September 1996 The key to effective regulation of water companies is to generate information that allows the regulator to make good rules and allows the interest groups to watch out for improprieties by the regulator. Both public and private water companies need regulation (of water price and quality) when real competition is not feasible. Piped water systems tend to be monopolies or to contain monopoly elements. To counteract monopoly power, regulatory mechanisms exist in all countries, as part of the executive branch of government or in more independent agencies. Regulators rule on issues of price and quality of services and sometimes also on investment performance. Pricing rules try to balance incentives to use water efficiently with social concerns, such as quality of the water supply, universal service goals, and subsidy schemes for the poor. The regulator has a countermonopoly to the water companies and may also be tempted to abuse that power. Because the regulator does not invest in fixed, immovable assets, it has more freedom than the private monopolist, who is exposed to pressures once a water system has been built. Under political pressure, the regulator may therefore be tempted to exploit the private investor by not granting prices sufficient to cover investment costs. Or the regulator may team up with the company and exploit the consumers. To guard against such behavior, the powers of the regulator should be carefully circumscribed. And the office of the regulator should be set up so as to be able to resist improper influence by different interest groups (companies, consumers, and government). The key to effective regulation is to generate information that allows the regulator to make good rules and allows the interest groups to watch out for improprieties by the regulator. The best way to generate information is to introduce multiple players in the water system in ways that enhance direct or indirect competition. In particular, it seems advisable to minimize exclusivity rights and to let companies compete for concessions with limited terms. Incentives to compete and to behave efficiently will be strongest when the owners have their own money on the line. For this reason, government-owned water companies could on average be expected to perform worse than investor-owned companies. Competent government-owned companies should be given a chance to compete on an equal footing with private companies rather than be sheltered from competition. An equal playing field will require that they not benefit from taxpayer subsidies (for example, through equity injections) but face a budget constraint as hard as that of private competitors. This paper -- a product of the Private Sector Development Department -- is part of a larger effort in the department to analyze issues arising from private participation in infrastructure.