The Australian Economic Review, vol. 39, no. 2, pp. 227–37

For the Student Efficient Urban Water Pricing Hugh Sibly School of Economics and Finance University of Tasmania

1.

Introduction

By the latter half of the 20th century, urban water in Australia was both cheap and plentiful. Urban consumers took for granted the engineering achievements that made this possible and treated cheap (or free) clean water as a right. However, recently this complacency has been challenged. The new constraint is an environmental, rather than an engineering, one. The large cities (Sydney, Melbourne and Perth) have grown so much in population that, under their current allocation arrangements, they are in danger of using more water than can be readily extracted from the surrounding environments. The solutions to this new ‘water crisis’ are controversial. Prominent among solutions are technological ones, which involve various types of new infrastructure work. Desalination plants are proposed for both Sydney and Perth. Western Australia is considering building a pipeline from the Kimberley to Perth. ‘Conserve water’ campaigns are also prominent in most major cities. Proponents of such solutions to the current water shortage rarely think in economic terms. To economists, pricing is the central mechanism that determines the availability and allocation of urban water. The use of economically efficient pricing makes the most effective use of the existing water provisions. This article applies simple diagrammatic economic analysis to explain the general economic principles of efficient urban water pricing. It should be noted that the use of urban water also imposes the associated costs of sewage and drainage services. ©

For simplicity of exposition this article only considers the provision of urban water. However, similar principles apply to the efficient pricing and provision of wastewater services. It is difficult to generalise about the current and past pricing regimes for urban water in Australia. Every region has its own urban water provider, and these providers differ in institutional arrangements. Urban water providers may be an agency of either state or local government. This heterogeneity in providers’ institutional arrangements leads to a variety of pricing methods as each authority responds to local political and consumer demands. Nonetheless, it is reasonable to claim that there has not been a history of efficient pricing of urban water in Australia. Historically, urban water prices had typically been set to achieve only partial cost recovery, with the rate of return on water assets below a commercial level (even for a business with very low risk).1 Urban water authorities thus had an either explicit or implicit cross-subsidisation by government. Typically the urban water charges that had been levied were on the basis of an annual access fee (fixed charge). The size of the access fee was commonly related to the customer’s property value, a practice that is still used in a number of jurisdictions today. The use of a consumption-based charge (known as a volumetric charge) varied from jurisdiction to jurisdiction. Many jurisdictions have not used a volumetric charge, with some regions not requiring the installation of water meters.2 There has been a change in the way urban water is priced, largely as a result of the implementation of National Competition Policy

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(NCP). NCP is aimed at increasing the productivity of government businesses by ensuring they face competitive pressure. An important component of NCP is the requirement for competitive neutrality, which means that the businesses receive no special advantages from being government owned. In particular, competitive neutrality requires that urban water authorities satisfy a ‘revenue requirement’; that is, they cover all their costs, including the cost of capital. NCP also has seen the requirement of ‘consumption-based pricing’ for urban water, with the aim of curbing ‘excessive’ consumption. Economic efficiency is determined by the size of the volumetric charge. As is demonstrated in this article, because a water provider is a natural monopoly, an efficient volumetric charge is unlikely to satisfy the revenue requirement. The volumetric charge is not enough, by itself, to ensure satisfying the twin goals of efficiency and revenue neutrality. A two-part tariff, consisting of both an annual access fee and a volumetric charge, can be used to achieve both outcomes. Although the implementation of NCP has seen a significant increase in the number of urban water providers using two-part tariffs, not a great deal of focus has been placed on how the volumetric charge is determined.3 This article describes the principles that are used to determine the efficient volumetric charge. One of the important implications of this analysis is that, in order to achieve economic efficiency, the volumetric charge needs to be flexible in the face of changing cost and demand conditions. In particular, the volumetric charge should rise in a period of drought when water is relatively scarce. Currently no Australian urban water provider sets the volumetric charge in this way. Rather, urban water providers continue to use water restrictions (that is, rationing) instead of a volumetric charge to allocate water. For example, the Victorian Government is planning to introduce permanent controls on particular types of water use in the Melbourne metropolitan area (Victorian Government Department of Sustainability and Environment 2004). However, as the case with all other ©

