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| Urban water is typically provided by a monopoly supplier. An unregulated monopoly supplier of urban water would have an incentive to increase prices to excessive levels, resulting in an inefficient allocation of water. In Australia, urban water is typically supplied by government owned and/or operated organisations, subject to independent regulation including price control. In this report it is assumed that the combination of government ownership and regulation effectively ensures monopoly water utilities act in the public interest. Competition in the provision of urban water is not considered in this report. For a discussion of the potential for competition in urban water provision, see Productivity Commission (2008). In pursuing the public interest, the urban water utility seeks to maximise the net benefits of water use in the long run, subject to water availability constraints. In achieving this objective, the water utility has two main policy tools: demand management and supply augmentation. Demand management is a term used to encompass a range of polices designed to restrict or reduce water use in times of scarcity. Given the regulatory control over urban water prices, water utilities rely on a range of alternative policies to ration demand. These policies can include water restrictions, awareness 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. In this report the focus is specifically on infrastructure that generates additional water inflows and storage capacity such as new dams or desalination plants. |
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| Demand management | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| It is useful to consider demand management policy over short and long-run time frames. In the short run, when supply infrastructure is fixed, the water utilities’ primary response to low inflow (drought) conditions is to limit water use through demand management measures (for example, water restrictions). Such short-term rationing of demand may be optimal in an intertemporal context — that is, if we use less water today we will have more water for future periods. In the long run, supply infrastructure can be altered and demand management policy and supply augmentation policy are simultaneously determined. This involves a trade-off between the consumer benefits associated with non-essential water consumption and the costs of supply augmentation. In Australia, urban water utilities accept that ‘gold plating’ supply infrastructure (so that all demand for urban water can be met at all times) would be unnecessarily costly. The optimal long-run demand management policy (for example, the long-run mean frequency of restrictions or the mean price level) will maintain the ideal balance between the benefits of non-essential water consumption and the costs of supply augmentation. |
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| Water restrictions | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Water restrictions are currently the main mode of short-run demand management employed by Australian water utilities. Water restrictions involve rules that regulate the outdoor use of urban water. Water restrictions do not impose pure quantity-based limits on water consumption; rather they involve a combination of complete bans on certain water uses and limitations on others. The less severe stages of water restrictions rely largely on the imposition of inconvenience costs to discourage consumption. For example, restrictions may involve limits on the hours of the day or days of the month in which watering can occur and/or bans on the use of sprinkler systems. Some households may be willing to work around these restrictions, while for others the inconvenience of having to hand water at irregular hours will present a major barrier to outside water use* . In economic terms, these types of restrictions can be represented as a transaction cost imposed on consumers. From an economic welfare perspective, a scarcity price yielding the same reduction in consumption would be preferable, as it would involve a transfer of rent to the utility/government rather than imposing irrecoverable time and inconvenience costs. A scarcity price would, however, result in some distributional changes. For example, it would tend to benefit consumers who valued their time more highly. Water restrictions in their more severe forms involve complete bans on outdoor water uses. Where the willingness to pay for water varies across individuals, prescriptive rationing will result in an inefficient allocation of resources where water is not necessarily directed to its most valued uses. In contrast, price-based rationing ensures that water use is directed to its highest value uses and that the marginal value of water use is equalised across households and across different water uses within households. Water restrictions further distort market outcomes by targeting different water uses to varying degrees while providing implicit and explicit exemptions for other uses. This effectively imposes arbitrary judgments on the social desirability of certain water uses which override private valuations (Edwards 2006). For example, water restrictions are limited to outdoor residential water use (for reasons of enforcement) and do not directly limit indoor residential water use and industrial water use. In addition to the transaction costs and the allocative efficiency costs, water restrictions involve substantial implementation costs, such as the costs of advertising and enforcement. Quantifying the various costs associated with water restrictions is a complex task and one which is not attempted in this report. A number of studies have been undertaken to estimate the costs of restrictions using varying techniques, including Hensher et al. (2006), Brennan et al. (2007) and Grafton and Ward (2007). |
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| Other demand management measures | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Water utilities also employ a range of other non-price-based polices aimed at reducing the long-term consumption of urban water, including advertising campaigns and subsidies for water saving equipment. Advertising campaigns typically involve advertising across various mediums promoting water conservation and providing advice on how to improve water use efficiency. Such campaigns can be costly while their actual impact on water consumption is difficult to measure. Government subsidies are also commonly offered for a range of water-saving products, including residential rainwater tanks. One of the problems with government subsidies for water-saving devices is that they may induce over-investment in products which are of little benefit in some cases. For example, most states in Australia offer broad subsidies for rainwater tanks; however, the relative effectiveness of rainwater tanks varies significantly across regions and across households within regions. Ideally, water conservation efforts and investments in water use efficiency should be motivated by water prices which accurately reflect scarcity. Under these conditions, subsides or publicly funded advertising campaigns would not be required. |
