When to increase urban water supply? And at what price?

August 11th, 2014

Prof. R. Quentin Grafton, Australian National University, Australia

Many of the world’s urban centers have increasing populations and are close to their capacity to deliver residential water. In locations such as the US South West, Spain and Southern Australia, the problems of meeting water demands are compounded by extended periods of low inflows into catchments and dams. Responding to this challenge involves balancing supply and demand over time and in ways that account for weather variability and the costs of investing in additional supply.

While some non-price measures are effective at managing the quantity demanded by households, quantitative water restrictions do not maximize welfare if they prevent the equalization of the marginal benefits of restricted and unrestricted water uses within households or the equalization of marginal benefits across households.1 Volumetric water pricing (i.e. a price of $X per litre of water consumed) that fails to consider the effects of current prices on future quantity demanded and the decision of when to augment, or add to, supply can also generate long-term welfare losses if it results in premature supply augmentation. By contrast, dynamically efficient pricing can postpone investments in additional supply 2,3,4,5 to the benefit of the water consumers whom will ultimately pay for them though higher prices.

In a recent paper6, we addressed the problem of balancing urban water supply and demand by deriving dynamically efficient volumetric prices for residential water. Our results are important because billions of dollars are spend globally on investments in water infrastructure and supply augmentation each year. If water utilities and water price regulators were to adopt a similar framework and analysis they might avoid premature investments and, thus, generate potentially large welfare gains to water consumers.

The standard economic prescription for water pricing is to set the volumetric price of water equal to the marginal cost of supply, including all internal and external costs. Where marginal costs differ for groups or classes of users as a result of locational differences or level of service then the price charged should also differ by customer group.1

Implementing marginal cost pricing for residential water consumers poses a number of challenges. Typically, marginal cost that is based on current water supply capacity is called “short-run marginal cost” while marginal cost that is based on augmentation to existing capacity is defined as “long-run marginal cost”. Although both types of marginal cost are well defined in a static framework, with a fixed capacity constraint, this is not the case if both supply and demand are variable and uncertain.

It has long been recognized that pricing of water should account for the costs of supply augmentation and that postponing investments in new capacity can be cost effective.7,8 To price water efficiently, however, does not just depend on the cost of supply augmentation beyond the current capacity constraint which is the typical method water utilities use to calculate long-run marginal cost. In addition, efficient water pricing, as well as any non-price water conservation measures, should account for the variability of future inflows into existing storages and consideration of the possibility of either delaying or permanently avoiding supply augmentation through higher current prices and non-price water conservation measures. In other words, given uncertainty about future water supply the long-run ‘marginal cost’ of supply is not exogenous, but is determined by the current and future volumetric water price. This is because the volumetric price determines quantity demanded and simultaneously the timing of the supply augmentation, or when the marginal cost of the next best incremental supply is triggered.

Sydney is Australia’s largest city with over four million residents. Its principal water supply is sourced from 11 dams that have been built in catchments west of the city. Water is delivered to households via a distribution network operated by a single supplier, the Sydney Water Corporation (SWC), which is a state-owned corporation that provides dividends to the Government of New South Wales. The maximum price that SWC can charge water consumers is set by the Independent Pricing and Regulatory Tribunal (IPART) of New South Wales that also sets the prices of energy and public transportation. To date, the maximum regulated volumetric price set by IPART has been the actual price charged by SWC.

IPART’s price setting rule is to establish the maximum volumetric price equal to what it considers to be the long-run marginal cost of supply. To calculate this price it uses an Average Incremental Cost Method for what it considers to be the next best available supply augmentation. IPART’s regulatory pricing is typical of the procedures employed in other parts of Australia, and also in other countries.9 It claims to base its pricing on long-run marginal cost. There is, however, no single or unique long-run marginal cost as claimed by IPART because it depends on the highly variable inflows of water into Sydney’s catchments and dams.5

Sub-optimal volumetric pricing generates welfare costs because it can result in premature investments in supply augmentation. This is because during a drought, if prices are not raised sufficiently, and with less than effective non-price instruments, water is consumed too rapidly. In other words, sub-optimally high consumption brings forward the time that supply augmentation is required. This occurred in Sydney when the decision was taken in 2007 to build a desalination plant to augment Sydney’s water supply that was almost exclusively provided for, at that time, by water in dams. Before the decision was taken to build the desalination plant, IPART’s regulated water prices did not include a scarcity component for the water in Sydney’s dams despite the fact that Sydney had been suffering from a drought for three to four years.

We built a dynamic model that includes an economically optimal decision as to when to invest in supply augmentation and also the volumetric price that should have been charged to Sydney households to account for the capital and operating costs of building a desalination plant. The results depend on realizations of the weather and we use data based on two time periods, a longer and wet period (1919-2008) and a shorter and drier period (1969-2008). The drier the period, all else equal, the greater is the net benefit associated with a desalination plant because the fewer are the periods where the expensive backstop technology needs to be utilized.