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goods, rationing of water is inefficient. This article indicates how this is the case. The analysis of this article provides a description of the principles of efficient urban water pricing, and provides a benchmark against which NCP reforms can be measured. The analysis begins with a discussion of costs facing urban water providers and benefits to consumers (Section 2). An understanding of these costs and benefits is necessary in order to identify when these businesses are operating efficiently. Efficient pricing—particularly two-part tariffs—is then considered (Section 3). The addition of new capacity and its efficient pricing is discussed (Section 4). The efficient pricing response to drought is considered in Section 5. The article concludes with Section 6. 2.

Costs and Benefits of Urban Water Provision

2.1 Types of Costs Urban water providers’ costs may be divided into private and external costs. Like any firm, urban water providers’ private costs can also be divided into fixed and variable costs. The provider’s fixed costs are those independent of the amount of water delivered to consumers. Typically these include infrastructure costs and administrative costs. The provider’s variable costs are those that vary with the amount of water delivered to consumers. Typically these include pumping, treatment and the cost of purchasing the water. Private costs can be calculated for each delivery point of the water network. In the exposition below it is assumed for simplicity that costs do not differ across each node of the water network. External costs arise because extracting water for urban use denies that water to the environment. For example, taking water from a dam reduces the amount of water available to maintain river flows below the dam. This may place stress on the local ecosystem. It could, for example, cause local extinctions of fauna that rely on the river. An external cost arises because the environmental quality is a public good. Note that this type of cost is purely a variable cost.

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Sibly: Efficient Urban Water Pricing Another distinction that is made is between common and attributable costs. As its name suggests, common costs are those costs that cannot be attributed to one customer or a particular group of customers. Much of the infrastructure of water providers represents a common cost. For example, a pipeline from a dam to the city must be in place before any customers can receive water. However, there is no unique way to attribute the cost of the pipeline to customers. This contrasts with water purification and pumping, which can be directly attributed to the user of the water. The presence of common costs means that a ‘user pays’ principle cannot be unambiguously invoked when determining pricing. 2.2 Marginal Cost Short-run marginal cost (MC) is the cost of supplying an extra unit of output for a given state of the infrastructure. A typical example of a provider’s marginal cost is depicted in Figure 1. The capacity of the network is shown as Qc. At output levels less than Qc, MC is the sum of a private component labelled MCp and an external component labelled MCe. The private component includes the costs arising from producing additional water within the existing capacity. These include the costs of water treatment, chemicals, chlorination and pumping. MC is vertical at output Qc, reflecting the inability of the network to deliver water beyond its capacity. In some instances, drawing water from the environment for urban water use denies use of

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that water for other valuable purposes. For instance, water drawn for urban use is not available to agricultural producers. The cost of lost opportunities of alternative uses of water, whether paid for or not, is also included in the calculation MCp. Note that as the level of extraction rises, the remaining alternative uses of water are likely to be of increasing value. In this event, MCp increases with output. Thus, the MCp curve is drawn upward sloping in Figure 1. When urban water use is only a small fraction of all uses, drawing water does not significantly change the marginal cost of alternative uses and therefore MCp is horizontal. In addition, drawing water for urban use may damage the local ecology. In this event, as the quality of the ecology is a public good, taking water imposes a cost on the community. It should be noted that marginal environmental costs are likely to increase with the quantity of water extracted (as more water is extracted the environment is likely to come under increasing strain). Thus, the marginal environmental cost, MCe, is shown as increasing in Figure 1. The maximum water available in the catchment is Qy. Figure 1 is drawn so that the capacity of the water network is less than the water available in the catchment. This is the case when water availability is constant overtime. (What sense would there be in going to the expense of building more infrastructure than can ever be used?) However, in some networks the availability of water in dry periods may be less than capacity. This case is discussed in Section 5 below. 2.3 Average Private Cost

