Managing and conserving urban water: Should we adopt a regulatory or a marketbased approach

1
Managing and conserving urban water Should we
adopt a regulatory or a market-based approach?

• Clevo Wilson
• School of Economics and Finance
• QUT

2
Background

• Australia is the driest continent
• It is also the hottest in terms of the duration
  and intensity of heat
• Australia also has a very fragile ecosystem
• Most of Australias fauna and flora are unique

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Two other important events

• Annual rainfall is decreasing

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Australias population is growing

• SEQ is no exception
• Figure 1 - SEQ region actual and projected
  population growth (1976 to 2026)

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So what are the implications?

• Has implications for supply,demand and price of
  water

S2
P
S1
D2
D1
Q
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Approaches available to decision-makers
Regulatory Approach Market-based Approach
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What is the regulatory approach?

• Setting limits to water use
• Restrictions/bans on watering the garden
• Reducing water pressure
• How is it implemented?
• Education/information provision
• Water patrolling
• Fines
• Writing please explain letters
• Naming and shaming those who over-use water
• Water spies!

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Are these measures effective?

• In the short term it is effective to some extent
• However, the recent success has mainly been
  because
• It rained last month
• It is winter
• But what are the costs of a regulatory approach?
• Water patrolling is expensive
• Education campaigns are expensive
• It is inconvenient to people
• Does not create strong incentives to invest in
  water storage/water saving devices
• Encourages cheating

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Market-based approach

• How does such a system work?
• No interference in the market market forces are
  at work
• Water is priced according to demand and supply

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Are households affected?

• Pricing can be undertaken in a manner that does
  not affect the consumers?
• How?
• Lets look at the demand curve for an individual
• We need some water to meet our basic needs
• (for drinking, washing, etc this can be
  easily determined)
• Very few or no substitutes exist
• In such a case how does the demand curve look
  like?

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The demand curve is perfectly inelastic
P
D
Q
This is for, say 75 liters per person per day
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But the demand curve does not remain the same
P
A stage where substitutes/options become
available (e.g can avoid a second shower,
minimise toilet flushing, etc.
D
Q
This is for, say the next 50 liters per person
per day
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The demand curve changes even further .
A stage where substitutes/options become widely
available. This is especially in the garden.
P
D
For example getting used to a brown lawn instead
of a green lawn
Q
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What are the salient features of this system?

• Compared to the regulatory approach it is less
  cumbersome
• Achieve water targets with less costs
• Households have more freedom
• Adopt water conservation strategies
• The results can be improved even more if an urban
  water trading scheme is introduced
• i.e reward those who save water

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If a market approach is efficient why are
decision-makers not making use of such a system?

• Some likely reasons
• Historically, decision-makers have relied on
  regulatory approaches they dont like change
• They do not like to experiment they do not want
  to be guinea pigs
• They are reluctant to reduce bureaucracy
• Fearful of consumer/voter reactions
• They perceive that low-income families will be
  affected
• Decision-makers also wish to increase supply of
  water very popular among consumers
• Bureaucrats do not have to worry about costs
  taxpayers pay for costly exercises
• Thank You

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The Case for a Regulatory Approach in Urban Water
Management

• Nemanja Antic

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Why Not Regulate?

• The arguments against regulation point out that
  water in Australia is regulated poorly at present
  (although this is changing slowly NWI in 1994)
• I aim to convince you that regulation, and not
  the market mechanism, is the best way to deal
  with water policy
• this is why almost every country regulates water
• Think about what happens to public utilities when
  the market is introduced
• e.g. California privatising electricity markets

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Water A Natural Monopoly

• Water supply in urban areas is a natural monopoly
  there is no two ways about that
• It therefore needs to be regulated (like any
  other monopoly) to ensure that rents are not too
  extravagant
• If not, a monopolist can price discriminate, at
  the detriment of the poorest people in our society

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Pricing under Regulation
Individual household water supply and demand
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Pricing under Market Mechanism
Individual household water supply and demand
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Do we really want to price at marginal cost?

