'O Academy of Management journal 1999, Vol. 42, No. 5, 526-538.

CORPORATE PERFORMANCE AND STAKEHOLDER MANAGEMENT: BALANCING SHAREHOLDER AND CUSTOMER INTERESTS IN THE U.K. PRIVATIZED WATER INDUSTRY
STUART OGDEN University of Leeds ROBERT WATSON University of Strathclyde
This study examined a major contention of stakeholder theory: namely, that a firm can simultaneously enhance the interests of its shareholders and other relevant stakeholders. Financial data relating to the U.K. water supply industry and the customer service performance indicators introduced after privatization in 1989 to protect customer interests provided the hasis of our empirical analysis. The results show that, although improving relative customer service performance is costly for firms in terms of current profits, shareholder returns respond in a significantly positive manner to such improvements. We interpret this finding as being consistent with stakeholder theory.

Privatization has been a significant feature of the political and economic scene in the United Kingdom since 1980. Privatization refers to the transfer of ownership and control of an economic activity previously undertaken hy nationally or locally government-controlled agencies to private-sector, profit-seeking organizations. In various forms, privatization has also become increasingly popular in the rest of western Europe (Vickers & Wright, 1989), in the formerly centrally planned economies (Ash, Hare, & Canning, 1994), in less developed countries (Price, 1994), and in Canada and Australia (Richardson, 1990). Privatization of publicly owned utilities is of particular interest from the perspective of stakeholder management. The transfer from public to private ownership not only involves significant changes in the composition of stakeholders, but also requires consideration of how the interests of the different stakeholders are to be balanced by the managers of the privatized utility. This is highlighted in the case of the recently privatized U.K. water industry, where, by virtue of the essential nature of the product, managers could not be left to pursue the interests of the new shareholders exclusively. The need to ensure that account was taken of customer interests has led to the development, by an independent government-appointed regulaWe thank the editors of this AMJ special research forum and the two anonymous reviewers for their helpful comments on a draft of this article and Helen Short of the University of Leeds for her invaluable research assistance. Both authors contributed equally to this work.
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tor, of performance measures of customer service. These measures provide an opportunity to empirically examine a key contention of stakeholder theory, namely, that companies practicing stakeholder management will, other things being equal, be relatively successful in conventional financial performance terms (cf. Donaldson & Preston, 1995). Privatization in 1989 resulted in the ten stateowned regional water companies becoming public limited companies, each with a full London Stock Exchange listing of its shares. Despite the government's claim that private-sector provision of goods and services subject to the disciplines of market forces would be more efficient than public-sector provision (Department of the Environment, 1986), there had been scant opportunity to develop market competition in the water industry (Littlechild, 1986). Consequently, privatization left the monopoly character of the industry largely unchanged. Each of the ten water companies continued to operate as a regional monopolist controlling the supply of an essential commodity. Privatization, therefore, required the U.K. government to design a regulatory system that would ensure that the managers of the ten water companies had, in addition to legal obligations regarding water quality and other public health matters, incentives to maintain a satisfactory balance between the potentially conflicting interests of two key stakeholders: the new shareholders, and customers. The regulatory system, though primarily based upon price controls, also provides strong financial incentives for firms to be cost-efficient while encouraging them to in-

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vest resources on improvements in customer service. Thus, the regulatory system provides an opportunity to empirically test stakeholder notions whereby the proper objectives and responsibilities of firms extend beyond the maximization of shareholder returns (cf. Freeman, 1984; Freeman & Evan, 1990). The purposes of this study were, first, to examine how the potential conflicts of interest between shareholders and customers were intended to be reconciled through the system of regulation and, second, to determine whether any empirical evidence suggested that the system of regulation actually achieved its main purpose. We empirically investigated the performance of the privatized water companies in terms of both financial measures (that is, relative shareholder returns and profitability) and customer service performance measures. These latter performance measures, which are monitored and published by the water industry regulator annually, constitute an important criterion for determining the maximum allowable price increase for each water company. In addition, a water company's high score on customer service measures both reduces the probability of its experiencing adverse regulatory interventions and enhances its reputation with potential purchasers of nonregulated services. Consequently, attaining high levels of customer service can be expected to have a positive effect upon anticipated future income streams. This expectation in turn is an incentive for water company executives to ensure that their organizations perform well on these customer service measures. It is hypothesized that although discretionary expenditures made to improve customer service will be costly in terms of current reported profits, they will be associated with higher shareholder returns since investors will perceive that future profit levels and risk exposure will be improved. Our empirical results are consistent with the above hypotheses. We found that performance on customer service measures is significantly, negatively correlated with current profits but significantly, positively correlated with shareholder returns measures.
STAKEHOLDER THEORY AND THE REGULATION OF THE PRIVATIZED WATER INDUSTRY