Figure 1 Average and Marginal Cost for an Urban Water Provider $/ML

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Figure 1 also depicts the typical relationship between average private cost, ACp, and MC for urban water providers. Urban water providers’ costs display the important features common to public utilities. The bulk of the total cost is infrastructure (capital) costs. This means that ‘fixed costs’ dominate in total costs. This cost structure means water providers exhibit declining average costs as production increases. This reflects the fact that as output increases, the fixed cost can be spread across more units of water. Note that when average cost is declining,

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marginal cost lies below average cost as depicted in Figure 1. Because infrastructure dominates the cost of urban water providers, they are usually considered ‘natural monopolies’. It is usually not cost-effective, and thus impractical, for another firm to replicate the infrastructure required to compete in the supply of water.

Figure 2 An Individual Consumer $/KL

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2.5 Benefit of Water Provision The benefit to each consumer from urban water provision consists of two components. The first component is the benefit from consumption, ©

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2.4 Productive and Dynamic Efficiency Productive efficiency requires that, whatever the level of consumption, water services are supplied at the lowest possible average production cost given the state of technology. Dynamic efficiency occurs where the average production cost lowers over time in response to technological change and innovation in management. A common concern is that the incentive for public utilities to utilise the least cost production methods is not strong. The management and workers of public utilities may benefit from excessive costs, and may exercise their monopoly power to pass these inefficient expenditures on to their customers. In this way some of the economy’s scarce resources are lost. Instruments designed to promote productive and dynamic efficiency within public utilities include (i) benchmarking against similar public and private businesses; (ii) discounting allowable price increases for expected productivity increases (CPI-X pricing formula), thus forcing the utility to improve its operational efficiency if it is to improve its financial performance; and (iii) opening the business up to increased private competition, so that the utility must increase efficiency to compete effectively. The last is the strategy of NCP for ensuring the cost-effectiveness of public infrastructure. However, the role of the private sector in urban water provision remains controversial in Australia, and there is no significant private involvement in its provision.

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q1

KL

which is the value the consumer places on the water consumed. The height of a consumer’s demand curve represents the marginal benefit of water to that consumer at each level of water consumption. Thus, the area under a consumer’s demand curve represents the benefit of consumption to that consumer. This is shown graphically in Figure 2. An individual consumer has the demand curve d. Suppose the customer is consuming q0. The marginal benefit from consumption (at consumption level q0) is the height of the demand curve at this point (that is, p0). The consumer’s benefit from consumption is the area s1 + c1. The second component is the benefit from connection, which is the value the consumer places on the connection to the water network. The benefit from connection is independent of the level of water consumption. For example, it might represent the value of the connection for potential fire fighting. 2.6 The Surplus A consumer’s surplus from the provision of water services is defined as the difference between the consumer benefit and the cost of providing water to that consumer. It can be divided into two components. The first component is the surplus from consumption, which is the difference between the consumer’s benefit from consumption and the cost of providing the water consumed. Figure 2 shows how the surplus from consumption of an individual consumer is determined. The common marginal cost of supplying the individual with water, CMC, is shown. (It is horizontal, and the same for all consumers, because each

