'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 stakehold-
ers. 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 im-
provements. 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 King-
dom since 1980. Privatization refers to the transfer
of ownership and control of an economic activity
previously undertaken hy nationally or locally gov-
ernment-controlled agencies to private-sector, prof-
it-seeking organizations. In various forms, privat-
ization 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 (Rich-
ardson, 1990). Privatization of publicly owned util-
ities 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 high-
lighted 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 exclu-
sively. The need to ensure that account was taken
of customer interests has led to the development,
by an independent government-appointed regula-
We thank the editors of this AMJ special research fo-
rum 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 assis-
tance. Both authors contributed equally to this work.
526
tor, of performance measures of customer service.
These measures provide an opportunity to empiri-
cally examine a key contention of stakeholder the-
ory, namely, that companies practicing stakeholder
management will, other things being equal, be rel-
atively successful in conventional financial perfor-
mance terms (cf. Donaldson & Preston, 1995).
Privatization in 1989 resulted in the ten state-
owned regional water companies becoming public
limited companies, each with a full London Stock
Exchange listing of its shares. Despite the govern-
ment'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 monop-
oly character of the industry largely unchanged.
Each of the ten water companies continued to op-
erate as a regional monopolist controlling the sup-
ply of an essential commodity. Privatization, there-
fore, required the U.K. government to design a
regulatory system that would ensure that the man-
agers of the ten water companies had, in addition to
legal obligations regarding water quality and other
public health matters, incentives to maintain a sat-
isfactory balance between the potentially conflict-
ing interests of two key stakeholders: the new
shareholders, and customers. The regulatory sys-
tem, though primarily based upon price controls,
also provides strong financial incentives for firms
to be cost-efficient while encouraging them to in-
1999 Ogden and Watson
vest resources on improvements in customer ser-
vice. Thus, the regulatory system provides an op-
portunity to empirically test stakeholder notions
whereby the proper objectives and responsibilities
of firms extend beyond the maximization of share-
holder 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 evi-
dence suggested that the system of regulation actu-
ally achieved its main purpose. We empirically
investigated the performance of the privatized wa-
ter companies in terms of both financial measures
(that is, relative shareholder returns and profitabil-
ity) and customer service performance measures.
These latter performance measures, which are
monitored and published by the water industry
regulator annually, constitute an important crite-
rion 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 expe-
riencing adverse regulatory interventions and en-
hances 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 in-
come streams. This expectation in turn is an incen-
tive for water company executives to ensure that
their organizations perform well on these customer
service measures.
It is hypothesized that although discretionary ex-
penditures 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 lev-
els and risk exposure will be improved. Our empir-
ical results are consistent with the above hypothe-
ses. We found that performance on customer
service measures is significantly, negatively corre-
lated with current profits but significantly, posi-
tively correlated with shareholder returns mea-
sures.
STAKEHOLDER THEORY AND THE
REGULATION OF THE PRIVATIZED
WATER INDUSTRY
Stakeholder models of the firm have attracted
considerable support in recent years (e.g., Donald-
son & Preston, 1995), not only because of ethical
dissatisfaction with the exclusive privileging of
shareholder interests, but also on the grounds of
527
economic efficiency. The "incomplete contracting"
literature (Ezzamel & Watson, 1997; Garvey &
Swan, 1994; Hart, 1995; Kay & Silberston, 1995), for
example, contains the argument that economic ef-
ficiency frequently requires firms' executives to ex-
ercise their discretion in a way favoring the inter-
ests 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 partic-
ular partyfor instance, shareholders or the exec-
utives 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 non-
shareholder 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 finan-
cial performance measures in part explain the con-
tinuing 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 prin-
ciples 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 signif-
icant example known to them.
In the case of the U.K. privatized water compa-
nies, these problems of defining stakeholder inter-
ests and measuring how well those interests are
served are much reduced. The regulatory system
for the water industry requires an explicit articula-
tion 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 examin-
ing 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 re-
turns could not be pursued without constraint.
528 Academy of Management foumal
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 qual-
ity and customer service. In this context, the water
companies presented a strong prima facie case for
arguing that managers were required to take a stake-
holder perspective on their performance. The ap-
propriateness of this was widely acknowledged.
Kay and Silherston (1995), for example, writing
from an incomplete contracting perspective, com-
mented that, given the nature of water as a product,
no sensible person would wish to have water sup-
plied 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 regula-
tory system is contained in the duties prescrihed
for the director general of the Office of Water Ser-
vices (OFWAT). According to the 1991 Water In-
dustry 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 cus-
tomers 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 con-
trols, 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 compo-
nent 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 infrastruc-
ture 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 appro-
priate, 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.