Stakeholder models of the firm have attracted considerable support in recent years (e.g., Donaldson & Preston, 1995), not only because of ethical dissatisfaction with the exclusive privileging of shareholder interests, but also on the grounds of

economic efficiency. The "incomplete contracting" literature (Ezzamel & Watson, 1997; Garvey & Swan, 1994; Hart, 1995; Kay & Silberston, 1995), for example, contains the argument that economic efficiency frequently requires firms' executives to exercise their discretion in a way favoring the interests of other stakeholders, such as customers and suppliers. The executives do so because, if other stakeholders perceived that managerial discretion was always being exercised in favor of one particular partyfor instance, shareholders or the executives themselvesthey would be unwilling to do business with the firms. From this perspective, an economically successful firm will necessarily be one in which senior management adopts corporate governance strategies and policies that facilitate the maintenance of an appropriate balance between different stakeholder interests. Though this argument is conceptually clear, it has proved difficult in practice to evaluate specific institutional arrangements for incorporating nonshareholder interests, particularly in terms of their effect on economic performance. Indeed, the ease with which shareholders can be identified and the ready availability of shareholder wealth and financial performance measures in part explain the continuing primacy attached to shareholder interests. Defining who other stakeholders are, determining how their interests are best served, and developing performance indicators that measure a compajiy's degree of success in doing so are corhplex issues not easily resolved in practice. Donaldson and Preston, for example, commented that testing a simple hypothesis, such as the statement that cor- . porations whose managers adopt stakeholder principles and practices will perform better financially than those that do not, "involves some formidable challenges" (1995: 77). Not surprisingly, they noted a dearth of empirical tests of such hypotheses and cited the work of Clarkson (Clarkson, Deck, & Shiner, 1992; cf. Clarkson, 1995) as the only significant example known to them. In the case of the U.K. privatized water companies, these problems of defining stakeholder interests and measuring how well those interests are served are much reduced. The regulatory system for the water industry requires an explicit articulation of the interests to be served by regulation and the measures by which its effectiveness may be assessed. The water companies therefore provide an interesting research site for empirically examining some of the issues raised by a stakeholder view of the firm. Although managers had for the first time to consider the interests of shareholders after water privatization, maximizing shareholder returns could not be pursued without constraint.

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Given the nature ofthe product, managers had also to satisfy a numher of public health and safety concerns and to meet standards set for water quality and customer service. In this context, the water companies presented a strong prima facie case for arguing that managers were required to take a stakeholder perspective on their performance. The appropriateness of this was widely acknowledged. Kay and Silherston (1995), for example, writing from an incomplete contracting perspective, commented that, given the nature of water as a product, no sensible person would wish to have water supplied hy a company that invariably put the interests of its shareholders ahead of those of its customers! The essence of the U.K. water company regulatory system is contained in the duties prescrihed for the director general of the Office of Water Services (OFWAT). According to the 1991 Water Industry Act, he^ has a primary duty to ensure that the functions of water and sewerage undertakers are properly carried out and that companies are able (in particular, by securing reasonable returns on their capital) to finance the proper carrying out of their functions. The director general also has the secondary duties of protecting the interests of customers in respect to the level of charges, the quality of services, promoting economy and efficiency and, where possible, facilitating competition between the water companies. Econom.ic regulation operates through price controls, based on the so-called RPI + k formula. The first component of the pricing formula is designed to allow each firm to recover general rises in prices outside of its control, or inflation, as measured by the retail price index (RPI), and the second component is an adjustment factor (k) that is separately negotiated between each company and the director general of OFWAT. The individual ic-factors, which are subject to periodic review, are based on an assessment of each company's inherited infrastructure and the new investment it needs to achieve the. requisite water quality and service standards, other unique local factors that impact upon costs (such as geology and climate), and an efficiency target. The director general assesses the scope for improved efficiency in terms of both the individual operating circumstances of each company and comparisons with the costs incurred by the most efficient of the other companies for similar activities (the so-called yardstick or benchmark cost basis). Where appropriate, the director general determines the speed with which a firm can reasonahly be expected to get its costs down to the levels of the most efficient

^ One man has held this office since its inception.

supplier while still providing a reasonable return to investors (Cowan, 1994; Littlechild, 1986). This partial adjustment process promotes cost efficiency hy providing firms with an incentive to achieve greater-than-anticipated cost savings, since the resulting increase in profitability represents a recurring annual windfall gain until the ic-factor is renegotiated. An exclusive focus on providing incentives for firms to reduce costs may, however, result in managers reducing expenditures on activities related to customer service. Indeed, Littlechild, in his official report for the Department of the Environment on the regulatory framework for the privatized industry, questioned whether "a privatized Water Authority [would] have any incentive to set and meet challenging levels of service targets which do not contribute directly to profits" (1986: 18). Public awareness of the obvious conflict of interests between shareholders' desire to have increases in profits and customer service requirements was high. Consequently, in establishing the new regulatory framework, the government claimed that it would "be designed to ensure that the benefits of greater efficiency are systematically passed on to customers in the form of lower prices and better service than would otherwise have occurred" (Department of the Environment, 1986: 3). This claim is reflected in OFWAT's aim, stated in an information leaflet distributed to the public: "to ensure that the companies provide customers with a good quality and efficient service at a fair price" (Office of Water Services, 1998). To allow companies to finance their provision of water services and to encourage them to improve customer service levels, the regulator is able to allow^ all or part of the costs involved to be recovered from customers through adjustments to the i:-factor in the pricing formula. Customer service improvements have typically involved reducing problems of low water pressure, improving the security of the water supply, reducing the need for restrictions in periods of low rainfall, and improving the handling of contacts with customers, such as billing complaints. In determining whether to allow the costs of new investment to improve customer service levels, the director general of OFWAT has first to decide whether a planned investment is appropriate and second, what proportion of these costs may be passed on to customers. In considering this, he takes into account the quality of service already provided, the levels of service provided by the other water companies, cost comparisons with other companies, and the scope for improvements in internal efficiency. Insofar as the director general allows costs (including a reason-

