| Summary |
 Recent drought conditions across Australia have significantly depleted water storages in most urban centres. While the recent drought has been abnormally severe, current urban water shortages are indicative of a broader long-term trend of increasing urban water scarcity in Australia. This trend has been driven by a gradual long-term decline in mean inflows into storage, increasing demand because of population growth and minimal additions to supply capacity.
Prior to the recent spate of supply augmentation activity, urban water scarcity was dealt with primarily through demand management measures, including the imposition of water restrictions.
Supply augmentation, in response to long-run demand growth, has traditionally involved the periodic construction of new dams. However, concern over environmental impacts, a lack of suitable sites and potential climate change effects, have forced water utilities to consider alternative supply options such as desalination and recycling. These new supply options provide a more reliable supply of water but involve substantially higher capital and operating costs. |
| Urban water policy |
Urban water utilities have two main policy instruments at their disposal: demand management policy and supply augmentation policy. Demand management policy includes the use of water restrictions and pricing as well as advertising campaigns and incentives for improvements in water use efficiency. Supply augmentation policy is concerned with the nature and timing of additions to water supply infrastructure.
Urban water policy can be considered to have both short and long-run contexts. In the short run, when supply infrastructure is fixed, the water utility must rely on demand management policies such as water restrictions to ration available water in the event of any scarcity (as may arise under drought conditions). In the long run, water utilities can influence the supply of water by undertaking supply augmentation. The optimal long run demand management policy (for example, the long-run mean frequency of restrictions or mean price level) will need to maintain the optimal balance between the benefits of water consumption and the costs of supply augmentation. |
| A potential role for scarcity pricing |
Water restrictions involve complex rules that govern the use of outdoor water by urban households. Water restrictions are a relatively inefficient method of demand management, as they impose inconvenience costs, generate allocative efficiency losses and require substantial enforcement effort.
Currently in Australia, urban water prices are set by regulators. Current practice involves setting urban water prices to match estimates of long-run marginal cost (LRMC). A fixed LRMC price does not respond to changes in scarcity levels and will be lower than optimal when storage levels are low, necessitating a rationing of demand through alternative measures such as water restrictions.
In this report, scarcity pricing is proposed as an alternative to water restrictions. A scarcity price system would involve adopting a variable price that responds to changes in water scarcity where, for example, the price varies inversely with storage levels. In July the National Water Commission (2008) released a position statement recommending that scarcity pricing receive further consideration as an alternative approach to urban water demand management.
Scarcity pricing is a potentiality more efficient demand management tool than water restrictions. With any scarcity pricing system it would be necessary to ensure that any equity considerations were adequately addressed, such as the need to ensure essential water supply remains affordable for all households. One way to achieve this could be to adopt a two-block price scheme, where a low (or zero) constant price would apply to the first block of consumption and a variable scarcity price would apply to consumption above this level.
Scarcity pricing could also assist in supply augmentation decisions. Historically, urban water utilities have made relatively arbitrary judgments on the timing of supply augmentation, often involving the targeting of an ‘acceptable level’ of reliability as measured by the expected duration of water restrictions. Scarcity pricing would provide a more accurate measure of society’s willingness to pay for urban water, which could be directly compared with the costs of supply augmentation. |
| Issues in implementing scarcity pricing |
There are a number of practical considerations associated with adopting a scarcity pricing system that would need to be addressed. For example, there would be a need to maintain some form of regulatory effort to prevent abuse of monopoly power by urban water utilities. There may also be a need to improve current water metering practices and technologies.
Urban water utilities may also face an information problem when administratively setting prices. For example, utilities have incomplete information on the distribution of future inflows and the community’s willingness to pay for urban water. However, this information problem is not necessarily more burdensome than that faced under a system of water restrictions. Further, the use of scarcity pricing may, over time, reveal more information, particularly on consumers’ willingness to pay.
One approach to setting scarcity prices would be to adopt a system of price stages similar to that used for water restrictions. A number of price stages could be defined, with each stage aiming to achieve a specific reduction in water consumption and having an associated trigger point. |
| Modelling urban water policy under climate variability |
One of the main difficulties in designing urban water policy, particularly in Australia, is the extreme variability of rainfall and dam inflows. This report considers the design of optimal demand management and supply augmentation policies under climate variability, by constructing and applying a stochastic dynamic model of an urban water market. This model is used to demonstrate how a scarcity pricing system would operate and to evaluate the basic factors governing the optimal timing of supply augmentation investment.
A stochastic dynamic programming model of an urban water market was constructed using data on urban water supply and demand in the Australian Capital Territory. The model estimates optimal price and investment policy functions, given a theoretical probability distribution over future dam inflows.
The model results demonstrate how a scarcity pricing system would operate, with the optimal price inversely related to storage levels, increasing in time with demand growth and decreasing with the introduction of supply augmentation. The model was also used to demonstrate how a scarcity pricing system could be implemented under a system of price stages similar to the current system of water restrictions.
The nature of optimal investment policy, involving the execution of investments once storage levels decline below specific storage trigger points, was also examined. Substantial differences were observed between the estimated optimal investment rules of rain-dependent and rain-independent augmentation options. The higher costs and the certain inflows associated with rain-independent augmentation may mean that water utilities are likely to adopt an opportunistic approach: where investment is delayed until substantial decline in storage levels occurs. |
| Conclusions |
Urban water restrictions impose significant costs on consumers in the form of allocative efficiency costs and inconvenience costs. Scarcity pricing is an alternative to water restrictions which could potentially avoid many of the costs of water restrictions. This report provides a detailed qualitative discussion of the various benefits and costs of adopting scarcity pricing.
The main focus of this report has been to consider how a scarcity pricing system could potentially operate. This has involved economic modelling to demonstrate how an urban water scarcity price would typically vary, given a specific set of assumptions, over time and in response to changes in storage levels. This also involved considering a range of practical implementation issues, including the possibility that scarcity pricing could be implemented using a system of stages similar to that used for water restrictions.
Continual demand growth, increasing supply augmentation costs and potential climate change impacts are driving a long-term trend toward increased urban water scarcity in Australia. Given this reality, policy-makers should be considering ways to improve the efficiency of demand management and supply augmentation policies. Scarcity pricing is one approach that warrants further consideration. |
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