October
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 re-
sulting increase in profitability represents a recur-
ring annual windfall gain until the ic-factor is rene-
gotiated.
An exclusive focus on providing incentives for
firms to reduce costs may, however, result in man-
agers 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 indus-
try, questioned whether "a privatized Water Au-
thority [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 be-
tween shareholders' desire to have increases in
profits and customer service requirements was
high. Consequently, in establishing the new regu-
latory 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" (De-
partment of the Environment, 1986: 3). This claim
is reflected in OFWAT's aim, stated in an informa-
tion leaflet distributed to the public: "to ensure that
the companies provide customers with a good qual-
ity 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 recov-
ered 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 se-
curity of the water supply, reducing the need for
restrictions in periods of low rainfall, and improv-
ing the handling of contacts with customers, such
as billing complaints. In determining whether to
allow the costs of new investment to improve cus-
tomer service levels, the director general of
OFWAT has first to decide whether a planned in-
vestment is appropriate and second, what propor-
tion of these costs may be passed on to customers.
In considering this, he takes into account the qual-
ity of service already provided, the levels of service
provided by the other water companies, cost com-
parisons with other companies, and the scope for
improvements in internal efficiency. Insofar as the
director general allows costs (including a reason-
1999 Ogden and Watson
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 incen-
tives in the privatized system. The director general
annually scrutinizes each company's progress to-
ward meeting its quality obligations and its perfor-
mance 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 allow-
ance for the costs incurred (cf. Office of Water
Services, 1997). The director general is likely to be
particularly severe to companies in which invest-
ment 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 agreed-
upon 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 cus-
tomers has been estimated to be approximately 44
million. Ultimately, of course, the director general
may seek to have a company's appointment to pro-
vide water services terminated. Consequently, per-
forming 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 com-
panies 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 Ser-
vices, 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 regula-
tor with the necessary data in July. OFWAT's as-
529
sessments of company performance are then pub-
lished 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 re-
sponses 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 pur-
poses because the data currently available lack con-
sistency. The adequacy of the water supply and
restrictions on water use are also considered un-
suitable 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 ser-
vices 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 rep-
resent 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 mar-
ket" (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 high-
lighted in OFWAT's annual reports. The com-
plaints to the customer service committees provide
an important additional measure of customer ser-
vice; 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 se-
riously, 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
530 Academy of Management Journal October

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)
Posttax profit/equity "^ 12.10 (2.30) 12.70 (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) "*
Shareholder returns for -0.04 (0.03) -0.03 (0.02) -0.05 (0.03) 0.05 (0.03) 0.08 (0.03) 0.04 (0.10)
profits announcement
month (May-June) "*
Shareholder returns for - 0 . 0 6 (0.02) 0.05 (0.02) -0.04 (0.03) 0.06 (0.02) 0.02 (0.03) 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)
Inadequate water 0.90 (1.00) 1.00 (0.80) 1.00 (0.80) 0.80 (0.70) 0.60 (0.50) 0.80 (0.90)
pressure''
Supply interruptions "^ 0.40 (0.40) 0.20 (0.20) 0.30 (0.30) 0.40 (0.50) 0.30 (0.40) 0.70 (0.90)
Responses to billing 2.20 (1.20) 2.90 (1.20) 2.90 (1.30) 3.80 (1.20) 4.40 (0.70) 4.80 (0.40)
queries
Responses to written 1.90 (1.00) 1.90 (0.90) 3.20 (1.40) 3.90 (1.70) 4.80 (0.40) 4.90 (0.30)
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 pro-
vide additional improvements in customer service.
