Externalities are those impacts of economic activity that are not paid for because they are not reflected in the price of the service or product that causes the impact.
Thus, externalities are the “spillover” or “third-party” effects associated with economic activity. The presence of externalities implies that the full costs or benefits of economic activity are not recognised in individual producer or consumer decisions, and – according to economic theory – outcomes for society will be less than optimal.
For example, water transfer between catchments to meet increased demand for urban water may result in changing river flow regimes, which may adversely affect recreational activities in and near rivers. Traditionally, the ‘cost’ of those impacts would not be estimated, and not ‘paid for’ in this transaction between retailer and water customer.
The Victorian Government’s White Paper on water reform proposes the development of five regional sustainable water strategies. A key input into these strategies is for the Urban Water Authorities to prepare Water Supply and Demand Strategies that identify measures to be used to maintain the long-term (50 year) balance between demand for water and available supply. These strategies are to identify the potential for utilisation of a range of water resources (including stream flow, groundwater, urban stormwater, recycled water and integration with adjacent water systems). They will identify water conservation, infrastructure and investment proposals necessary to maintain the long-term supply-demand balance. It will be necessary to calculate the costs and benefits of the various demand and supply options. To enable a full consideration of the options, externalities need to be included in the costs and benefits.
This project aims to develop and document the processes and develop tools required for the water industry to estimate the:
- cost of externalities that could be included in the industries’ current estimates of either costs or revenues for water and sewer
- cost of externalities associated with various options that decrease demand and augment supply.
The key deliverables of the project included:
- a detailed plan describing how the research will be undertaken and how the findings will be delivered.
- a research paper describing the principles that support the Grantee’s proposed methodology for estimating the costs of externalities, including any literature review on this issue.
- identify the sources of externalities (both positive and negative) associated with the present supply arrangements within Melbourne. This assessment is to include consideration of the implications to the Water Businesses.