs for each company in a manner the company or its customers would like to see. These
are just some examples which show that the regulator is not a magic panacea for the sector.

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