Companies have variously offered customers re-
bates or abatements of the available price increase
allowed for in their A:-factors, and they have intro-
duced customer service initiatives that went be-
yond statutory requirements in areas such as com-
pensation for missed appointments (Office of Water
Services, 1997). These improvements were de-
signed 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 invest-
ment 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 pursu-
ing improvements in customer service. In the first
instance, managers were keen to distinguish their
newly privatized companies from the old public sec-
tor companies. They were also anxious to counter the
many critics of the water privatization process (Og-
den, 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 depen-
dency theory (e.g., Pfeffer & Salancik, 1978), a credit-
able demonstration of commitment to customer ser-
vice 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 pro-
vides 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 im-
proved customer service could serve as a source of
legitimacy for their new private-sector status. Manag-
 1999 Ogden and Watson
ers' pursuit of legitimacy may be considered as re-
flecting strategic initiatives (cf. Ashforth & Gibbs,
1990; Pfeffer & Salancik, 1978; Suchman, 1995) to
instrumentally deploy and manipulate their new-
found 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 institu-
tional response to cultural pressures for enterprise
and consumer sovereignty that underpinned the gov-
errunent'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. Ana-
lysts' reports on individual water company perfor-
mance, although primarily concerned with finan-
cial performance, have considered performance on
customer service as an important indicator of man-
agerial competence and company success. Analysts
have also incorporated the levels of service perfor-
mance 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., Char-
terhouse Tilney Equity Research, 1993; Warburg
Securities, 1991).
Finally, senior managers have seen commercial
potential in achieving good performance on cus-
tomer service measures that extends beyond the
regulatory sphere of OFWAT. Establishing a repu-
tation as a customer-focused organization, particu-
larly when doing so may be externally validated by
an independent body such as OFWAT, is valued as
a resource in exploiting business opportunities out-
side 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 mar-
keting 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, par-
ticularly in terms of the attention given to custom-
ers' 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 compa-
nies since they remain regional monopolists in re-
gard to the provision of water services.
From the above, it can be argued that the privat-
ization ofthe U.K. water industry provides a poten-
531
tially rich research setting for examining many of
the implications and actual consequences that arise
in the practical application of stakeholder concep-
tions of the firm. Our primary concern here was to
investigate whether any empirical evidence sug-
gested 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 publi-
cations affirming the importance of customer ser-
vice may have simply constituted marketing hype
and/or self-serving rhetoric declaimed by the inter-
ested parties to legitimate their current policies and
practices. What would count as evidence that the
regulator and the water companies w^ere taking im-
provements in customer service seriously would be
(1) evidence that customer service performance (as-
sessed in terms of the published measures) was
improving over time coupled with (2) evidence that
customer service performance was also economi-
cally significant in relation to reported profits and
shareholder w^ealth measures.
Given the possibility that the published customer
service measures might simply reflect the regula-
tor's and the water companies' joint desire to be
seen to be attending to customer interests, a plau-
sible null hypothesis was that results on these mea-
sures 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 al-
ternative hypotheses suggest themselves:
Hypothesis 1. The customer service perfor-
mance ofthe United Kingdom's privatized wa-
ter companies, as measured by published cus-
tomer service levels, will be negatively related
to the companies' contemporaneous reported
profitability.
Hypothesis 2. The customer service perfor-
mance ofthe United Kingdom's privatized wa-
ter companies, as measured by published cus-
tomer service levels, can be expected to have a
positive impact on future profitability and
will therefore be positively related to current-
period shareholder returns.
We tested the first hypothesis to establish
whether or not differences between companies in
terms of the published measures of customer ser-
vice were related to differences in profits. Support-
ive results would indicate that the water companies
were prepared to commit real resources, which
532 Academy of Management Journal
would have otherwise accrued to their sharehold-
ers, 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 com-
panies 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 cus-
tomer service indicators could be expected to be
positively related to current-period relative share-
holder returns.
It is by no means certain that managers' decisions
about expenditures to improve customer service
will inexorably enhance future profitability. Con-
siderable 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 min-
imum standards of customer service. There is reg-
ulatory 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 im-
proved customer service entails considerable ex-
penditure. Moreover, managers may be too ambi-
tious in their plans for customer service, be
inefficient in carrying out those plans, or fail to
secure enough recompense through the ic-factor de-
termined by the director general, all of which
would have adverse consequences for their compa-
nies' 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 there-
fore reward the water companies with high scores
on these measures.
EMPIRICAL MODELING OF THE
RELATIONSHIPS BETWEEN SHAREHOLDER
WEALTH, PROFITS, AND CUSTOMER
SERVICE LEVELS
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 obser-
vations, 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 vari-
ation in the ranking of companies in terms of their
profitability. In addition to these time-invariant.
October
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 perfor-
mance levels on profitability and changes in share-
holder 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 control-
ling for fixed effects.^
Finally, given the combination of price regula-
tion and highly stable operating and cost condi-
tions 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 re-
ducing 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 sig-
nificant 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 influ-
ences on company profits by defining our depen-
^ We also reestimated each of the empirical models
including five dummy variables relating to the time pe-
riod 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' in-
clusion did not result in any improvement in the explan-
atory power of the estimates.