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able return on capital) to be passed on to customers, a firm may enhance its future profits, although clearly, its current-year profits would be reduced by the costs of the improvements. However, there are penalties as well as incentives in the privatized system. The director general annually scrutinizes each company's progress toward meeting its quality obligations and its performance in delivering services to customers. He may penalize companies whose performance is poor by, for example, making punitive adjustments to the ic-factor, or by requiring a company to engage in additional expenditure to make good performance shortfalls without taking any compensating allowance for the costs incurred (cf. Office of Water Services, 1997). The director general is likely to be particularly severe to companies in which investment programs are not on track for delivering the targeted service improvements allowed for in price limits. Investigations (Office of Water Services, 1996) of three companies' failure to meet agreedupon outputs resulted in one company, Yorkshire Water, having to agree not to raise charges by more than the rate of inflation from April 1, 1998, until March 2000. The benefit to Yorkshire Water's customers has been estimated to be approximately 44 million. Ultimately, of course, the director general may seek to have a company's appointment to provide water services terminated. Consequently, performing well in delivering services to customers is of critical importance to the water companies.

MEASURES OF CUSTOMER SERVICE

OFWAT has developed seven indicators of levels of service to monitor the quality of service the U.K. water companies provide to their customers. These are the adequacy of water resources, the pressure of water mains, interruptions to the supply, water use restrictions, properties at risk of sewer flooding, the total number of written and telephoned queries about billing and the time taken to respond to them and, finally, the total number of written complaints received about any aspect of service and the time taken to respond to them. These measures are seen by OFWAT as "important output measures" (Office of Water Services, 1990: 1). Each year all the companies are required to report to OFWAT on the quality of the delivery of their services in terms of these seven indicators (e.g.. Office of Water Services, 1991). The reporting period covered by the customer service measures coincides with the firms' accounting year, which runs from April 1 to March 31. Firms are required to supply the regulator with the necessary data in July. OFWAT's as-

sessments of company performance are then published in late November or early December. OFWAT has noted, however, that only four of the measures of servicewater pressure, interruptions of supply, responses to billing queries, and responses to written complaintscurrently allow for comparisons between companies (see Table 1). OFWAT views the number of properties at risk for sewer flooding as unsuitable for comparative purposes because the data currently available lack consistency. The adequacy of the water supply and restrictions on water use are also considered unsuitable as they are largely influenced by climatic and weather patterns (Office of Water Services, 1994). Also, reliable comparable data have only been available since 1991 for two of the measures that can be compared, pressure and interruptions. Another initiative to protect customers' interests involved the establishment of ten customer services committees (CSCs). Each covers a geographic area approximately equivalent to the boundaries of one of the old water authorities. The committees are independent of the water companies, and the chair and members (usually 12) of each customer service committee are all appointed by the director general. Their mission statement, as set out in an annual report, is the following: "The CSC will represent the interest of customers of the water and sewerage companies in its region and will advise and support the DG in regulating the water industry to secure for customers the combination of service and price they would have in a competitive market" (Office of Water Services National Customer Council, 1998). One of the CSCs' principal tasks is to investigate and resolve complaints made to them about the water companies. These are reported, as a percentage of each company's customer base, each year in the CSCs' annual reports and are highlighted in OFWAT's annual reports. The complaints to the customer service committees provide an important additional measure of customer service; see Table 1, where this measure appears as "complaints to OFWAT."
INCENTIVES FOR BALANCING SHAREHOLDER AND CUSTOMER INTERESTS

The water company executives have had to take OFWAT's disciplinary powers and the regulatory penalties for poor or substandard performance seriously, particularly since the director general has declared his intention to take into account each company's performance on customer service in his periodic review of prices and ic-factors (Office of Water Services, 1993). Consequently, the managers have been keen to achieve quality improvements to

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TABLE 1 Descriptive Statistics by Year'

