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| In Australia the predominant approach to demand management in urban water is the imposition of water restrictions. Water restrictions are a relatively limited and inefficient method of rationing demand, imposing inconvenience costs and allocative efficiency costs and also involving significant enforcement costs. In this report scarcity pricing is proposed as a potentially more efficient demand management tool. Scarcity pricing would involve the water utility adopting a variable price that responded to changes in the level of water scarcity, where for example price would vary inversely with the storage level: when storage levels were lower, prices would be higher. Scarcity pricing could be implemented under a two-block price scheme that ensured essential water consumption remained affordable at all times. Scarcity pricing may also 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. A number of practical considerations associated with adopting a scarcity pricing system 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. There may also be a need to improve current water metering practices and technologies. One way to implement scarcity pricing could be to adopt a system of stages similar to that used for water restrictions. A number of price stages could be defined, each corresponding to a different level of scarcity and each aiming to achieve a specific reduction in water consumption and having an associated trigger point. A stochastic dynamic optimisation model of an urban water market was constructed using data on urban water supply and demand in the ACT. The model estimates optimal price and investment policy functions, given a theoretical probability distribution over future dam inflows. The model results demonstrated 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 model results illustrated that a staged price system would result in a minimal loss of efficiency relative to a more flexible price system. 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 optimal investment rules of rain-dependent and rain-independent augmentation options. The higher costs and the certain inflows associated with rain-independent augmentation mean water utilities are more likely to adopt an opportunistic approach: where investment is delayed until substantial decline in storage levels occurs. 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. Urban water utilities will have to rely on more stringent demand management, such as more frequent imposition of restrictions or higher prices, and/or substantial investment in costly rain-independent supply options. 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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