^ All of the shareholder returns models were also re-
estimated with controls for fixed effects included. How-
ever, as expected, the fixed effects models did not result
in any statistically significant improvement in the ex-
planatory power of the estimates.
1999 Ogden and Watson
dent variable in terms of the relative profits avail-
able for distribution to sbareholders (that is,
posttax profits or, in U.S. accounting terminology,
net income). To obtain an accounting-based mea-
sure of the return to shareholders, we needed to
control for differences in the sizes of the compa-
nies' 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 differ-
ences 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 bench-
mark, did not include any customer service vari-
ables. Models 2 and 3 both included customer ser-
vice measures. Model 2 included five customer
service variables, which consisted of the standard-
ized 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 ser-
vice variables were of equal sign and magnitude.
Shareholder Returns Model
As for the relative profits models, for the share-
holder returns model we isolated the common ex-
ternal influences upon shareholder returns from
the firm-specific factors in each period. Our depen-
dent 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.
533
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 infor-
mation (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 infor-
mation 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 cus-
tomer service performance measures between late
November and early December of each year. To test
Hypothesis 2, we measured returns over two differ-
ent 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 infor-
mation'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 mea-
sured 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 asso-
ciated with improvements in customer service lev-
els, we expressed three of them (complaints to
OFWAT, inadequate water pressure, and supply
interruptions) as 100 percent minus the reported
534 Academy ofManagement Journal
TABLE 2
Estimation of Relative Profits Function 1991-92 to 1996-97"
Independent Variable Model 1
Book value of capital employed,-,'' -0.013 (1.39)
(Debt/equity),-, 0.012 (2.58)**
F for constant and firm-level fixed effects 15.570**
Complaints to OFWAT,,
Inadequate water pressure,-,'^
Supply interruptions,-,"
Responses to billing queries,/
Responses to written complaints,-,'^
Customer service,-,"
F for new variables
Adjusted R^ 72.00
Equation F 14.79**
" The dependent variable was calculated as (profits/equity)^, - (sector-average profits/equity],. N = 60. White's (1980) heteroskedasticity-
adjusted (-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 re-
sponses to billing queries and to written com-
plaints were expressed as integer values on a five-
point scale. In order to aggregate the five indicator
variables, we thus transformed each variable into
an annual standardized value.
These standardized relative measures of cus-
tomer 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 ser-
vice performance, the regulator had to have con-
structed a similar composite measure.^ We entered
^ The individual standardized customer service vari-
ables were also entered into the shareholder returns mod-
els. However, none of the individual variables were of
any statistical significance and, consequently, these re-
sults 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-
October
Model 2 Model 3
-0.010 (1.39) -0.012 (1.41)
0.011 (2.88)** 0.012 (2.68)**
18.180** 17.520**
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)**
4.06** 6.26**
78.80 74.80
14.68** 15.57**
our composite measure into the relative profits
(model 3] and shareholder returns models. A sta-
tistically significant, negative coefficient on this
variable in the profits model would imply that per-
forming on customer service was costly in terms of
current reported profitability, as stated by Hypoth-
esis 1. However, although such an effect was ex-
pected to depress profits, the costs associated with
improvements in customer service are costs that
the regulator may allow to be passed on to custom-
ers. Hence, as stated by Hypothesis 2, a statistically
positive coefficient on this variable was to be ex-
pected when it was entered into the (announce-
ment month and annual) shareholder returns mod-
els, since thus passing costs on implies higher
future profits, which is good news to shareholders.
RESULTS
Table 2 presents our estimates relating to Hy-
pothesis 1. As stated above, we made three alterna-
tive 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 propor-
tion 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.
1999
TABLE 3
Relative Shareholder Returns Functions 1991-92 to 1996-97'
Earnings
Independent Announcement Month
Variable Returns
(Profit/equity),-, 0.125 (0.28)
Customer service,-.
Constant 0.014 (1.93)'*'
Adjusted R^ -1.6
Equation F 0.09
" 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 sig-
nificant at the 1 percent confidence level.