2006 The University of Melbourne, Melbourne Institute of Applied Economic and Social Research

Sibly: Efficient Urban Water Pricing individual is assumed to consume only a small fraction of total output and therefore does not influence the cost of supplying water.) The height of the consumer’s demand curve, d, represents the marginal benefit of water to that consumer. The marginal surplus of water is the difference between the marginal benefit and marginal cost of water. Graphically it is the distance between the demand and marginal cost curves. At output level q0 the marginal surplus is p0 – p1. The individual’s surplus from water consumption at output level q0 is s0. The surplus from consumption is maximised when consumption is at the level q1, in which case the surplus is s0 + s1. Observe that consumers choose this level of consumption when price is p1 (that is, marginal cost). The second component is the surplus from connection, which is the difference between the benefit of a connection and its cost. Individual consumers also obtain a benefit from connection. The value of this benefit is independent of the level of consumption. An example of such a benefit arises from fire protection. Individuals also face a cost of connection to the water network, which includes the cost of laying pipes from their building to the best available network connection. The surplus from connection is the difference between the benefit from connection and the cost of connection. The surplus from connection can be negative. For example, consider a prospective customer of an urban water provider who is currently using tank water. The consumer may be satisfied with using tank water, and therefore feel there is little benefit to connection to the water network. However, connection to the network may involve significant cost. In this example the surplus from connection is negative.

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from water provision is maximised. There are two conditions that must be satisfied. (i)

Individuals are to be supplied with water provided their total surplus from water provision is positive.

(ii) If they are supplied, the efficiency level of consumption is that level at which the marginal benefit is equal to the marginal cost of water. It is shown below that allocative efficiency and revenue neutrality of urban water supply can be achieved using a two-part tariff. Under two-part tariffs both a volumetric charge and a fixed access charge are levied on customers. 3.2 Efficient Volumetric Charge and the Revenue Requirement The efficient volumetric charge is equal to the marginal cost of water. Figure 3 shows the urban water provider’s efficient volumetric charge for two demand levels. With the low demand level D1 the efficient price is p1 which results in production Q1. When demand rises to D2 the efficient price is p2 that results in output Qc. As can be seen from Figure 3, when demand is D1 the efficient price, p1, is less than AC1, the average cost of production. Thus, the volumetric charge does not, by itself, recover the costs of production. Hence, marginal cost pricing alone does not meet the requirement that the pricing structure provide revenue adequacy. The difference between AC1 and p1 represents Figure 3 Efficient Pricing of an Urban Water Provider $/ML

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Efficiency and Pricing

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3.1 Allocative Efficiency The gain to society from urban water provision is measured by the total surplus. The total surplus from the provision of urban water is the sum of individuals’ surpluses. Allocative efficiency is achieved when society’s total surplus ©

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the amount of under recovery per unit sold if the efficient volumetric charge is set. Thus (AC1 – p1).Q1 represents the total amount of under recovery from the volumetric charge. In contrast, when demand rises to D2, the efficient price is above the average cost of production. In this case (p2 – AC2).Qc represents the (positive) profit of the water provider. Marginal cost pricing alone satisfies both the efficiency and the revenue requirement. 3.3 Efficient Two-Part Tariffs A two-part tariff can simultaneously satisfy the twin objectives of efficiency and revenue requirement for an urban water provider. Twopart tariffs levy a fixed access charge on each customer and additionally impose a volumetric charge. The fixed charge paid by the customer is independent of the volume consumed. It therefore does not influence the consumers’ choice of volume. Thus, the volumetric charge is efficient if set equal to the marginal cost. The fixed charge is thus set to make up the shortfall between the revenue from a marginal cost price and the revenue needed to cover total costs. For the fixed charge levied on a customer to be efficient it is necessary that it is less than his/ her total surplus from water provision. In practice, the fixed charge is likely to be so small that it does not influence the connection decision. However, in principle, there is no requirement that the fixed charge be equal across consumers in order to achieve allocative efficiency. Indeed, efficiency may require that the charge vary across consumers if it turned out the fixed charge was relatively large. To explain this claim, recall from above that efficiency requires that water be provided to all consumers for whom the total surplus from water provision (that is, the sum of the surplus from connection and consumption) is positive. For the fixed charge to be efficient it is necessary that it is allocated across consumers in such a way that each consumer’s share of the fixed charge is less than his/her total benefit from water provision. This requires that a low fixed charge be levied on those customers with a low surplus from water provision. ©

