Review of Industrial Organization 15: 25–42, 1999.
© 1999 Kluwer Academic Publishers. Printed in the Netherlands.
Increasingly Marginal Utilities: Diversiﬁcation and
Free Cash Flow in Newly Privatized UK Utilities
Department of Economics, University of Leicester, Leicester, LEI 7RH, UK
Abstract. This article was the experience of the newly privatized UK utilities as a unique natural
experiment to explore aspects of the life cycle/free cash-ﬂow hypothesis of Dennis Mueller and
Michael Jensen. It demonstrates that in their immediate post-privatization, regulated environment
the UK utilities experienced severe attenuation of all the principal forms of corporate governance,
while remaining substantial cash generators but with limited scope for core business growth. It
shows that the ﬁrms responded with a rapid – and apparently unsuccessful – expansion of non-
core activities. The article then uses a two-way random effects panel design and ﬁnds substantial and
robust support for the maintained hypothesis that (lagged) cash-ﬂow drove diversiﬁcation. The results
also generate clear implications for privatization policy. In particular, they suggest that the incentive
beneﬁts anticipated from substituting private for government ownership may become distorted if the
managements of newly privatized enterprises are sheltered from the regular disciplines of corporate
Key Words: Diversiﬁcation, free cash-ﬂow, privatized utilities, regulated utilities
JEL Citation Index: D23, G32, L22
The water industry, writing off £1.2 billion of its ini-
tial investment outside the industry, while its prices
rise and executive salaries balloon, is merely the
most noxious example of a general trend.
Will Hutton (1995, p. 7)
Many helpful comments on earlier versions of this article were received from Alfred
Kleinknecht, editor of the Review of Industrial Organization and two anonymous referees, Steve
Diacon, Norman Gemmell, Rick Harper, Catherine Waddams, Mike Wright and participants at the
EARIE Conference, Vienna, Austria, September 1996, and at workshops in the Departments of
Economics and Management, University of Nottingham. The assistance of Nick Clay, Ann Lavin,
Sandra Mienczakowski and the library staff at OFFER and OFFWAT in the preparation of this article,
and ﬁnancial support from the Leverhulme Trust, is acknowledged with gratitude.