Model 2 includes the five individual standard-
ized customer service variables (complaints to
OFWAT, inadequate water pressure, supply inter-
ruptions, and responses to billing queries and writ-
ten 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 con-
strains all five variables to have the same slope
coefficients. Despite this restriction, model 3 ap-
pears to be well specified: the composite variable is
negative and statistically significant at a 1 percent
level of confidence, though there is a slight de-
crease 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 con-
sequences of customer service increases for current
reported profits, managers are prepared to expend
resources to improve such service. We now con-
sider 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 Hypoth-
esis 2, which predicts that the customer service
measures will be positively related to current-
Ogden and Watson 535
Customer Service
Announcement Month Annual
Returns Returns
0.121 (0.16)
2.611E-3 (2.29)* 10.045E-3 (2.46)*
-0.069E-3 (0.02) 0.288E-3 (0.03)
6.3 7.5
4.96* 3.40*
period shareholder returns. We made this predic-
tion because some or all of the costs associated with
improvements in customer service can likely be
subsequently passed on to customers, thus increas-
ing future profits and current value.
Though in both the annual returns and announce-
ment 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 al-
tered the existing perceptions of investors regard-
ing 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 location-
specific cost structures of individual firms, and the
limited scope for increasing sales of their price-
regulated product. In an informationally efficient
market, share prices should already reflect any an-
ticipated 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 dif-
ferent time horizons for the measurement of the depen-
dent variable. These additional estimates did not, how-
ever, produce significantly different results from those
presented here.
536 Academy of Management Journal
price reaction should occur at the time of its re-
lease.
The situation in regard to the customer service
performance measures is, however, somewhat dif-
ferent. Table 2 shows that the estimated positive
coefficient on the customer service variables, for
both the announcement and annual returns ver-
sions of the model, is statistically significant at
better than 5 percent confidence levels. This pat-
tern appears to indicate that our composite cus-
tomer service variable is of some statistical impor-
tance in explaining both relative annual share-
holder 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. Al-
though this positive relationship between relative
shareholder returns and relative performance in
terms of customer service measures is not particu-
larly 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
The empirical results presented in this article pro-
vide statistical evidence indicating that it is possible,
to some extent, to align the apparently conflicting
concerns of different stakeholder groups. Our find-
ings 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 privat-
ized 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
October
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 execu-
tives. 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 Monopo-
lies and Mergers Commission over the OFWAT di-
rector general's determination of its efficiency tar-
get (that is, its ic-factor) following its 1994 periodic
review. The outcome of this appeal for the com-
pany 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 im-
portance Jones (1995) attached more generally to
trust in developing an instrumental theory of stake-
holder management. He argued that "trusting and
cooperative relationships help solve problems re-
lated to opportunism" (Jones, 1995: 432) and that
because "the costs of opportunism and of prevent-
ing 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 ex-
planation for altruistic firm behaviors, but also a
basis for an instrumental theory of stakeholder
management.
Our discussion of the respective roles of manag-
ers and regulator in balancing competing stake-
holder 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 the-
ory. 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 oppor-
tunistically at their expense. Donaldson and Pres-
ton argued instead for a normative basis for stake-
holder theory, which, they suggested, resides in
1999 Ogden and Watson
managers' recognition that all stakeholders' inter-
ests have intrinsic value. The ultimate managerial
implication of stakeholder theory is that, rather
than treat stakeholders' interests instrumentally,
managers "should acknowledge the validity of di-
verse 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 in-
dicates, however, that such a hasis for managerial
behavior is still far from heing realized. It could be
expected, given the essential nature of their prod-
uct, 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 en-
suring that customer interests are adequately at-
tended to is located with the regulator. Moreover,
the incentives and sanctions at its disposal are de-
signed to operate on the assumption that managers
will act instrumentally.
One limitation of our study is that it was re-
stricted to one industry. Moreover, given the
changes occasioned by that industry's recent pri-
vatization, the small number of companies operat-
ing 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 em-
pirical 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 stake-
holder theory. The first of these is reiteration of the
importance of the abilities to define stakeholders'
interests and to measure and monitor those inter-
ests. The second is to emphasize the need for the
measurement and monitoring of companies' perfor-
mance in regard to stakeholders' interests to be
transparent. Such transparency would facilitate in-
dependent 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 seri-
ous account of stakeholder interests may welcome
such evaluation, because it would provide an op-
537
portunity to demonstrate the validity of their
claims about serving stakeholders.
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Stuart Ogden is a professor of accounting and organiza-
tional analysis at the University of Leeds. He received his
M. A. in industrial relations at the University of Warwick.
His current research interests are privatization and pro-
cesses of organizational change, corporate governance
and executive compensation, and management compe-
tences.
Robert Watson is a professor of finance and accounting at
the University of Strathclyde. He received his Ph.D. in
finance at the University of Manchester. His current re-
search interests are corporate governance and executive
compensation, managerial labor markets, and financial
statement analysis.