Separate sets of results are provided for the two periods. In all results the construction and establishment costs of the desalination plant are fixed at the actual cost of A$ 1,918 million and the cost of increasing the capacity of the plant from 250 Ml/day to 500 Ml/day estimated at A$ 1,020 million.10

The net present value (NPV) of the change in welfare is the sum of the establishment/construction cost of the desalination plant plus the change in the social surplus associated with price charged to households. The loss in social surplus is a result of the higher price paid by water consumers from paying a higher marginal cost of water delivered from the desalination plant earlier than is necessary and the associated deadweight loss. The overall welfare loss is a greater amount because of the capital costs incurred in constructing the desalination plant. In NPV terms under the base case assumptions about the discount rate (5%) and operational life of the plant (100 years), and assuming a drier weather realization, the loss in welfare is A$ 3,201 million or about A$ 1,900 per household. Under the wetter weather realization the welfare loss is even greater. The results are sensitive to assumptions made about the discount rate and also the longevity of the desalination plant. The longer the plant remains operational the greater the net benefit of the plant for a fixed construction cost.

In large measure because of the decision to prematurely build the desalination plant, the regulated volumetric price in Sydney increased by about 50% between 2007 and 2010. By contrast, with dynamically efficient water prices and if the desalination plant had not been built volumetric prices paid by Sydney households would, in real terms, average about $0.30/kL less than current and projected prices.

While our findings are specific to Sydney, they are of general interest because there are no water utilities or water regulators we know of that have implemented dynamically efficient volumetric water pricing or used it to determine optimal supply augmentation. Given that global expenditures in water infrastructure are estimated to be some $US75 billion per year, our results suggest that there could currently be very large welfare losses world-wide from inefficient volumetric water pricing and premature water supply augmentation.

References:

Hirshleifer, J., J.C. DeHaven and J.W. Milliman. 1960. Water Supply Economics, Technology and Policy. University of Chicago Press: Chicago, Illinois. Riordan, C. 1971. Multistage Marginal Cost Model of Investment Pricing Decisions: Applications to Urban Water Supply Treatment Facilities. Water Resources Research 7(3): 463-478. Gysi, M. and D.P. Loucks. 1971. Some Long Run Effects of Water-pricing Policies. Water Resources Research 7(6): 1371-1382. Riordan, M. 1984. On Delegating Price Authority to a Regulated Firm. Rand journal of Economics 15(1): 108-115. Grafton, R.Q. and Kompas, T. 2007. Pricing Sydney Water. Australian Journal of Agricultural and Resource Economics 51: 227-241. Grafton, R.Q., Chu, L., Kompas, T. and Ward, M. 2014. Volumetric water pricing, social surplus and supply augmentation. Water Resources and Economics, available at: http://dx.doi.org/10.1016/j.wre.2014.07.001. Dandy, G.C., E.A. McBean, and B.G. Hutchinson. 1984. A Model for Constrained Optimum Water pricing and Capacity Expansion. Water Resources Research 20(5): 511-520. Timmins, C. 2002. Measuring the Dynamic Efficiency Costs of Regulators’ Preferences: Municipal Water Utilities in the Arid West. Econometrica 70(2): 603-629. Howe, C. 2005. The Functions, Impacts and effectiveness of Water Pricing: Evidence from the United States and Canada. Water Resources Development 21(1): 43-53. Independent Pricing and Regulatory Tribunal (IPART) 2008. Review of Prices for Sydney Water Corporation?s Water, Sewage and Stormwater and Other Services from 1 July 2008 Water – Determination and Final Report June 2008.

This article is based on an original journal article published in the Elsevier journal Water Resources and Economics entitled “Volumetric water pricing, social surplus and supply augmentation” (http://dx.doi.org/10.1016/j.wre.2014.07.001) by R.Q. Grafton, L. Chu, T. Kompas and M. Ward. Water Resources Economics have provided free access to the article until October 9, 2014 at the following link.

Water Resources and Economics addresses the financial and economic dimensions affecting the use of water resources, be it water extraction, pollution or allocation, across different economic sectors like agriculture, energy, industry and urban water supply as well as between local, regional and transboundary river basins. Water Resources and Economics aims to contribute to the development of advanced integrated hydro-economic modeling at river basin, national and international scale, water resources valuation, the design and evaluation of water policy instruments, including water markets, and the economics of public water supply, sanitation and waste water treatment in developed and developing regions.

R. Quentin Grafton is Professor of Economics and Chairholder of the UNESCO Chair in Water Economics and Transboundary Water Governance at the Crawford School of Public Policy, Australian National University.

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.