An analysis of the cost structure of water supply in Sri Lanka

September 22nd, 2012

Dr. Dinusha Dharmaratna & Dr. Jaai Parasnis, Monash University, Australia

Sri Lanka presents an interesting and representative case study for analysing the structure of water supply in Asia. Water supply in developing countries, particularly the Asian countries, exhibits the following common characteristics:

1. These countries typically do not experience physical scarcity of water due to a combination of adequate annual rainfall and extensive river systems. However, high demand and unsustainably managed supply lead to water shortages. Sri Lanka receives average annual rainfall of 1850mm, however the supply of safe drinking water is inadequate, especially in the rural areas. Currently, only 14 per cent of the rural population in Sri Lanka have access to pipe-borne water.*

2.This gap between demand and supply continues to worsen as countries face growing demand for piped water through increasing population, rapid urbanisation, and increasing capacity constraints on the supply side.

3. The institutional setup in these countries consists of a public utility with monopoly over water supply (National Water Supply and Drainage Board (NWSDB) in case of Sri Lanka). The pricing policy is aimed at the recovery of operational costs. Despite this aim, revenues collected by the NWSDB account for only a portion of the utility’s total costs, the average contribution of water user charges is approximately 32 per cent.1,2

4. Introduction and review of tariffs (i.e. the prices assigned by the water utility for the supply of a volume of water) is a contentious issue. As access to water is traditionally considered a right, there is a need to balance competing demands, and the inherent efficiency-equity trade-off. Sri Lanka introduced tariffs only in 1982 and tariff adjustments are hard to implement due to the highly politicised nature of the process.3 The current pricing regimes in the developing Asian countries typically consist of a generous first block of consumption at a very low tariff. Tariffs need to be affordable to enable poorer households to access safe water supply. On the other hand, there is a need for tariffs to reflect the actual cost of sustainable supply and to act as a tool of demand management. It is also imperative to ensure the financial viability of the water supply bodies and to generate new investment to extend the water supply to rural areas.

Understanding the cost structure of water supply is the first step towards analysing and devising appropriate pricing and subsidy regimes for water utilities in developing countries. In this article we summarize a paper that comprehensively investigates the cost structure of pipe-borne water supply in Sri Lanka using the production theory approach.4 Specifically, in our paper we estimate the marginal cost of pipe-borne water supply in the short run and the long run.4 Estimation of the marginal cost (i.e. the cost of supplying an extra unit of water – this is the additional cost that needs to be incurred if an additional unit of water is produced) is important for benchmarking the pricing decision since water resources can then be managed efficiently by using cost-reflective pricing.5,6 If the costs of additional water delivery are not financed through higher revenues then utilities will not be economically sustainable.

We then estimate the relationship between the inputs used in water supply, thus quantifying the effect of changes in prices on the demand for inputs as well on the cost of production. We also investigate the existence of economies of scale (i.e. declining average costs associated with increasing production – in the presence of economies of scale the unit cost of producing water units will decrease with increasing water units produced) to understand the underlying market structure and to determine the optimal levels of investment and production. We specify a cost function in a systematic and theoretically consistent framework and differentiate between the long run and the short run to account for the nature of capital investment in this sector.4 The capacity expansion activities such as building dams and expanding dam capacities are considered to occur in the long run while dam capacities are considered to be fixed in the short run.

The results of our paper confirm the hypothesis that water is under-priced under the current pricing regime.4 The estimated marginal cost of water supply is SLRS 16.50 per cubic metre in the short run and rises to SLRS 47.25 in the long run. The substantially higher long run marginal cost reflects the importance of capital costs to the utility. The short run estimate represents only expenditures on variable inputs, while the long run cost also includes expenditure on capacity expansion.7 Our estimates of marginal cost reflect the operational and financial costs but should be treated as a lower bound of the ‘real’ costs which should also include marginal social or user costs, such as the opportunity costs of inputs used in water production. 4

All estimates of marginal cost are substantially higher than current average volumetric charges for water in Sri Lanka, supporting the generally accepted belief that water is under-priced. If the current charges are not increased to reflect the marginal cost, policymakers have to find alternative means of ensuring the financial viability of the water supplier and funding the required infrastructure to extend the supply in rural areas. Under-pricing of water can also pose problems from the demand side, leading to excess demand and wastage of this valuable resource.

