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| This chapter contains a brief description an economic model of urban water supply and demand. A more detailed discussion of the model is contained in appendix A. The model is a single region model of the water market in an urban centre. The model is a stochastic dynamic programming model, which estimates the optimal pricing and investment policies of the water utility. The model is based on the ACT region and incorporates data on the demand and supply of urban water in the region, provided by the Actew Corporation. An attempt has been made to incorporate a degree of realism into the model. However, a number of simplifying assumptions are made, particularly on the supply side of the model, in order to keep the level of hydrological and engineering detail to a minimum. The model is not designed to forecast or estimate the likely impacts of a change in urban water policy in the ACT. For example, the model is not designed to compare social welfare under a system of restrictions with that under a system of scarcity pricing. Rather, the model has been constructed to demonstrate a number of general economic concepts related to urban water pricing and investment decisions in the presence of climate variability. Figure d summarises the main features of the model. The model estimates the price and investment policy rules that maximise the expected discounted value of economic welfare over a predetermined time horizon. In this instance, economic welfare refers primarily to the expected discounted sum of consumer surplus from non-essential water consumption less the costs of supply augmentation, less penalties imposed for any inability to meet essential demand. The model comprises two main components, one specifying the evolution of water demand and the other specifying water supply. The demand component involves an aggregate urban water consumption function which accounts for long-term growth of demand, seasonal variation, response to stochastic climate variability and response to price changes. The seasonal variation of demand and the response of demand to climate variability are estimated econometrically. Inflows were used as a proxy for prevailing weather conditions (such as rainfall and temperature), as this allows the model to have a single source of risk. Demand is separated into a non-essential or price-responsive portion and an essential portion unresponsive to price. A constant elasticity relationship is assumed to exist between urban water demand and price, set to a value of –0.45 based on a search of the literature. The supply component of the model assumes a single water storage with stochastic seasonal inflows. A single storage model can be interpreted as an approximation of a multiple reservoir system. Seasonal inflow probability distributions were estimated using historical ACT data. The supply side of the model also accounts for evaporation from storages and environmental flow. |
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 Source: Actew, personal communication, 2006. |
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| The supply side of the model also accounts for the impact of supply augmentation on total water storage capacity and inflow levels. The model allows for two forms of supply augmentation: rain-dependent (representative of new dams) and rain independent (representative of desalination or recycling). Rain-dependent augmentation is modelled as providing additional storage capacity and additional stochastic inflows. Rain-independent augmentation is modelled as providing additional certain inflows but no additional storage capacity. Finally it is assumed that the SRMC of water supply is constant over time and is independent of the level of water consumption and the level of supply augmentation. An arbitrary value of $1 per kilolitre (kL) is assumed for the SRMC. |
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