Authors: Thiago Caldeira and Victor Gomes
Article title: Technology, Competition, and Markups: The Organization of the Water and Sanitation Market
Location of the intervention: Brazil
Data base: National Sanitation Information System (SNIS)
Variable of interest: Markups for sanitation companies
Methodology: Estimation of production function and calculation of markups from production and cost data.

Summary

The sanitation sector in Brazil faces significant structural challenges, including low levels of sewage coverage and large regional inequalities. Currently, just over half the population has access to sewage networks, and the difference between regions is significant. This study investigates the market power of water and sanitation companies in Brazil through the estimation of... markupsThe marginal cost of production (MCP) is the ratio between the price of the service and the marginal cost of production. This measure allows for the evaluation of companies' ability to generate revenue above their costs and, consequently, finance infrastructure investments. The results show that larger companies, operating in several municipalities or regions, exhibit greater efficiency and higher markups. Smaller companies, mainly municipal providers, often operate with prices close to or below the marginal cost, which can limit their capacity for investment and service expansion. Furthermore, the study finds evidence that increased competition following the new regulatory framework for sanitation has contributed to reducing the sector's aggregate markup, indicating potential efficiency gains in the competitive environment.

Public Policy Problem

The basic sanitation sector in Brazil faces historical structural challenges related to low service coverage and strong regional inequalities in access to infrastructure. Recent estimates indicate that just over half of the population has access to sewage systems, with marked differences between regions of the country.

In this context, understanding the economic structure of the sector is fundamental to assessing the companies' ability to finance investments and expand services. A widely used measure in the industrial organization literature to assess the market power of companies is the... markupMarginal cost, defined as the ratio between price and marginal cost, is a metric that allows companies to identify their ability to generate revenue above their operating costs.

This study investigates the markup levels of water and sanitation companies in Brazil and their relationship with investments and market structure. The results show that larger companies, operating in different municipalities or regions, exhibit greater efficiency and higher markups. Smaller providers, especially municipal ones, often operate with prices close to or below marginal cost, which can limit their investment capacity.

Additionally, the study presents evidence that increased competition in the sector, following the implementation of the new sanitation regulatory framework, contributed to reducing the industry's aggregate markup, indicating a possible improvement in the competitive environment.

Policy Implementation Context

The sanitation sector in Brazil underwent significant institutional changes with the approval of the new legal framework for sanitation in 2020. The legislation established ambitious goals for the universalization of services, including access to drinking water for 99% of the population and sewage collection and treatment for 90% by 2033.

To achieve these objectives, the new regulatory framework introduced mechanisms aimed at expanding competition and increasing private sector participation in service provision. Among the main changes are the mandatory bidding process for concessions, incentives for regionalizing service provision, and the expansion of the role of the National Water and Basic Sanitation Agency in defining reference standards.

These changes have altered the dynamics of the sector by stimulating competition among companies for the operation of services in different municipalities and regions. In this model, competition occurs mainly through bidding processes for concessions, rather than direct competition for consumers.

Evaluation Details

This study analyzes the relationship between markups, market structure, and investment incentives in the sanitation sector. The presence of markups can have different interpretations from an economic point of view.

On the one hand, high markups can indicate market power and generate concerns about resource allocation and consumer welfare. On the other hand, in sectors characterized by high fixed costs and capital-intensive infrastructure, positive margins may be necessary to ensure the economic sustainability of operations.

In this sense, the analysis seeks to assess whether companies with higher markups also have a greater capacity for investment and whether the market structure influences the economic incentives for service expansion. However, the existence of markups may be necessary to ensure the economic sustainability of operations.

Method

The analysis uses data from the National Sanitation Information System (SNIS), a national database that gathers information on water and sewage service providers throughout the country. The database includes information on production, revenue, operating costs, and institutional characteristics of the providers.

Based on this data, the authors estimate a production function for companies in the sector, using information on capital, labor, and intermediate inputs. This estimate allows them to calculate the elasticity of production with respect to inputs and, consequently, estimate the companies' markup.

The study uses two approaches to estimate markups: one based on optimal input demand and the other based on the relationship between revenue, total costs, and economies of scale. These methodologies allow for the analysis of companies' market power and its relationship to the size of their operations.

Main results

The results indicate that larger companies, operating in multiple municipalities or regions, exhibit higher levels of productive efficiency and markups greater than one. This suggests that these companies are able to offer prices above marginal cost, which helps finance infrastructure investments.

On the other hand, smaller companies, especially municipal providers operating in limited local markets, often have markups of less than one. This situation may indicate difficulties in sustaining investments and expanding service coverage.

Furthermore, the study shows that companies with higher markups tend to make higher levels of investment. This result suggests that positive margins can play an important role in the financial sustainability of the sector.

Finally, the analysis also indicates that increased competition following the new regulatory framework contributed to reducing the sector's aggregate markup, suggesting improvements in the competitive environment.

Lessons in Public Policy

The study results indicate that the market structure of the sanitation sector has important implications for the expansion of services. Companies with a larger scale of operation tend to exhibit greater efficiency and a greater capacity for investment in infrastructure.

In this sense, policies that encourage the regionalization of service provision and the expansion of operational scale can contribute to improving the sector's efficiency.

Furthermore, promoting competition through bidding processes and concessions can help reduce market distortions and improve economic incentives for service expansion.

Finally, the results suggest that positive margins in the sector can play an important role in the financial sustainability of the investments needed to achieve the goals of universal sanitation in Brazil.