Variable

1992

1993

1994

1995

1996

1997

Financial characteristics and firm performance Total sales'' 332.40 (179.20) 393.30 (233.70) 467.80 (279.80) 524.50 (314.90) 584.40 (326.40) 627.20 (350.20) Total capital employed'' 1,243.20 (505.60) 1,505.50 (607.70) 1,700.80 (671.80) 1,891.80 (773.10) 2,034.30 (837.40) 2,210.10 (962.70) Debt/equity '^ 0.13 (0.07) 0.29 (0.08) 0.35 (0.12) 0.38 (0.16) 0.38 (0.18) 0.68 (0.72) 12.10 (2.30) 12.70 Posttax profit/equity " ^ (1.90) 12.50 (1.70) 11.90 (1.60) 12.40 (1.30) 14.20 (2.20) Annual shareholder 30.60 (7.60) 0.80 (2.50) 55.50 (3.90) 8.30 (4.40) -0.30 (13.30) 27.00 (7.10) returns (April-March) " * -0.04 (0.03) -0.03 (0.02) -0.05 (0.03) Shareholder returns for 0.05 (0.03) 0.08 (0.03) 0.04 (0.10) profits announcement month (May-June) " * - 0 . 0 6 (0.02) 0.05 (0.02) -0.04 (0.03) 0.06 (0.02) 0.02 (0.03) Shareholder returns for 0.02 (0.03) customer service performance announcement month (November-December) " ^ Customer service performance measures Complaints to OFWAT 1.80 (0.80) 4.80 (3.60) 6.60 (4.50) 6.50 (4.60) 5.20 (3.00) 5.50 (2.70) 0.90 (1.00) 1.00 Inadequate water (0.80) 1.00 (0.80) 0.80 (0.70) 0.60 (0.50) 0.80 (0.90) pressure'' 0.40 (0.40) 0.20 (0.20) 0.30 (0.30) 0.40 (0.50) 0.30 (0.40) Supply interruptions " ^ 0.70 (0.90) 2.20 (1.20) Responses to billing 2.90 (1.20) 2.90 (1.30) 3.80 (1.20) 4.40 (0.70) 4.80 (0.40) queries 1.90 (1.00) 1.90 (0.90) 3.20 (1.40) 3.90 (1.70) 4.80 (0.40) 4.90 (0.30) Responses to written complaints Statistics are means and standard deviations (in parentheses). JV = 10 (observations per year). ^ Millions of U.K. pounds. " Proportions. Percentages. ^ " Ratings on a five-point scale, where 1 was "very poor" and 5 was "very good."

customer service within declared time scales and budgets and have, on occasion, volunteered to provide additional improvements in customer service. Companies have variously offered customers rebates or abatements of the available price increase allowed for in their A:-factors, and they have introduced customer service initiatives that went beyond statutory requirements in areas such as compensation for missed appointments (Office of Water Services, 1997). These improvements were designed to secure the goodwill of the director general as w^ell as to benefit customers. However, all these "voluntary" provisions have entailed significant amounts of expenditure, which have on occasion caused concern to shareholders. Certainly investment analysts have been conscious that the water companies could spend too much money on achieving high standards of customer service, as well as too little (Ogden, 1997). Senior managers of the water companies have had reasons beyond regulatory considerations for pursuing improvements in customer service. In the first instance, managers were keen to distinguish their

newly privatized companies from the old public sector companies. They were also anxious to counter the many critics of the water privatization process (Ogden, 1991). On both counts, there is little doubt that managers believed that being responsive to customer needs and providing good service to customers w^as part of the definition of a successful private sector company. From the perspective of resource dependency theory (e.g., Pfeffer & Salancik, 1978), a creditable demonstration of commitment to customer service was simply seen as a condition of their continued survival. This is particularly evident in the mission statements made by the boards of the water companies in their statutory annual reports. The Northimibrian Water Group's 1994 annual report provides a typical example: "At the heart of our new vision of the Group's future is the need for us all within Northumbrian Water to focus our efforts ever more intensely on the needs and desires of our customers." Furthermore, managers were conscious that improved customer service could serve as a source of legitimacy for their new private-sector status. Manag-

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ers' pursuit of legitimacy may be considered as reflecting strategic initiatives (cf. Ashforth & Gibbs, 1990; Pfeffer & Salancik, 1978; Suchman, 1995) to instrumentally deploy and manipulate their newfound commitment to customer service and thus to gamer support for their new private-sector status. It may also be considered as an example of an institutional response to cultural pressures for enterprise and consumer sovereignty that underpinned the goverrunent's whole privatization project (Ogden, 1997). Managers were also aware that comparisons of performance made possible by OFWAT's measures of levels of service were used by other audiences, most notably the City and financial analysts. Analysts' reports on individual water company performance, although primarily concerned with financial performance, have considered performance on customer service as an important indicator of managerial competence and company success. Analysts have also incorporated the levels of service performance into assessments of a company's exposure to regulatory risk and the likelihood of any company's having to remedy some shortfall in performance expected by the regulator, with all its attendant cost im^plications and reputational damage [e.g., Charterhouse Tilney Equity Research, 1993; Warburg Securities, 1991). Finally, senior managers have seen commercial potential in achieving good performance on customer service measures that extends beyond the regulatory sphere of OFWAT. Establishing a reputation as a customer-focused organization, particularly when doing so may be externally validated by an independent body such as OFWAT, is valued as a resource in exploiting business opportunities outside the regulated activities of water services. The importance of this, and the resource-based view of the firm it reflects (e.g.. Hall, 1992), should not be underestimated. To date, the two main areas of diversification for the water companies have been waste management services and international con, tracts for providing water services. Further support for this consideration can be drawn from the marketing literature (e.g., Kotler, 1984). In particular, Narver and Slater's study (1990) indicates that business performance may be enhanced in the longer term by increasing market orientation, particularly in terms of the attention given to customers' current and future needs. This effect appears to apply whatever the degree of competition within a company's environment (Slater & Narver, 1994), a finding of particular relevance to the water companies since they remain regional monopolists in regard to the provision of water services. From the above, it can be argued that the privatization ofthe U.K. water industry provides a poten-

