A Model of Water Pricing for Melbourne, Sydney and Perth

This report was produced for the Urban Water Research Association of Australia, a now discontinued research program.

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A Model of Water Pricing for Melbourne, Sydney and Perth

Report no. UWRAA 2

August 1989


In 1987, the Water Authority of Western Australia commissioned the Institute to set out the theoretical principles which should guide urban water pricing decisions. The resulting paper by Professor Ng was published in the Australian Economic Review, 3rd Quarter 1987.

In 1988, the water authorities of Melbourne, Sydney and Perth asked the Institute to apply these theoretical principles in a quantitative framework. The result is the pricing model reported in this paper.

The preliminary results contained in this report have been derived using the best data currently available to test the realism of the model constraints and assumptions. Some physical aspects of the water supply and sewerage systems are not adequately modelled at this stage, and as a result, the model will be further developed and data refined to provide a more realistic forecasting capability which can be applied in practice. Notwithstanding, some tentative conclusions have been made based on the initial results. These should not in any way be construed to represent the views of the sponsoring authorities.

The model uses data on demands for water authority services and the technologies for producing them. From these data it projects for 50 years the output levels in the water authority and the authority’s investments in water harvesting facilities(mainly dams), waste water treatment plants and main sewers. With the demand and supply sides in place, the model generates optimal prices for water authority services.

Preliminary applications of the model have been made for Melbourne, Sydney and Perth. We find that volumetric charges for water and waste water disposal in these three cities have usually been too low. Too much reliance has been placed on non-volumetric charges (water rates) for water authority financing. This may have led to over-investment in water authority capital and over-production of water authority services. If the cost to a household of consuming an extra kilolitre of water is only 15 cents, then the household is likely to expand its consumption of water until the last kilolitre produces a benefit which the household values at 15 cents. However, if the resources used up in producing this last kilolitre have an opportunity cost of 90 cents, then the community would be better off with one less kilolitre of water and 90 cents worth of alternative production.

Although our model indicates that volumetric charges should rise and non-volumetric charges should fall, we find that these changes should be introduced quite slowly. All three cities currently have sufficient infrastructure to satisfy the demands for water which arise at very low volumetric prices, especially Melbourne where a major increase in water supplying capacity (the Thomson dam) has recently become available. If volumetric charges were substantially raised in the short run, then demand would be suppressed leaving the existing capital of the water authorities wastefully under-used.

Over the next 10to 20 years as the populations of the three cities grow, the appropriate policy will be to choke off some of the resulting increases in demand for water services by increases in volumetric prices. At the same time, non-volumetric charges should be lowered. In this way, the existing capital of the water authorities will continue to be adequately used while future over-investments will be avoided.

The model developed in this project focuses primarily on the promotion of economic efficiency. Such an objective is a key consideration in formulating water pricing policies but there are others, including the financial viability of the water authority, equity between different consumer groups and generations, environmental considerations and political feasibility. Professor Ng has indicated that the pursuit of economic efficiency is also conducive to the achievement of some of these other objectives. Nevertheless, a water pricing model based on economic principles should not be regarded as taking into account all of the factors relevant to water pricing.

The report contains separate sections on Melbourne, Sydney and Perth in non-technical language. A full technical specification of the model is in the appendix. The concluding remarks list some of the shortcomings of the model and suggest directions for future research.

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