Marginal cost water pricing: welfare effects and policy implications using minimum cost and benchmarking models, with case studies from Australia and Asia.

Abstract

Recent studies in water management policy point to insufficient recognition of water as a scarce commodity and the failure of pricing policies to account for the full economic costs of its production and supply. These costs include opportunity costs related to alternative uses of water; user costs associated with managing a scarce resource; and costs of externalities such as ground water depletion, pollution of waterways, and greenhouse gas emissions. Existing cost recovery based pricing policies may lead to inefficiencies such as excess consumption, under-investment in water infrastructure, and unnecessary subsidisation. Water scarcity can be managed in several ways. We can increase supply by investment in additional harvesting capabilities or new technologies such as desalination; we can constrain consumption so that existing supplies last longer; or we can use water in more efficient ways. As a short term measure, most countries adopt water restrictions when supplies are at critical levels. In the future, as urban population growth continues, harvesting of storm water and reuse of grey water may become part of a sustainable water management strategy. Water trading can be used to move water to where the marginal benefits are highest. Considerable water savings are possible through the use of more efficient industrial and domestic appliances. There is evidence in some countries that higher water tariffs have reduced consumption and promoted awareness of conservation. If we accept that water is an economic good, then we need to understand the costs related to its production, the patterns of its use, and the benefits received by different users. This thesis is an examination of theoretical and applied aspects of urban water pricing based on analysis of cost, demand, and welfare. We present theoretical models of cost that include economies of scale as a parameter, and a model of water demand by households with heterogeneous preferences. We determine marginal cost at the efficient level of output based on a partial equilibrium of supply and demand. We also show that when water is produced with increasing returns to scale, the efficient price will be insufficient to recover all costs, and therefore a form of second best pricing is required. We contrast conventional notions about water suppliers being cost minimisers with an alternative frontier model of cost efficiency. Two case studies examine the provision of water services under different forms of ownership. The first case study examines the provision of water to domestic households in the state of Victoria, Australia. The second case study examines the supply of water to the residents of Manila, one of the world’s largest cities that privatised its water service in 1997 under a form of concession agreement. A third case study derives an efficient cost frontier for a sample of water utilities from Asia and Australia and proposes a form of best practice pricing. The thesis concludes with a summary of the main results and policy conclusions, and ideas for future research.