tially rich research setting for examining many of the implications and actual consequences that arise in the practical application of stakeholder conceptions of the firm. Our primary concern here was to investigate whether any empirical evidence suggested that the postprivatization regulatory system actually produced significant benefits to both shareholders and customers. Positive results are not a forgone conclusion since the history of utility regulation is replete with examples of "regulatory capture" (for a review, see Self [1993]). The many statements in OFWAT and water company publications affirming the importance of customer service may have simply constituted marketing hype and/or self-serving rhetoric declaimed by the interested parties to legitimate their current policies and practices. What would count as evidence that the regulator and the water companies w^ere taking improvements in customer service seriously would be (1) evidence that customer service performance (assessed in terms of the published measures) was improving over time coupled with (2) evidence that customer service performance was also economically significant in relation to reported profits and shareholder w^ealth measures. Given the possibility that the published customer service measures might simply reflect the regulator's and the water companies' joint desire to be seen to be attending to customer interests, a plausible null hypothesis was that results on these measures would not be related in any economically meaningful manner to either the companies' profits or their returns (dividend payments and capital gains) to their shareholders. The following two alternative hypotheses suggest themselves: Hypothesis 1. The customer service performance ofthe United Kingdom's privatized water companies, as measured by published customer service levels, will be negatively related to the companies' contemporaneous reported profitability. Hypothesis 2. The customer service performance ofthe United Kingdom's privatized water companies, as measured by published customer service levels, can be expected to have a positive impact on future profitability and will therefore be positively related to currentperiod shareholder returns. We tested the first hypothesis to establish whether or not differences between companies in terms of the published measures of customer service were related to differences in profits. Supportive results would indicate that the water companies were prepared to commit real resources, which

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would have otherwise accrued to their shareholders, to improving their customer service. We tested the second hypothesis to ascertain whether these customer service results had any consequences for shareholder wealth. If the regulator allowed companies to recoup all or most of their costs (plus a profit margin) through higher charges to customers, then external capital markets would interpret better-than-average customer service levels as value-enhancing. In these circumstances, the customer service indicators could be expected to be positively related to current-period relative shareholder returns. It is by no means certain that managers' decisions about expenditures to improve customer service will inexorably enhance future profitability. Considerable pressures and risks influence managers' judgments about how best to balance shareholder and customer interests. On the one hand, there is, of course, the regulatory imperative to achieve minimum standards of customer service. There is regulatory risk if not enough is achieved. Managers may also enhance the legitimacy of their companies as private-sector actors and secure reputational benefits that can be commercially exploited in other markets. On the other hand, achieving improved customer service entails considerable expenditure. Moreover, managers may be too ambitious in their plans for customer service, be inefficient in carrying out those plans, or fail to secure enough recompense through the ic-factor determined by the director general, all of which would have adverse consequences for their companies' financial performance. Despite these potential difficulties, the regulator can be expected to have confidence in the reliability of his own system for determining customer service levels and to therefore reward the water companies with high scores on these measures.
EMPIRICAL MODELING OF THE RELATIONSHIPS BETWEEN SHAREHOLDER WEALTH, PROFITS, AND CUSTOMER SERVICE LEVELS

firm-specific fixed effects, both the average profit levels and shareholder returns of the sample were influenced by common economy- or sector-wide factors. In testing our hypotheses, therefore, we needed to be able to control for these time-varying and firm-level fixed effects in order to isolate the influence of different customer service performance levels on profitability and changes in shareholder wealth (returns). In both the profits and shareholder returns models described below, the dependent variables are expressed in terms of the deviation of company j's profits (or returns) at time t from the sector's average profits (or returns) for the same period. This method effectively overcame the problem of time-specific effects.^ As for the firm-level fixed effects, these were only likely to be of any importance in respect to the profit model because, in an informationally efficient market, share prices will rapidly incorporate the financial consequences of any anticipated firm-level fixed effects (see Malkiel [1996] for a review). Hence, we estimated only the relative profits models controlling for fixed effects.^ Finally, given the combination of price regulation and highly stable operating and cost conditions that give rise to fixed effects with respect to relative profitability, one of the few ways open to an individual water company to significantly im: prove its posttax profitability ranking is to increase its debt-to-equity ratio. For any positive level of operating profits, taking on more debt and/or reducing the equity base (through, for instance, share repurchases) has the effect of increasing the posttax return per unit of equity. Hence, because capital structure changes could be expected to have a significant impact on our relative profits measure, our empirical analysis also had to include controls for this factor.
Relative Profits Model We controlled for common time period influences on company profits by defining our depen^ We also reestimated each of the empirical models including five dummy variables relating to the time period of the observations (the number of years covered by our panel data minus one, which is represented by the constant term). However, as expected, the dummies' inclusion did not result in any improvement in the explanatory power of the estimates. ^ All of the shareholder returns models were also reestimated with controls for fixed effects included. However, as expected, the fixed effects models did not result in any statistically significant improvement in the explanatory power of the estimates.

