Water Management in France: Delegation and Irreversibility
Journal of Applied Economics, Vol. 3, No. 2, pp. 325-352, November 2000
Posted: 20 Jun 2004
The problem that we address in this paper stems from the trend to delegation in the water management field. It refers to the municipality's negotiating disadvantage in the face of cartelized water management firms that makes delegation, once undertaken, virtually irreversible. We show why the characteristics of the delegation auction render is useless as a tool for collective welfare maximization. We also show that the remaining tool for achieving collective welfare maximization, i.e. the municipality's right to revoke delegation and return to direct management, is also ineffective due to a lack of credibility that is essentially financial in nature. Thus, if the credibility of revocation could be restored, the municipality's bargaining power could also be restored. Using standard methods of stochastic calculus, we model the municipality's right of revocation as a call option held by the municipality. We show that the key variable for the value of this option, and thus for the municipality's position, is the exercise price, which is partly determined by objective economic criteria and partly by legal and institutional conventions. We show that community welfare maximisation occurs at the point where the exercise price is determined exclusively by objective economic criteria. Since the delegated firm as a simple agent has the right to abrogate the contract if delegation becomes unprofitable, we then model this right as a put option held by the firm. Its value also depends to a large extent on the exercise price, which is partly determined by objective economic criteria and partly by legal and institutional conventions. Combining the exercise points of the two options enables us to determine the price-profit interval over which delegation will be acceptable to both parties. We conclude that the optimal interval will be the one where the exercise prices are determined entirely by objective economic criteria.
Keywords: Water management, delegation, insurance mechanisms, technological changes, real options
JEL Classification: D44, D81, Q00, Q25, O33, G13
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