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There is an important practical problem faced when trying to determine whether a particular customer’s fixed charge is efficient, and that is identifying that customer’s total surplus. The urban water provider cannot rely on consumers identifying their own level of total surplus, as each customer has an incentive to under-report. However, it may be possible for urban water authorities to use some measure that can act as a proxy for total surplus of water provision in setting the fixed charge. There is some freedom, from the water provider’s viewpoint, on how to allocate the fixed charge. Proxies do not have to be perfect, as under most realistic allocations each consumer’s fixed charge is much less than his/her total surplus. In practice, it is concepts of equity, rather than efficiency, that have often dominated the allocation of the fixed charge. In some allocation methods the concepts of efficiency and equity are compatible whereas in others they are not. One possible proxy, which is commonly used, is the customer’s property value. Property values are often seen as fair because the rich pay a higher proportion of the common costs. Property value is not directly linked to water use and hence fulfils one of the necessary conditions for the fixed charge to be considered efficient. The other condition is that the fixed fee be less than the consumer’s total surplus of water provision. To the extent that property value represents the benefit to the consumer from his/her property, the higher the property value, the greater the consumer’s benefit of water provision. To this extent, property value does relate the fixed charge to total surplus of water provision. However, it is unlikely that the correlation between property value and the consumer’s benefit from water provision is perfect. Nevertheless, it is also unlikely that consumers are inefficiently excluded from water provision by the use of property value to set the relative fixed charge.4 Another proxy that has been used is the consumer’s share of total consumption (or possibly the moving average of past total consumption).5 This method of allocation is attractive from an equity point of view because people pay for ‘their share’ of the common

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Sibly: Efficient Urban Water Pricing costs. However, a moment’s reflection reveals that this type of ‘fixed charge’ is in fact a defacto volumetric charge. As such, this type of pricing represents average cost pricing, rather than efficient marginal cost pricing. Therefore, an important requirement for the efficiency of the fixed charge in a two-part tariff is that it be independent of the volume consumed. 3.4 Inefficient Volumetric Charge Equity and political considerations have often led to an inefficient volumetric charge being set. Two inefficiencies that arise from mispricing the volumetric charges are now considered. An inefficiency in production occurs when the total volume of water consumed differs from the level that is allocatively efficient. Inefficiency in production is often the result of setting the volumetric charge at a value different from the marginal cost. For example, in many council areas in southern Tasmania, water meters are not installed and hence consumers face a volumetric charge of zero. The impact of a zero volumetric charge when demand is D1 is illustrated in Figure 3. When the volumetric charge is zero the demand for water is Q0. For all output between Q1 and Q0 the marginal cost is greater than the marginal benefit, resulting in a deadweight loss given by DWL. The deadweight loss measures the extent of the inefficiency. An inefficiency in consumption occurs when there is an inefficient allocation of a given supply of water across consumers. Water is allocated efficiently across consumers when the marginal surpluses (which is the difference between the marginal benefit and marginal cost) of all consumers are equal. To understand this claim, consider a situation in which the marginal surplus of water from consumer A is greater than that of consumer B. To make the example concrete, suppose the marginal surplus of A is $5, whereas that of B is $3. A litre of water can be transferred from B, with a loss of $3, to A, with a gain of $5. Although total water consumption has not changed, the total surplus from water consumption has increased by $(5 – 3) = $2. When an inefficiency in consumption is present, water is not put to its most ©