• This would not resolve the water crisis
• Prices are too low for people to respond
• People in urban areas spend only a small
  percentage of their income on water and therefore
  do not go through the trouble of being fully
  rational consumers
• Marginal water pricing is an expensive exercise
  (hiring economic consultants) but gives no results

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What else is there?

• In order to control supply in the short term, if
  people do not respond to price signals
  governments attempt to get them to respond based
  on a feeling of community
• At some point water conservation schemes and
  educating the public that there is just no more
  water to use become attractive

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Are people really the problem?

• Water usage in cities is problematic because of
  breakages in the pipelines and leaks millions
  of litres of water are wasted in this way.

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Command and Conquer
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Treat water as any other economic good

• Redzo Mujcic

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• Water is no different from any other economic
  good. It is no more a necessity than food,
  clothing, or housing, all of which obey the
  normal laws of economics.
• Baumann Boland (1998)

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• With increased population growth rates, improved
  life style, and gradually decreasing supplies,
  both in terms of quantity and quality, the
  competition over scarce water resources is
  increasing. It is thus of increasing importance
  that the existing water resources be allocated
  more efficiently.
• Allocation of water to different sectors can be
  viewed from a purely economic point of view as a
  portfolio of investment projects water is the
  limited resource capital, and the economic
  sectors use the capital and produce returns.

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• In an economically efficient resource allocation,
  the marginal benefit from the use of the resource
  should be equal across sectors (individuals) in
  order to maximize social welfare. In other words,
  the benefit from using one additional unit of the
  resource in one sector (or by one individual)
  should be the same as it is in any other sector
  (by another individual). If not, society would
  benefit by allocating more water to the sector
  where the benefits, or returns, will be highest.

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Appropriate means of resource allocation to
achieve optimal allocation of the resource

• Several criteria used to compare forms of water
  allocation
• the real opportunity cost of providing the
  resource is paid by the users, so that other
  demand or externality effects are internalized.
• Allows the allocation to account for
  environmental uses with a non-market value, such
  as providing a habitat for wildlife.
• Directs the employment of the resource to
  activities with the highest alternative values.

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Disadvantages of Regulation(Command and
Control instruments)

• Under public management the dominant incentive to
  comply is coercion that is, setting regulations,
  such as water use restrictions, and using
  sanctions for those who break them.
• Only effective if the state detects infractions
  and imposes penalties.
• The state lacks the local information and ability
  to penalise, for example, for breaking water
  delivery structures or for excessive water use.
• Since voluntary water restrictions are mostly
  associated with drought periods, such
  restrictions only encourage temporary
  conservation measures, which may be abandoned
  once the drought is over.
• Consumers lose interest as the crisis passes and
  free riding becomes a popular choice as reliance
  on other households to conserve water spreads.

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Disadvantages of Regulation(Command and
Control instruments) cont.

• Most implementing agencies dealing with water
  resources have only sectoral responsibility, for
  example, to deal with irrigation or drinking
  water or industry or the environment.
• While the state as a whole has responsibility for
  overall water use, the executing agencies have
  neither mandate nor incentive to create
  integrated projects or to balance the needs of
  various users.
• the agencies operate within strict limits on the
  quantity of water use or respond only to single
  interest groups. For example farmers or
  industrialists.
• provides very little flexibility to respond to
  changing patterns of water demand, and the
  decision-making mechanisms for inter-sectoral
  allocation are either unclear or highly
  politicised.

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Marginal Cost Pricing (MCP)

• A marginal cost pricing (MCP) mechanism, in
  essence, targets a price for water to equal the
  marginal cost (MC) of supplying the last unit of
  that water.
• An allocation which equates the unit price, that
  is, the marginal value of water, with the
  marginal cost is considered an economically
  efficient, or socially optimal, allocation of
  water resources.
• If there are higher costs to allocate water to
  some uses than to others, then the price can be
  differentiated to be equivalent to the relevant
  marginal cost of provision to each type of use.