Our empirical testing of Hypotheses 1 and 2 needed to take account of the character of the water industry and the panel nature of our dala, which consisted of six annual cross sections of ten observations, each representing one water company. As we were analyzing regulated enterprises supplying an identical basic product, but with very different inherited cost bases and local operating conditions, there was likely to be very little intertemporal variation in the ranking of companies in terms of their profitability. In addition to these time-invariant.

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dent variable in terms of the relative profits available for distribution to sbareholders (that is, posttax profits or, in U.S. accounting terminology, net income). To obtain an accounting-based measure of the return to shareholders, we needed to control for differences in the sizes of the companies' equity bases by deflating the profit measure by the book value of shareholders' equity (issued share capital plus reserves). The dependent variable, the sector-relative profit of company J over time t (a year) was therefore defined as follows: Relative profits^ = (profits/equity)^ (sector-average profits/equity j^. Our estimating equation for explaining the differences in relative profitability became: Relative profits^ = 2 a,-' +/3 log (book value of capital employedjj + ^(debt/equity)n +^(customer service performancen)+ Uy^, where 2 a^ represents firm-specific fixed effects* and u,-f is an error term. Three alternative specifications of the above profit model were estimated. Model 1, our benchmark, did not include any customer service variables. Models 2 and 3 both included customer service measures. Model 2 included five customer service variables, which consisted of the standardized values of five individual measures, and model 3 had a single composite customer service variable. Thus, the difference between models 2 and 3 was this: in model 2, the individual slope coefficients could differ, but in the more restrictive model 3, the slope coefficients on the individual customer service variables were of equal sign and magnitude.

Our empirical equation thus was: Relative returnSjt = 2 li(firm-specific factors)it + u^. Because we assumed an informationally efficient capital market, the vector of firm-specific factors assumed to influence returns included only information (news) received by the market within time period t that could have been expected to have altered investor expectations regarding the level and riskiness of an individual firm's anticipated future profits. The two items of firm-specific information incorporated into our empirical models that would have been released to the market during a one-year period w^ere relative profits and measures of customer service performance. A major difficulty in any analysis ofthe impact of an economic variable upon shareholder returns is determining the most appropriate time frame for observing such an impact. All ten privatized water companies had accounting year-ends on March 31, and the financial accounts for each year were all published in late May or early June. To date, the director general has published results on the customer service performance measures between late November and early December of each year. To test Hypothesis 2, we measured returns over two different periods. We assessed announcement or news effects by measuring returns over the month in which the regulator released the customer service findings. Only the customer service variable or variables were included in this customer service announcement month model. Then, to compare the relative announcement impacts upon share prices of profits and ofthe performance variables, we also estimated a profit announcement month model. To test the possibility that investors inferred some financial and customer service performance information from other sources prior to the information's actual release by the regulator, and to allow for the possibility that investors may have taken some time to appreciate the impact of such information on future profitability, we also measured returns for the subsequent one-year period, from April 1 to March 31. The resulting annual returns model included both relative profits and customer service as explanatory variables since both items were released during the year covered by the dependent variable. To ensure that the values associated with all five of the indicator variables were all positively associated with improvements in customer service levels, we expressed three of them (complaints to OFWAT, inadequate water pressure, and supply interruptions) as 100 percent minus the reported

Shareholder Returns Model As for the relative profits models, for the shareholder returns model we isolated the common external influences upon shareholder returns from the firm-specific factors in each period. Our dependent variable, relative shareholder returns for firm i over time t, was thus defined as follows:

Relative returns^ = returns^ sector-average returnst

* See chapter 2 of Baltagi (1995) for an exposition of the methods used to control for fixed effects.

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TABLE 2 Estimation of Relative Profits Function 1991-92 to 1996-97"

Independent Variable Book value of capital employed,-,'' (Debt/equity),-, F for constant and firm-level fixed effects Complaints to OFWAT,, Inadequate water pressure,-,'^ Supply interruptions,-," Responses to billing queries,/ Responses to written complaints,-,'^ Customer service,-," F for new variables Adjusted R^ Equation F Model 1 -0.013 0.012 15.570** (1.39) (2.58)** Model 2 -0.010 0.011 18.180** 2.802E-3 (1.26) -7.804E-3 (3.60)** -4.269E-3 (2.83)** 0.325E-3 (0.21) -3.281E-3 (2.33)* -2.150E-3 (2.79)** 72.00 14.79** 4.06** 78.80 14.68** 6.26** 74.80 15.57** (1.39) (2.88)** Model 3 -0.012 0.012 17.520** (1.41) (2.68)**

" The dependent variable was calculated as (profits/equity)^, - (sector-average profits/equity],. N = 60. White's (1980) heteroskedasticityadjusted (-values are shown in parentheses. * Logarithm. " " Standardized measure. * p < .05 ** p S .01

percentages pnblished by OFWAT (and shown in Table 1). The five variables could not, however, be simply aggregated to provide a summary overall measure of customer service levels because the measurement units differed: the three just noted were percentages, but the variables measuring responses to billing queries and to written complaints were expressed as integer values on a fivepoint scale. In order to aggregate the five indicator variables, we thus transformed each variable into an annual standardized value. These standardized relative measures of customer service were individually entered into the model 2 relative profits estimate.^ Standardization also enabled us to aggregate these five measures to produce a single composite indicator of relative customer service performance, customer service, in which each indicator had equal weight (that is, the indicators were added together). In order to summarize each firms' customer service performance, the regulator had to have constructed a similar composite measure.^ We entered ^ The individual standardized customer service variables were also entered into the shareholder returns models. However, none of the individual variables were of any statistical significance and, consequently, these results are not reported here. Moreover, given the relatively few degrees of free* dom associated with our data set and the "pairwise" correlations between the individual nonfinancial indica-