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valuable use. Typically, inefficiency in consumption is a result of mispricing across consumers or rationing (such as water restrictions). For example, if the marginal cost of supplying two customers is different, but the customers are charged the same volumetric rate, then there arises an inefficiency in consumption. The high marginal cost customer may use too much water while the low marginal cost customer uses too little water. To maximise the total benefit from water use, customers should face a volumetric charge equal to the marginal cost of supplying them with water. Rationing such as water restrictions may be used when the water network cannot cope with demand.6 Consider an increase in demand from D1 to D2 as shown in Figure 3. Even if initially the volumetric charge is at the efficient level p1, political considerations may halt the increase in price to the new efficient level. Suppose price is kept at p1 but production of water is increased to Qc, which is the maximum possible. Note that Qc is also the efficient production level. However, at price p1 there is an excess demand equal to Qx – Qc. In order to reconcile this excess demand with available water, the provider may impose restrictions. For example, the watering of gardens may be prohibited. This prohibition ignores the variation in the benefit of gardens across consumers. In particular, keen gardeners may place a very high value on their prized creations, and be particularly badly affected by restrictions. At the same time, others may unthinkingly be using water for unrestricted activities that have a relatively low marginal benefit. Rationing therefore does not account for the potential difference in the marginal surplus across consumers, and therefore risks creating an inefficiency in consumption. 4.

Efficient Capacity

4.1 Efficient Pricing and Capacity Augmentation When demand rises, for example from D1 to D2 in Figure 3, there are perceptions of a water shortage. Indeed, there is likely to be political pressure to expand the capacity of the water

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4.2 Efficiency and Long-Run Marginal Cost Pricing

Figure 4 Adding Extra Capacity $/ML D2 p2 MS

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network rather than raise the price. Suppose that expansion can be achieved without significant negative environmental consequences.7 Then Figure 4 can be used to indicate whether expansion is efficient. By their nature, capacity expansions of water networks are ‘lumpy’ rather than incremental. Some examples of capital expenditure that augment capacity are (i) increased water storage capacity; (ii) increased pipe capacity; (iii) new and enlarged capacity of treatment plants; (iv) additional pumps that are capable of meeting increased demand; and (v) water recycling plants. In Figure 4, the existing capacity is assumed to be Qc. The network augmentation increases capacity to Qn. The extra new capacity produces water with a marginal cost p3. If augmentation proceeds, the efficient price is p3 (that is, the new marginal cost) and the efficient output is Q3. The shaded area in Figure 4, MS, represents the increase in the component of the surplus arising from additional production of water (that is, the difference between the marginal benefit and marginal cost). The expansion yields an increase in surplus equal to MS less the cost of capacity augmentation. It is efficient to expand the network when MS is greater than the cost of the augmentation. If the network is expanded, the cost of expansion is included in the new fixed cost. As the marginal cost may have also changed, the efficient volumetric charge may have changed too. Under efficient two-part pricing the fixed charge must also then be adjusted to cover the additional fixed cost in order that the revenue requirement remains satisfied. ©

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Long-run marginal cost (LMC) is a cost concept that is defined when capital can be varied incrementally. It represents the marginal cost when all factors of production (including capital) can be varied. When capital can be varied incrementally, the efficient level of production occurs when price equals LMC (see, for example, Call and Holahan 1983, pp. 258–62). As noted above, urban water providers’ capital is lumpy in nature, and thus this rule for the efficient volumetric charge is not strictly applicable. Nonetheless, many practitioners have suggested that a modified version of this rule should, in fact, be used to set the volumetric charge of water. To make the rule functional they calculate the ‘marginal capacity cost’ (MCC), which is calculated as: Cost of augmentation MCC = --------------------------------------------------- 8 Increase in capacity LMC is then calculated as follows: LMC = pc + MCC where, as shown in Figure 4, pc is the value of marginal cost just as capacity is reached. LMC is intended to estimate the long-term cost consequences of consuming additional water. However, it can be seen that this version of LMC is not a true marginal cost because MCC is in fact an average cost of new capacity rather than a true marginal cost. When demand is D1 this formula provides a volumetric charge above the efficient level, and may well provide a volumetric charge below the efficient level when demand is D2. When marginal cost pricing is applied, the volumetric charge has a ‘saw tooth’ pattern over time. In the short run, when there is excess capacity (for example, demand at D1 in Figure 3), the volumetric charge is low (p1), reflecting the short-run marginal cost of water. However, as growth causes capacity to be used up, the efficient volumetric charge rises (to p2) to reflect the relative scarcity of water. Once new infrastructure had been built, and the strain on

