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Irrationality in the Current Australian Water Supply and Pricing Policies

Paper Type: Free Assignment Study Level: University / Undergraduate
Wordcount: 5391 words Published: 25th Sep 2020

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Executive Summary

This thesis provides an analysis and evaluation of the current Australian water supply and pricing policies. Methods of analysis include cost-benefit analysis, inductive and deductive reasoning. Results of the cost benefit analysis has shown that both large scale and small-scale schemes are economically sound and financially viable. Deductive reasoning has shown that current Australian water supply and pricing policies are not compatible with orthodox economic reasoning and theory. Inductive reasoning is used to confirm this theory.

The report finds that policies relating to penalty charges, water restrictions and use regulations upon urban and rural users create further water market inefficiencies and does not solve the water scarcity issue.

Recommendations discussed include:

  • Implementation of alternative water relief schemes
  • Improved data collection for further analysis
  • Reducing water austerity measures

The report also investigates the fact that the analysis conducted has limitations. Some of the limitations include:

  • Public opinion may not be completely rational
  • Forecasting figures are not provided
  • Current economic conditions data limits 

Table of Contents


Executive Summary........................................................i

Table of Contents.........................................................ii

1. Introduction

2. Prior Knowledge

3. Basic Assumptions

4. Assessment of Current Water Restrictions

4.1 Obstructing the Construction of New Dams

4.2 Reliance on Water Regulations and Restrictions

4.3 Increasing Water Prices

4.4 Profitisation of Water Utilities

5. Conclusion

6. Future Work

7. References

1. Introduction


This thesis is a continuation of Thesis A, where an economic analysis of a large scale and small-scale water relief schemes were conducted. The revelations, of Thesis A, showed that whilst the schemes were economically sound and financially viable, there was an inherent necessity to investigate the question of ‘why these projects are not being implemented?’.

Given the relatively dry and variable climate within Australia, combined with the emergence of climate change, water scarcity is becoming a persistent and recurring issue. Compared to investments in infrastructure for other areas of the Australian economy and other global economies, water investment is seemingly highly undervalued. However, this lack of investment in water infrastructure has invited irrational water supply and use policies, instead of increased expenditure.

Over the years, the introduction of policies relating to penalty charges, water restrictions and use regulations upon urban and rural users, invites the assumption that water is an extremely scarce utility. This thesis argues that this scarcity has been caused by a lack of investment and a failure in preparation for the future.

Thus, Thesis B is an attempt to answer one facet of the question through orthodox economic theory and is an exploration into the irrationality of the current water supply and pricing policies. It aims at showing that the implementation of water relief schemes is still a rational and viable alternative approach for correcting inefficiencies in the water market and misguided water supply and pricing policies.

2. Prior Knowledge

The understanding of the following principles is necessary in order to critically analysing the Australian water supply and pricing policy from an economical point of view. These principles help distinguish between rational and irrational actions on pricing and policy making and allows the establishment of basic propositions.

Marginal Cost Pricing – the practice of setting the price of a product at or slightly above the cost to produce it – for example, no one should be charged to use underutilised water infrastructure when their use does not cause any wear and tear. There is no marginal cost, socially or financially, to their use, and forcing them to find other sources causes market inefficiencies.

Deadweight loss – a loss of economic efficiency that occurs when the free market equilibrium for a good or service is not achieved. As water’s benefits are highly multifaceted, we can estimate marginal cost pricing using strategies similar in minimising deadweight losses of sales or income taxes.

Sunk Cost – a cost that has already been incurred and thus cannot be recovered - often the associated fixed costs with infrastructure are covered by rates on the lands benefited and this has historically how the government has paid for water infrastructure. Currently, the government is moving towards pricing models whereby they seek to recover the costs by usage rates, for example, toll roads and water usage pricing.

