Water Pricing and the Marginal Cost of Water

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

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Water Pricing and the Marginal Cost of Water

Occasional Paper No. 1

December 1996


The Australian Water Industry is arguably moving through the most important and fundamental period of change experienced since its inception. Many of these changes are directed towards improving both the productive efficiency of agencies that make up the industry as well as the efficient allocation of resources between the industry and other segments of the economy.

 Within this changing environment, however, it is important that sight not be lost of the need for proper and effective water resource management, and the role of appropriate price setting practices in that process. Pricing mechanisms for water should allow consumers to indicate to the supply authority the quality and quantity of water services customers wish to consume at the prevailing price. In turn, the pricing mechanism should allow the supply authority to transmit to customers the qualities and quantities of its services it is willing to supply having regard to the cost of producing them.

 Pricing arrangements and price levels can be determined with various levels of sophistication and detail. This paper seeks to develop a quite simple approach to price setting for urban water supply authorities, underpinned by the concept of marginal cost, to aid consistency of message and ease of computation while at the same time recognising that simplification can, at times violate strict economic efficiency criteria.

 After traversing the theory behind marginal cost pricing and different approaches to calculation, the paper develops a mechanism for establishing a unit water price through time underpinned by the economics of exhaustible natural resources.

 The approach seeks to accommodate the real world concerns of the lack of flexibility to move unit prices in a manner consistent with short-run marginal cost/long run marginal cost pricing rules. It also recognises that the adaptive responses of water consumers are not instantaneous and often require long periods of continuous reinforcement to achieve behavioural responses.

 The prospect of customer weariness in the face of increasing water prices as scarcity emerges, and associated regulatory risks are addressed by trading off short term economically efficient outcomes against efficiency in the longer term by means of managed price paths.

 The paper draws on contemporary experiences of Sydney Water to demonstrate the practical application of the approach being suggested.

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