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Sibly: Efficient Urban Water Pricing capacity had passed, the efficient volumetric charge falls back to a short-run marginal production cost (p3). Such a pricing rule brings about an ‘efficient allocation’ of resources, but it also creates significant fluctuations in water prices over time. Customers may not like this price variability associated with marginal cost pricing. Longrun marginal cost pricing has the ‘political’ advantage that it smooths the volumetric charge over that period of time when new capacity is being introduced. However, the costs of providing this advantage are the inefficiencies discussed in Subsection 3.4 above. 5.

Drought

To most people a drought is a time when there is not enough water available. However, this is not a particularly good definition from an economic point of view. As was seen above, whether there is enough water depends on the level of the volumetric charge. The issue of how much water should be produced (that is, how much is ‘enough’) is considered in the previous section. From an economic viewpoint a drought is simply a period of time when the supply of water is significantly less than normal. More specifically, Figure 5 provides a useful definition of a drought from the perspective of urban water users. It can be thought of as a period in which the maximum available water from the catchment, Qy, is less than Qc, the capacity of the network. During the drought the marginal cost rises from MC to MCD. This reflects both the increased scarcity of water for non-urban uses and the increased environmental (external) costs of extraction during a drought. The efficient volumetric charge rises from p1 to pD during the drought. This reduces demand from Q1 to the new efficient level QD. Urban water providers in Australia have been reluctant to raise the volumetric charge during droughts. This is no doubt, in part, because droughts are seen as unpredictable disasters, and it would be seen by customers and voters as grossly unfair to exploit their occurrence to raise the volumetric charge. Of course, it is questionable whether long dry periods re©

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Figure 5 Drought $/ML D1 MCD pD p1 MC QD Qy'

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ally are unpredictable disasters in the ‘land of droughts and flooding rains’. In addition, under an efficient two-part tariff the impact on a customer’s total water bill would, in all likelihood, be less than suggested by the change in the volumetric charge. This is because the volumetric charge p3 is likely to be closer to the revenuemaximising price than p1. As a consequence, revenue from the volumetric charge is likely to increase. Thus, the fixed charge could be lowered and the revenue requirement could still be satisfied. The impact of the water provider not raising the price during a drought can be understood using Figure 5. If price is left at p1 during the drought, demand remains at Q1. The water provider is tempted to supply as close to Qy' as possible in an attempt to satisfy this demand. In this case the non-urban use of water (including environmental flows) is inefficiently low, and as a consequence there is an inefficiency in production. However, even after extracting this additional water there is an excess demand of Q1 – Qy'. Typically water restrictions are then imposed. As discussed above, these restrictions lead to an inefficiency in consumption. 6.

Discussion

This article explains how pricing is essential to the efficient operation of urban water provision. The presence of a volumetric charge is necessary but not sufficient to ensure allocative efficiency. NCP reforms have seen the introduction of a volumetric rate in many jurisdictions. However, efficiency requires not simply