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| Current pricing regime | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| In Australia urban water pricing is regulated by state and territory government agencies. These agencies make price determinations specifying water charges over three to five year time frames. In the absence of scarcity or capacity constraints, an efficient allocation of water can be achieved with a price set to the short-run marginal cost (SRMC) of supply. Here the SRMC refers exclusively to the direct marginal costs associated with transferring water from storages to households for consumption, such as the costs of water pumping and treatment. In the presence of demand growth, scarcity and capacity constraints become inevitable in the long run. Australian water utility price regulators generally advocate some form of long-run marginal cost (LRMC) pricing. For more details on the various definitions and methods of estimating LRMC see Sibley (2006) or Productivity Commission (2008). A fixed LRMC price does not explicitly consider the variability of dam inflows and the potential for short-run fluctuations in storage levels. As a result, a fixed LRMC price will typically be too low during a drought (necessitating the implementation of restrictions) and too high when storages are full. Australian water utilities generally impose a two-part tariff involving a marginal (consumption based) price and a residual fixed access charge designed to achieve cost recovery. For example, in the ACT in 2007–08 a fixed annual supply charge of $75 applied for each parcel of land. In this paper we focus the marginal price of water rather than the average price. The impact of different price and investment polices on revenue and cost recovery is not considered in detail in this paper. In the ACT, as in most capital cities, an inclining block pricing scheme applies to urban water consumption. In 2007–08 a three-block pricing structure applied, involving a price of $0.75 a kilolitre for the first 100 kilolitres, $1.67 between 100 and 300 kilolitres and $2.57 for consumption over 300 kilolitres. Inclining block pricing schemes are economically inefficient relative to a single uniform price (Edwards 2006; Brennan 2006). |
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| Scarcity pricing | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| The scarcity price is the price which represents the full opportunity cost of urban water: the SRMC plus the opportunity cost of forgone storage. Water in storage has an opportunity cost since a reduction in storage levels can result in a reduction in the expected reliability of future supply and a bringing forward of expected future supply augmentation. This price will be state-dependent, meaning it will vary depending on the prevailing conditions. For example, a scarcity price would vary inversely with storage levels. Put simply, when water is scarce the price of water is higher; as water storages fill (water becomes less scarce), price falls. A scarcity pricing system represents an alternative approach to demand management policy, which could potentially avoid many of the efficiency costs associated with water restrictions. The adoption of scarcity pricing of urban water is sometimes opposed on the grounds of equity. However, equity concerns can be adequately addressed through any number of policy measures. For example, this could involve targeted subsidies to low-income households. Additionally, a two-block price scheme could be adopted to ensure essential water is provided at all times at an affordable cost to all households. Under a two-block price scheme a low (or zero) constant price would apply to the first block of consumption to cover essential water needs, while a variable scarcity price would apply to consumption above this level. A two-block price scheme would involve some loss of efficiency, but it would represent a substantial improvement over a three-block system (such as that imposed in the ACT) (Edwards 2006). Ideally, the threshold between the two pricing blocks would ensure all non-essential water demand would be exposed to the scarcity price. In practice, setting the threshold point would involve a trade-off between equity and efficiency objectives. Efficiency costs could be minimised further if the threshold took into account differences across households such as the number of occupants per dwelling. It is also worth noting urban water charges represent a relatively small proportion of household expenditure. ABS (2006) statistics show water and sewerage charges represent only 0.7 per cent of average weekly household expenditure in Australia, and the Organisation for Economic Cooperation and Development (1999) has demonstrated that Australia has relatively affordable water charges in comparison with other OECD countries. Finally, as noted by the Productivity Commission (2008), water restrictions are not devoid of their own equity concerns. An alternative to scarcity pricing of urban water would be a system of tradable water entitlements. However, such a system would be subject to substantial administration costs and transaction costs. This approach is not considered in this report. |
