Regulating Water for Cities: Balancing Supply with Demand

Presented at 11th ACCC Regulatory Conference

byProfessor R. Quentin Graftonquentin.grafton@anu.edu.au

30 July 2010

2

Overview

(1) Balancing Water Demand and Supply

(2) Dynamically Efficient Water Pricing

(3) Regulatory Water Pricing

(4) Contestability and Regulatory Reform

3

(1) Balancing Supply and Demand

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Balancing Supply with Demand

• Many of world’s urban centres have increasing populations and have reached or are close to existing capacity of infrastructure to deliver water to residents.

• In some locations (such as Australia) problems of meeting current water demands compounded by periodic but extended droughts.

5

Water Demand

• Water demand depends on several factors many of which are outside of the control of water utilities or regulators (weather, household income, family size, etc.)

• Most important demand factor that can be regulated in terms of water demand is volumetric price.

6

Water Consumption and Price

Korea

Canada

Australia

Italy

Mexico

Czech Rep

Netherlands

Sweden

Norway

France

0

20

40

60

80

100

120

140

160

180

200

0 0.5 1 1.5 2 2.5 3 3.5

mean price

me

an

wa

ter

co

ns

um

pti

on

pe

r c

ap

ita

Source: Grafton et al. (2010)

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Water Supply

• Water supply depends on factors outside of control of water utilities or regulators (weather, land-use and planning restrictions, etc.)

• Supply depends of volumetric price as the current price determines when the augmentation should occur.

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(2) Efficient Water Pricing

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Dynamically Efficient Water Pricing

Efficient water pricing must:(1) Be forward looking because current volumetric prices affect current demand which, in turn, determines when supply augmentation is needed; (2) Account for uncertainty because future supply is state contingent and depends on yet-to-be determined events (such as future weather);(3) Recognise that price determines supply

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Forward-Looking Prices

• Forward-looking volumetric water pricing is flexible/scarcity pricing because it takes into account that higher prices today (and thus lower present and future consumption) can postpone the need to invest in supply augmentation.

• Postponing supply augmentation during a drought until water storages increase when drought ends can generate very large payoffs.

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Expected Cost of Premature Investment in Sydney Desal Plant

57% actual

0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.00

200

400

600

800

1000

1200

Expected loss from investment before 21% trigger point

Stock as fraction of total capacity

Mill

ion d

olla

rs

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Account for Uncertainty

• Principal uncertainty in balancing water supply and demand is future weather (inflows, temperature, etc.).

• Efficient water pricing must account for this uncertainty that determines both timing and size of supply augmentation.

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Climate Scenarios and Water Supply in Perth

Climate Scenario

Estimated Yield of Integrated Water Supply Scheme

(90% reliability)

Year when next new source

needed

64 year(1911-1974)

512 GL/year 2052/53

31 year(1975-2005)

437 GL/year 2034/35

9 year(1997-2005)

363 GL/year 2018/19

5 year(2001-2005)

312 GL/year 2004/05

Source: Marsden Jacob Associate (2006); Water Corporation.Note: Based on April 2005 Source Development Plan and 155 kilolitres per capita demand scenario.

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Price determines Supply

• Typically, volumetric prices set equal to short-run (based on current capacity) or long-run (based on augmented capacity) marginal cost of supply.

• Given uncertainty over future supply (such as weather) long-run marginal cost is state contingent such that when increased capacity occurs and what is the actual cost incurred depends on volumetric price and uncertain inflows.

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Direct Costs of Water Supply Options

$0.25

$1.30 $1.45 $1.50 $1.58

$2.61$3.00 $3.00

$4.00

$5.00

$5.60$6.00

$9.30

$1.68

$1.15 $1.30

$0.63

$0.22

$0.30$0.06

$3.00

$0.00 $0.10 $0.20 $0.15 $0.08$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

$7.00

$8.00

$9.00

$10.00

$/k

L

Source: Marsden Jacob Analysis based on water supply plans for Sydney, Adelaide, Perth, Newcastle.

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‘Drought Proofing’ AustraliaCapacity

(GL)Proportion of current total water supply

(%)

Capital cost

($billion)

Expected date of

completion

Sydney 91 17 2.4 Current

Melbourne 150 35 3.5 End 2011

Adelaide 100 50 1.83 End 2010

Perth (1) 55 17 0.4 Current

Perth (2) 50 19 0.95 2011

Gold Coast 46 15 1.2 Current

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(3) Regulatory Pricing

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Regulatory Pricing• Water utilities are, typically, not allowed to set their own

prices because they are typically single-source suppliers and could generate monopoly profits.

• Two regulatory approaches to overcoming this potential pricing problem are:

(1) Contestability about who is given the right to supply water and at what price (such as in France)

(2) Regulated prices set by a price regulator to ensure zero profits (such as US) or equal to annualised cost associated with either most recent or next cheapest source of supply (such as in Australia). Typically, increasing block pricing imposed in attempt to promote water conservation but is inefficient and may be inequitable.

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Problem with ‘Marginal Cost’ Pricing

• Problem with ‘marginal cost’ pricing in an uncertain word is that volumetric price is fixed and only varies with costs associated with existing or augmented capacity and ignores affect of weather on current supplies.

• Thus, in a drought when supplies are reduced the volumetric price will, typically, be too low. To balance supply with demand without raising the price requires restrictions on water use.

• Restrictions generates large welfare losses and when they fail to balance supply with demand bring forward the need to undertake supply augmentation that may not have been necessary with higher volumetric prices.

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Welfare Costs of Water Restrictions

Costs of Water Restrictions:- Direct measurement of value of time spent hand-watering using household production approach ($347-870/household in Perth)– Stated preference surveys ($239/household in

Canberra)– Demand studies ($150/household in Sydney

relative to higher volumetric price)– ~ $900 million/year in Australia (Productivity

Commission)

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Equity: Prices versus Restrictions

• A common objection to scarcity pricing is that water is a need, and it is inequitable to the poor to raise prices in times of drought.

• Because demand is inelastic, higher prices generate substantial revenues. These revenues can be redistributed in a lump-sum fashion by reducing fixed water charges. Those who use little water anyway (such as the poor) can actually benefit.

• Infrastructure improvements are paid for by permanent increases in price. Most of the benefit accrues to households who would water outside because restrictions can be reduced or even removed. The poor and those in apartments do not benefit from reduced restrictions, pay a higher water price and will not get lump-sum payments in current pricing system.

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(4) Contestability and Regulatory Reform

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2004 National Water initiativeThe National Water Initiative committed Australian governments to:

64 iii) “facilitate the efficient functioning of water markets, including inter-jurisdictional water markets, and in both rural and urban settings”

66 i) “Continued movement to upper bound pricing…” 90. vi) “achieve improved pricing for metropolitan water”

69 “…proposal for investments in new or refurbished water infrastructure continue to be assessed as economically viable and ecologically sustainable prior to the investment occurring”

91 iii) “review the effectiveness of temporary water restrictions and associated public education strategies, and assess the scope for extending low level restrictions as standard practice”

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Australian Urban Water Sector

Source: Allen Consulting (2008)

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Alternative Water Sector

Source: Frontier Economics (2008)

Waste Water Treatment

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Reform Options

(1) Keep existing water sector structure but implement dynamically efficient water pricing.

(2) Introduce contestability and allow:- Bulk supply entitlements - Third party access to infrastructure networks (supply and wastewater)- Allow retailers to compete for customers