Evaluating Cost Efficiency in Water Utilities: a Latent Class Stochastic Frontier Approach to Address Technological Heterogeneity

Abstract

Improving the efficiency of water utilities is a key objective for regulators and policymakers, particularly in capital-intensive sectors such as water services. In this context, cost efficiency refers to the ability of water companies to provide a given level of service at the minimum possible cost. This study evaluates the cost efficiency of English and Welsh water utilities over the period 1991–2019 while accounting for technological heterogeneity across companies. To address this issue, a latent class stochastic frontier model is applied, allowing firms with similar technological characteristics to be grouped into different classes. The empirical analysis is based on a sample of English and Welsh water utilities from 1991 to 2019. The results identify three distinct groups of water utilities with average cost efficiency scores of 0.981, 0.983 and 0.965. Overall, the estimated efficiency levels are relatively high and remain stable over time, with limited potential for additional cost savings. The results also highlight differences in returns to scale and cost drivers across the identified classes of utilities.