We find existence of significant economies of scale in supply of pipe-born water, reflecting the technology and organisational structure of the public monopoly supplier. This indicates that there is a scope for accelerating investment and increasing production in this sector. Under correct institutional and financial structures it would therefore be possible to extend the supply of pipe-borne water in Sri Lanka.

The elasticities of substitution in inputs (i.e. the rate at which one input can be substituted for another to produce the same quantity of water) establish two interesting relationships: negative own price elasticity and positive cross-price elasticity (except between capital and maintenance). This means that an increase in one input’s price leads to a decrease in its demand but increases the demand for other inputs due to substitution possibilities. Thus, the water utility has various possibilities to substitute one input for another.

The paper we summarised is the first attempt to estimate the cost structure of water supply for Sri Lanka.4 Results of this analysis are of practical importance to regulators, policy makers and the NWSDB managers responsible for the design of rate structures for water and the management of water supply. Water supply in developing countries, particularly in Asia, share common physical and technical features and operate under similar institutional arrangements. Our results are, hence, applicable for policies and pricing of water supply in the wider Asian context.

Footnotes: * 95 percent of urban and 75 percent of rural population had access to safe drinking water and 75 percent of urban and 14 percent of rural population had access to pipe-borne water in 2005.8

References:

NWSDB (2006), Annual Report 2006. Colombo: National Water Supply and Drainage Board. NWSDB (2007), Management Information Report. Colombo: NWSDB. ADB (2007), Sri Lanka Country Assistance Program Evaluation: Water Supply and Sanitation Sector Assistance Evaluation: Operations Evaluation Department, Asian Development Bank. Dharmaratna, D. and Parasnis, J. (2012), “An analysis of the cost structure of water supply in Sri Lanka”. Journal of the Asia Pacific Economy, Vol.17 No.2, 298-314. Ng, Y. K. (1987), “Equity, Efficiency and Financial Viability: Public-utility Pricing with Special Reference to Water Supply”. Australian Economic Review, Vol.20 No.3, 21 – 35. Renzetti, S. (1999), “Municipal Water Supply and Sewage Treatment Costs, Prices and Distortions”. Canadian Journal of Economics, Vol.32 No.3, 688 – 704. Renzetti, S. (1992), “Evaluating the Welfare Effects of Reforming Municipal Water Prices”. Journal of Environmental Economics and Management, Vol.22, 147 – 163. Imbulana, K. A., Wijesekera, N. T. and Neupane, B. R. (2006), Sri Lanka National Water Development Report: UNESCO.

Dr Dinusha Dharmaratna is a Lecturer at the Department of Economics, Monash University. Dinusha completed her PhD in 2009 on the topic “Demand, Supply and Welfare Aspects of Pipe Borne Water Supply in Sri Lanka”. Her research is in the field of Environmental Economics with particular focus on Water and Climate Change Economics. She has published in a range of journals, including WHO Bulletin, Journal of the Asia Pacific Economy, Asia Pacific Journal of Economics and Business and Water Resources Management. For further information, please contact: Dinusha.Dharmaratna@monash.edu. Dr Jaai Parasnis is a Lecturer at the Department of Economics, Monash University. Her research is in the field of Labour Economics with particular focus on immigration and its role in the labour market and analysis using the production theory approach. She has published on this topic in economics journals, including Australian Economic Papers, Economic Papers and the Economic Record.

The views expressed in this article belong to the individual authors and do not represent the views of the Global Water Forum, the UNESCO Chair in Water Economics and Transboundary Water Governance, UNESCO, the Australian National University, or any of the institutions to which the authors are associated. Please see the Global Water Forum terms and conditions here.