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| Practical considerations | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| A number of important practical considerations need to be considered before a scarcity-based pricing system could be implemented. Firstly, a scarcity pricing system would require a relaxation of current water price regulation. Regulators could, however, continue to monitor total water utility revenue and profits in order to avoid misuse of monopoly power. Ideally, a regulator would influence the setting of the annual access charge or the price applying to the initial consumption block while allowing the scarcity price to be set appropriately by the water utility. The regulator may, for example, reduce annual access charges to offset the impact of increases in variable charges. Scarcity pricing could potentially be implemented using a system of stages similar to that used for water restrictions (see table 1). A number of price stages could be defined, each corresponding to a different level of scarcity. As with restrictions, each stage would aim to achieve a specific reduction in water consumption and have an associated trigger point. The water utility could simply replace each stage of restrictions with a scarcity price, based on its estimate of what price will achieve an equivalent reduction in consumption. In reality, the water utility may not have full information on the exact distribution of future inflows, the long-run growth rate of demand and the price elasticity of the demand for water. This means setting optimal prices would not be a simple task. It is important to realise, however, that this information problem is not necessarily more burdensome than that faced under a system of water restrictions. Water utilities require much the same information to optimally set water restriction quantity targets and storage trigger levels. Further, the use of scarcity pricing may over time reveal more information, particularly on consumers’ willingness to pay. One way to approach the problem of setting prices is to recast it in terms of optimal quantities. Water utilities are quite experienced in determining the optimal quantity of water consumption given available information on demand and supply. Determining a price that achieves this quantity is not necessarily a more difficult problem than developing a list of restrictions that achieves the same result. One of the additional advantages of scarcity pricing is that there is more flexibility regarding the number of scarcity stages chosen. With water restrictions, defining distinct stages of varying severity is difficult given that each stage involves numerous rules referring to different water use activities. The adoption of a scarcity pricing system would not increase the risk faced by urban water consumers; it would merely replace existing restriction risk with price risk. With scarcity pricing, it would become necessary to accurately measure household water consumption occurring within each billing period, which is currently quarterly. Actew has noted (personal communication, David Graham, 15 May 2007) it is currently not possible to read all meters on the same day, so meter reading cannot occur on the last day of the billing cycle for each household. One way to overcome this problem would be to invest in new smart metering technology. The ACT Government recently endorsed a pilot smart metering project (Actew 2007). Any scarcity pricing system would also require all households to be made aware of any changes in price as they occur. This may require some form of advertising, as with water restrictions at present. Scarcity pricing may not be practical in an extreme water scarcity situation, where it may be necessary to reduce water consumption to essential levels. Particularly where a two-block pricing scheme is adopted, it may simply not be possible to limit all non-essential water consumption for all users. It may be necessary in such an emergency situation to revert to prescriptive restrictions. It may therefore be advisable to retain water restrictions in some form as a backup option, to be used only in worst case situations. |
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| Supply augmentation | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| This report focuses specifically on the timing of supply augmentation investment under climate variability and not on making comparisons between specific supply projects. Decisions between alternative supply augmentation projects should be guided by comprehensive cost–benefit analyses that take into account financial, social and environmental considerations. Investment in urban water supply infrastructure is often described as ‘lumpy’, in that it involves large, infrequent additions to capacity rather than incremental growth. The optimal timing of supply augmentation projects involves a comparison of the expected net benefits of investing now with the expected net benefits of delaying investment. Such decisions are complicated by the substantial variability in the demand for water and, more importantly, in rainfall and inflows. Demand management policy and supply augmentation policy are interdependent: a supply augmentation project generating additional inflows will improve the reliability of supply, allowing urban water utilities to reduce the long-run mean frequency of restrictions (or the mean water price). Supply augmentation will also result in a reduction in the probability of a shortfall of essential water. Urban water utilities typically maintain supply infrastructure so as to ensure that the probability of such a system failure is near zero. The timing of supply augmentation involves trading off the benefits of supply reliability with the costs of augmentation: investing earlier will improve reliability but increase augmentation costs in present value terms. Industry practice has historically involved the targeting of an ‘acceptable level’ of reliability, measured as the expected time households are subject to restrictions. In the past, water utilities have made relatively arbitrary judgments on this acceptable level of restrictions and have placed little emphasis on consumers’ preferences (Hensher, Shore and Train 2006)* . One of the reasons for this is the benefits of increased water supply reliability depend on the community’s willingness to pay. Estimating this willingness to pay is difficult without a price mechanism that reflects scarcity. Scarcity pricing may assist water utilities to make supply augmentation decisions, as it 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. |
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| Environmental flows | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| An additional aspect of urban water policy not considered in detail in this report is that of environmental flows. Environmental flows are releases from storages back into streams with the aim of maintaining the ecology of the local river systems. The ACT government (2006) maintains guidelines outlining specific minimum environmental flow requirements from each ACT water storage. Provisions are made that permit the reduction of environmental flows during droughts when urban water supplies are threatened. There is a clear trade-off between releasing water to meet environmental objectives and maintaining storage levels to secure urban water supply. In times of drought, water has a substantial scarcity value which may exceed the benefits of environmental flows. Environmental flows in rural water systems have been the subject of previous ABARE research (Beare et al. 2006; Heaney and Hafi 2005). |
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