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Marginal Cost Pricing

• The two concepts, social cost and scarcity value,
  are reflected in higher MC curves then the
  private MC curve.
• For example
• -water use usually rises in the summer season,
  as does its scarcity value.
• Such an event is reflected in a higher MC curve
  then the private MC curve.
• Thus, prices for water should be higher in the
  summer season than in the winter season to cover
  the high energy and capital cost of providing the
  extra capacity, as is the case with electricity
  during peak demand periods.

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Marginal Cost Pricing

• Similarly, customers located further away from
  the water supply, or at higher elevations, are
  being subsidised by customers who pay the
  identical flat rate but are located closer to the
  main supply.
• Those households who require more pipes and
  pumping are more expensive to serve and therefore
  should pay more for reticulated water.

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Marginal Cost Pricing

• Marginal cost pricing can be applied also to
  develop differential prices for different
  qualities of water where higher-quality water has
  a higher marginal cost of provision.
• In the same way, reliability of supply is an
  important factor where higher marginal costs are
  associated with higher level of reliability.

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Advantages of Marginal Cost Pricing

• theoretically efficient
• Not only are the marginal costs and benefits
  equal, but at the efficient price, total economic
  welfare, measured as the sum of the consumer and
  producer surpluses, is maximised.
• MCP avoids the tendency to under-price and
  consequently allow overuse of water.
• Under conditions of scarcity, excessive water use
  is obviously undesirable and comes at a high
  social cost.
• A MCP system averts overuse because prices would
  rise to reflect the relative scarcity of water
  supplied.
• MCP approaches to water allocation can also be
  combined with pollution charges or taxes so that
  the externalities in use of water are embedded in
  the incentives facing the water user

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Table 1 Estimates of domestic water use for a
typical household in Brisbane (2007)

Source ABS (2007)
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Water Prices (in Brisbane city)

• 1.19 per kilolitre for the first 255 kilolitres
  per year 
• 1.23 per kilolitre for each kilolitre between
  256 kilolitres and 310 kilolitres per year
• 1.69 for each kilolitre in excess of 310
  kilolitres per year
• Source Brisbane City Council (2007)

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• a typical household in Brisbane, using 615L of
  water per day, would be looking at an annual
  water bill of approximately 270.
• Given a household whose combined annual income is
  30,000 expenditure on reticulated water of 270
  would exhaust only 0.9 of their annual income.
• Since, annual expenditures on reticulated water
  are significantly low it comes to no surprise
  why reticulated water is been used and wasted
  excessively.

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Simple Cost/Benefit Analysis for Rainwater Tank
Installation
Annual benefit (annual water saving (kL/year)
x price/kL) operating costs) x (1 r)
(198 x P 10) x (1.05) Annual cost
Cost of rainwater tank / economic life
3000/10
300 Economical if annual benefit annual cost
(198 x P 10) x (1.05)
300 P needs to be greater than or equal 198P
10 300/1.05 198P 10 286 198P
296 P 296/198 P
1.50 Price of reticulated water would need to
rise to 1.50 for rainwater tanks (costing
3,000) to become an economical investment for
Brisbane households.
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Price Elasticity of Demand for Water

• Reviewing fifty studies from various countries on
  the effect of water prices on demand, the Dutch
  researcher Jasper Dalhuisen (1999) and his
  co-authors found that on average, a 10 per cent
  increase in water prices led to a 4 per cent drop
  in consumption a price elasticity of -0.4 .
• Other studies focusing on Indonesia, found that
  increasing the price of water from US0.15 to
  US0.42 per cubic meter resulted in a 30 per cent
  decrease in housheold demain for water.Thus, a
  180 per cent increase in price led to a 30
  percent decrease in quantity consumed, meaning a
  price elasticity of -0.17. Espey and Shaw
  (1997)
• A considerable body of analysis for developed
  countries, parrallel to the study carried out by
  Dalhuisen (1999), shows a central range of price
  elasticities of demand for household water of
  -0.3 to -0.7.
• In urban Brazil and Mexico, estimated price
  elasticities for urban water demand are -0.60 and
  -0.38, respectively.