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the presence of a volumetric charge, but that it (i) be equal to the marginal cost, and (ii) respond to changing conditions. In particular, the volumetric charge for water should be based on the availability of water. The use of rationing (that is, water restrictions) rather than pricing is an inefficient way in which to allocate water. The presence of restrictions on water use is prima facie evidence that the volumetric charge is inefficient. As water restrictions are used in many jurisdictions, it suggests that NCP reforms have not yet achieved the efficient pricing of urban water. One caveat must be made to this claim. Urban water prices cannot be moved instantaneously, and must be set for a given period, say a quarter, because of the requirements of meter reading. In most cases the availability of water can be predicted a considerable time in advance. However, some events that require a substantial water allocation occur suddenly and with unpredictable timing. The most prominent example is bushfires. For such emergencies the price cannot be adjusted rapidly enough to ensure enough water for fire fighting (which is almost certainly the efficient allocation of water). In such emergencies water restrictions are likely to be the least cost method of allocating urban water. However, such restrictions would only be in place for a matter of days, and would not be a regular feature of urban water allocation. In the analysis in this article it is assumed, for simplicity, that marginal costs are constant across customers. In some jurisdictions marginal cost may vary across nodes of the network. (A node is a location within a network.) Where this occurs, the efficient volumetric charge at a particular node is the marginal cost of supply water from that node. Such ‘nodal pricing’ is not a prominent feature of urban water pricing in Australia. This is further evidence that, in spite of NCP reforms, urban water pricing is not yet efficient. Equity considerations are often used as an argument against the adoption of efficient pricing of urban water. However, the analysis in this article shows that these considerations are best addressed through the fixed charge. Most realistic allocations of the fixed charge are ©

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likely to be consistent with efficiency. For example, a fixed charge that is related to property value is unlikely to be inefficient. To the extent that property value can act as a proxy for a consumer’s ability to pay for water, this type of charge could be adjusted to achieve a ‘fair’ outcome. Alternatively, the fixed charge could be discounted to those sections of the community deemed worthy of welfare. The analysis of this article also puts into context the decision to solve water shortage by expanding capacity. Expanding capacity is popular because it is implicitly, and incorrectly, assumed that the additional water would be provided at the existing price. However, as noted above, the extra capacity is at least going to increase the fixed charge. Rather than begin increasing capacity, the efficient first response to a reduction in the availability of water is to raise the volumetric rate. If a small increase in the volumetric rate reduces water demand sufficiently to ease the shortage, it suggests that the benefit of additional capacity is unlikely to justify the cost. On the other hand, if a large increase in the volumetric rate is required to reduce demand, there is a possibility that the benefit of additional capacity outweighs the cost (including the external cost) of that capacity. The popular solution of expanding capacity is only efficient when this is the case. July 2005

Endnotes 1. See Industry Commission (1992). 2. For example, to this day many dwellings in the Hobart region do not have water meters installed. 3. Although there is some formal recognition by government that the nature of pricing can affect the efficiency of urban water provision. See the Intergovernmental Agreement on a National Water Initiative (Council of Australian Governments 2004) and Productivity Commission (2004).

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Sibly: Efficient Urban Water Pricing 4. It can also be argued that a fixed charge based on the property value acts like a property tax, and creates an ‘excess burden of taxation’. That is, it discourages investment in property. However, the excess burden of residential property taxes is often found to be quite low, as demand for residential property is insensitive to its price. This is consistent with the observation above that a fixed charge based on the property value is unlikely to change the consumer’s decision about connection to the network. 5. This mechanism has been used recently by Tasmanian bulk water authorities. 6. A common practice in southern Tasmania has been to automatically impose water restrictions over high demand months. 7. This is still the case for a number of regions in Australia (for example, Tasmania’s significant population centres).

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8. In practice, costs need to be appropriately discounted. References Call, S. T. and Holahan, W. L. 1983, Microeconomics, 2nd edn, Wadsworth, Belmont, California. Council of Australian Governments 2004, Intergovernmental Agreement on a National Water Initiative, June, viewed May 2005, . Industry Commission 1992, Water Resources and Waste Water Disposal, Report no. 26, AGPS, Canberra. Productivity Commission 2004, Review of National Competition Policy Reforms, Discussion Draft, October, Canberra. Victorian Government Department of Sustainability and Environment 2004, Securing Our Water Future Together, Victorian Government White Paper, June, Melbourne.

2006 The University of Melbourne, Melbourne Institute of Applied Economic and Social Research