Optimal water tariffs and supply augmentation for cost-of-service regulated water utilities
Introduction
The regulation of water prices is intended to ensure both a reasonable rate of return to the owners of water infrastructure and to prevent monopoly profits. A key challenge when setting water tariffs is to ensure that the volumetric prices paid by households are no higher than they need to be bring forth the existing supply, but are sufficiently high to optimally postpone future supply augmentation. In other words, by incorporating a scarcity price into the current price paid by households, it is possible to reduce the cost of water to households in a way that ensures water infrastructure is built at the optimal time (Riordan, 1971, Gysi and Loucks, 1971, Riordan, 1984, Grafton and Kompas, 2007), but is neither constructed too soon or too late from the perspective of minimizing the average water tariff over time paid by households. Such an approach to setting water tariffs has been called a dynamically efficient volumetric water price (Grafton et al., 2014) and explicitly accounts for the inherent uncertainty associated with future water supply, typically related to weather variability.
In this paper, we investigate the possible pitfalls of current methods of regulating water tariffs in Australia. We show how the existing method of price regulation can encourage premature supply augmentation and that this can increase the overall average water tariff paid by households over time. Our contribution is to derive a ‘golden rule’ to optimally augment supply. In Section 2 we outline the regulatory approaches to water utilities. In Section 3 we provide a regulatory background and description of the current system of water pricing in Sydney, Australia. We review the economics of water supply augmentation in Section 4 while in Section 5 present and apply a dynamic rule for optimal supply augmentation to calculate the optimal time to make operational a 250 ML/day desalination plant as a function of its expected operational life and weather realizations. We conclude, in Section 6, by proposing a system of fully flexible water tariffs and a golden rule for the optimal timing of supply augmentation.
Section snippets
Regulation of water utilities and water tariffs
The regulation of water tariffs varies substantially across municipalities and between countries. At one end of the scale, competitive markets could, in theory, determine water tariffs in the sense that households could contract directly with water distribution companies which would compete to use the existing water infrastructure network via third party access agreements (Sibly and Tooth, 2008). Provided that there were genuine competition among water distributors, and public assistance were
Regulatory background
Byrnes (2013) observes that in the past decade, and in response to a widespread drought in most parts of southern Australia, there was a very large capital expansion in terms of water infrastructure. This supply augmentation involved annual capital expenditures on urban water infrastructure that more than tripled between 2006–07 and 2009–10 (Topp and Kulys, 2011). It included the construction of desalination plants, enlargement of existing dams and water recycling investments. Byrnes notes in
Economics of water supply augmentation
To make a judgement on the optimal time to undertake supply augmentation, we first present a theoretical background of the underlying regulatory problem. We highlight how the costs of financing augmentation can be large relative to the historical cost of existing assets in the water supply sector (Whittington et al., 2009) and, thus, can have a major influence on the net benefits to water consumers. The pricing challenge to optimal supply augmentation is to ensure the fixed costs of increased
Application to Sydney desalination plant
We apply the theoretical framework in Section 4 to build a model for the optimal timing of the supply augmentation associated with the desalination plant in Sydney that was completed in 2010 at a cost of A$ 1920 million. While calculating the annual cost of supply augmentation is straightforward, evaluating how the annual benefit might evolve through time requires an analytical model that must capture key supply and demand uncertainties such as the population growth, weather uncertainties and
Insights and policy recommendations
The decision in 2007 to build the Sydney desalination was taken by the New South Wales state government and not the Sydney Water Corporation nor IPART. Thus, it could be argued that regardless of the method of price regulation employed by IPART the premature supply augmentation would have occurred. Our view is that the method of setting water tariffs by IPART increased the likelihood of premature and economically inefficient water supply augmentation. This is because of two key factors: (1)
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