our composite measure into the relative profits (model 3] and shareholder returns models. A statistically significant, negative coefficient on this variable in the profits model would imply that performing on customer service was costly in terms of current reported profitability, as stated by Hypothesis 1. However, although such an effect was expected to depress profits, the costs associated with improvements in customer service are costs that the regulator may allow to be passed on to customers. Hence, as stated by Hypothesis 2, a statistically positive coefficient on this variable was to be expected when it was entered into the (announcement month and annual) shareholder returns models, since thus passing costs on implies higher future profits, which is good news to shareholders. RESULTS Table 2 presents our estimates relating to Hypothesis 1. As stated above, we made three alternative estimates of our relative profits model. Model 1, which includes controls for the unobservable firm-level fixed effects, firm size, and differences in capital structure, is able to explain a high proportion of the cross-sectional variability in relative profits. As anticipated, the firm-level fixed effects are highly significantindeed, on their own, they tors, this composite variable was also likely to provide a more efficient statistical estimator of their influence.

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TABLE 3 Relative Shareholder Returns Functions 1991-92 to 1996-97'

Independent Variable (Profit/equity),-, Customer service,-. Constant Adjusted R^ Equation F Earnings Announcement Month Returns 0.125 (0.28) 2.611E-3 (2.29)* 0.014 (1.93)'*' -1.6 0.09 -0.069E-3 (0.02) 6.3 4.96* Customer Service Announcement Month Returns Annual Returns 0.121 (0.16) 10.045E-3 (2.46)* 0.288E-3 (0.03) 7.5 3.40*

" The dependent variable was calculated as relative returnSj, = returns,, - sector-average returns,. The returns for each company and the sector-average returns were calculated as natural logarithms. N = 60. White's (1980) heteroskedasticity-adjusted f-values are shiown in parentheses.
.05

account for some 70 percent of the cross-sectional variation in profitability. Also, the debt-to-equity ratio is, as expected, positive and statistically significant at the 1 percent confidence level. Model 2 includes the five individual standardized customer service variables (complaints to OFWAT, inadequate water pressure, supply interruptions, and responses to billing queries and written complaints). The incremental impact of these five measures is statistically significant at the 1 percent confidence level. However, although only three of the five variables are negative, all three are statistically significant at 5 percent or better levels of confidence. Model 3 includes only the aggregate variable customer service, which thereby constrains all five variables to have the same slope coefficients. Despite this restriction, model 3 appears to be well specified: the composite variable is negative and statistically significant at a 1 percent level of confidence, though there is a slight decrease in the overall explanatory power of the model relative to model 2. These results provide strong empirical support for our first hypothesis. As can be seen from Table 2, in both models that include customer service measures, the variables are negatively related to the dependent variable at a 1 percent confidence level. These results imply that, despite the negative consequences of customer service increases for current reported profits, managers are prepared to expend resources to improve such service. We now consider whether such expenditures appear to also be in the interests of shareholders. Table 3 presents our empirical estimates of the shareholder returns functions used to test Hypothesis 2, which predicts that the customer service measures will be positively related to current-

period shareholder returns. We made this prediction because some or all of the costs associated with improvements in customer service can likely be subsequently passed on to customers, thus increasing future profits and current value. Though in both the annual returns and announcement month returns models the relative profits measure has a positive coefficient, neither of these coefficients is statistically significant at a 5. percent level. These results imply that the revelation of the profit figures to the capital markets did not appear to be regarded as news in that there is no statistical evidence that this information systematically altered the existing perceptions of investors regarding the current values of the firms.'' Of course, given the huge fixed effects in relation to relative profits shown in Table 2, this finding should not be too surprising. These firm-level fixed effects reflect the highly regulated nature of the industry's pricing policies, the inherited infrastructure, the locationspecific cost structures of individual firms, and the limited scope for increasing sales of their priceregulated product. In an informationally efficient market, share prices should already reflect any anticipated intertemporal profitability rankings. Hence, much of the information contained in the financial statements regarding relative profitability would not constitute news and, therefore, no share

^ After obtaining the results presented in this article, we reestimated the shareholder return models using different time horizons for the measurement of the dependent variable. These additional estimates did not, however, produce significantly different results from those presented here.

