WATERPRICING AND THE MARGINAL COST OF WATER

WSAAOccasional Paper No 1

December 1996

EXECUTIVESUMMARY

TheAustralian Water Industry is arguably moving through the most important andfundamental period of change experienced since its inception. Many of thesechanges are directed towards improving both the productive efficiency ofagencies that make up the industry as well as the efficient allocation ofresources between the industry and other segments of the economy.

Withinthis changing environment, however, it is important that sight not be lost ofthe need for proper and effective water resource management, and the role ofappropriate price setting practices in that process. Pricing mechanisms forwater should allow consumers to indicate to the supply authority the qualityand quantity of water services customers wish to consume at the prevailingprice. In turn, the pricing mechanism should allow the supply authority totransmit to customers the qualities and quantities of its services it iswilling to supply having regard to the cost of producing them.

Pricingarrangements and price levels can be determined with various levels ofsophistication and detail. This paper seeks to develop a quite simple approachto price setting for urban water supply authorities, underpinned by the conceptof marginal cost, to aid consistency of message and ease of computation whileat the same time recognising that simplification can, at times violate stricteconomic efficiency criteria.

Aftertraversing the theory behind marginal cost pricing and different approaches tocalculation, the paper develops a mechanism for establishing a unit water pricethrough time underpinned by the economics of exhaustible natural resources.

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

Theprospect of customer weariness in the face of increasing water prices asscarcity emerges, and associated regulatory risks are addressed by trading offshort term economically efficient outcomes against efficiency in the longerterm by means of managed price paths.

Thepaper draws on contemporary experiences of Sydney Water to demonstrate thepractical application of the approach being suggested.

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