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price reaction should occur at the time of its release. The situation in regard to the customer service performance measures is, however, somewhat different. Table 2 shows that the estimated positive coefficient on the customer service variables, for both the announcement and annual returns versions of the model, is statistically significant at better than 5 percent confidence levels. This pattern appears to indicate that our composite customer service variable is of some statistical importance in explaining both relative annual shareholder returns and relative shareholder returns for the month immediately surrounding revelation of this information to the market. These results imply, for example, that a firm that performs one standard deviation better than the mean on customer service in any period will earn an approximately 1 percent higher-than-average return for its shareholders. Although this positive relationship between relative shareholder returns and relative performance in terms of customer service measures is not particularly large, it does nevertheless appear to constitute an important form of value-relevant information to equity investors. Indeed, it appears to be much more important to shareholders than information releases regarding relative profitability over the same period.
DISCUSSION AND CONCLUSIONS

of regulation that provides a relatively high degree of discretion to the regulator can, when coupled with market-based incentives and trust, result in mutual benefits for different stakeholder groups with apparently conflicting economic interests. Clearly, the effectiveness of this regulatory system relies very heavily on how the regulator exercises its discretion and on the quality of the relationships between the regulator and water company executives. Without a high level of mutual trust between the parties, the system would be beset with legal challenges to the regulator's decisions. The fact that, in the nine years since privatization, only one of the ten privatized water companies has sought judicial review of any of the regulator's decisions suggests that the required high level of mutual trust exists. Southwest Water appealed to the Monopolies and Mergers Commission over the OFWAT director general's determination of its efficiency target (that is, its ic-factor) following its 1994 periodic review. The outcome of this appeal for the company was, in fact, a more demanding ir-factor than that originally proposed by the director general (Monopolies and Mergers Commission, 1995). The role of trust identified here echoes the importance Jones (1995) attached more generally to trust in developing an instrumental theory of stakeholder management. He argued that "trusting and cooperative relationships help solve problems related to opportunism" (Jones, 1995: 432) and that because "the costs of opportunism and of preventing or reducing opportunism are significant, firms that contract on the basis of trust and cooperation will have a competitive advantage over those that do not use such criteria" (1995: 432). Seeking this advantage, he concludes, provides not only an explanation for altruistic firm behaviors, but also a basis for an instrumental theory of stakeholder management. Our discussion of the respective roles of managers and regulator in balancing competing stakeholder interests also has implications for debates about the basis of stakeholder theory. Although instrumental justifications for stakeholder theory are well established (Freeman, 1984; Freeman & Evan, 1990), some commentators have argued that these are inadequate as a basis for stakeholder theory. Donaldson and Preston (1995), for example, suggested that even if it is prudent for managers to pay attention to stakeholder interests, there is no guarantee that they will do so. Stakeholders have no assurance that their interests will be properly considered or that managers will not behave opportunistically at their expense. Donaldson and Preston argued instead for a normative basis for stakeholder theory, which, they suggested, resides in

The empirical results presented in this article provide statistical evidence indicating that it is possible, to some extent, to align the apparently conflicting concerns of different stakeholder groups. Our findings support both the plausibility of the stakeholder model of the firm and the possibility of quantifying and empirically testing propositions and predictions grounded on the stakeholder model. Opportunities to test these propositions further could be explored in other regulated and/or privatized utilities. In the United Kingdom, for example, customer service standards have been incorporated into the regulatory frameworks for British Telecom and the privatized gas and electricity industries. However, it is important to note that the use of measures of customer service in these regulatory processes is still at an early stage of development. With all the privatized utilities, including water, a number of issues remain unresolved. Principal among these is the question of who determines what customer service standards are to be, how they are to be measured, and their adequacy in reflecting customer needs. Nevertheless, from the evidence presented here, it is apparent that in some circumstances a system

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managers' recognition that all stakeholders' interests have intrinsic value. The ultimate managerial implication of stakeholder theory is that, rather than treat stakeholders' interests instrumentally, managers "should acknowledge the validity of diverse stakeholder interests and should attempt to respond to them within a mutually supportive framework, hecause that is a moral requirement for the legitimacy of the management function" (Donaldson & Preston, 1995: 87). Our evidence indicates, however, that such a hasis for managerial behavior is still far from heing realized. It could be expected, given the essential nature of their product, that managers in the water industry would take due account of all stakeholders' interests in their decision making. However, the regulatory system presumes the opposite. The responsibility for ensuring that customer interests are adequately attended to is located with the regulator. Moreover, the incentives and sanctions at its disposal are designed to operate on the assumption that managers will act instrumentally. One limitation of our study is that it was restricted to one industry. Moreover, given the changes occasioned by that industry's recent privatization, the small number of companies operating within it, and its regulatory environment, the U.K. water industry can by no means be considered typical. Another limitation of the study concerns the measures of customer service. Although we used the measures employed by the U.K. Office of Water Services, only four of the seven measures lent themselves to comparison. As regards our empirical analysis of the data, the power of the tests of the shareholder returns models might be improved if daily share data were used instead of monthly data. Further, although the estimation problems would be complex, there might be benefits from undertaking a more detailed analysis of the cash flow consequences directly associated with each customer service indicator. Beyond the confines of regulated utilities, our research has two major implications for stakeholder theory. The first of these is reiteration of the importance of the abilities to define stakeholders' interests and to measure and monitor those interests. The second is to emphasize the need for the measurement and monitoring of companies' performance in regard to stakeholders' interests to be transparent. Such transparency would facilitate independent substantive evaluation of companies' treatment of stakeholders and avoid the reliance on companies' own assessment of their performance. Companies that believe that they already take serious account of stakeholder interests may welcome such evaluation, because it would provide an op-

portunity to demonstrate the validity of their claims about serving stakeholders.

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