Externality – the cost or benefit that affects a party who did not choose to incur the cost or benefit. For example, new developers enjoy the benefits of existing water infrastructure and pays a land tax, with a water utility tax bundled together. Thus, they are indirectly paying for existing infrastructure (a sunk cost).

True Cost of Supply – in the production of water resources, the true cost of supply represents the difference between the market price and total societal cost. It is imperative that the environment, including impacts on human societies, are accounted for.

Monopoly Rent – when a monopoly producer of water lacks competition and thus can sell its product at prices far above the otherwise competitive market price would be, at the expense of consumers. Water prices in Australia reflect the existence of a monopoly and are not charged at the true cost of supply. With a monopoly, where there are no consumer choices, high profits indicate there is no return for any real services. For example, if it costs the government $0.0013/kL to pump water to users in the Murrumbidgee Irrigation Area and the government has an exclusive license/monopoly, they can charge what the market will bear, currently at $43/kL.

Utility Pricing – economists understand that the pricing of utilities, whether administered or arbitrary, are camouflaged taxes which impose deadweight losses end users.

3. Basic Assumptions

1. The Environment cannot be measured as an Absolute Value

An absolute value implies a business valuation method that uses discounted cash flows (DCF) analysis to determine the financial worth of a project. As it tries to determine a project’s intrinsic worth based on its projected cash flows, it highlights the necessity to forecast cash flows with complete certainty and projecting how long the cash flows will remain on a (whether growth or decay) trajectory leads into the realm of guesswork. The analysis is also based upon strict characteristics and fundamentals of a project, leading to a rigid framework that does not allow comparison with other sectors or industries. This leads to a baseline of requirement, that future analysis of water infrastructure needs to be compared with other sectors, for example, mining or electricity.

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The assumption requires the idea that human societal activity is a part of the environment and that should humans change the environment, if it serves as a net benefit towards human interests, the benefits must be weighed against the disadvantaged. Thus, environmental costs must be quantified and set against other environmental (human) or other benefits. For example, examining the costs of dams in restricting natural environmental water flow must be weighed against the benefits of dams in helping sustain environmental flows when there would have otherwise been no flow during a drought.

2. Marginal Cost Pricing represents an economic optimum method for pricing water utilities

We start with the basic proposition that water infrastructure finances are already invested to collect, store and distribute water and that the water supply exceeds demand. Thus, the only remaining cash flows are maintenance costs associated with water usage. Dupuit and Hotelling proposed that pricing infrastructure to recover sunk costs or to generate a rate of return on the installation of assets is not economically efficient.

The issues with using marginal cost pricing is the assumptions that there is no scarcity of water and the initial financing problem.

We argue that we can assume that there is no water scarcity, as water infrastructure investment should forecast a wide variety of climate scenarios and not be solely focused during droughts. However, this area should not be ignored and will be further investigated in Scarcity Pricing to determine scarcity value of water.

The initial financing problem implies that water suppliers have to recover sunk costs of investment or they will not invest. Governments using tax revenues to cover fixed costs of infrastructure usually creates distortions elsewhere in the economy. The George-Hotelling-Vickrey Theorem states that the external benefits capitalised in land values can exactly cover the fixed costs of economically justified infrastructure. Australia has transitioned away from this form of cost recovery and moved towards pricing models whereby they seek to recover the cost by usage rates.

We argue that if water infrastructure expenditure does not balance with profits from usage rates, then this would incur deadweight losses on societal growth.

3. The price of water scarcity should be determined by competitive markets and all users should pay the same scarcity price as a resource rent.

In contrast to Assumption 2, we consider the situation where water demand exceeds supply and water does not have a scarcity value.

Currently the National Water Institute (NWI) has allowed the implementation of trading water rights and entitlements, supporting and allowing for more efficient water allocation amongst recipients. Water trading should be Pareto efficient, which is a state of allocation of resources from which it is impossible to reallocate so as to make any one individual or preference criterion better off without making at least one individual or preference criterion worse off.

However, due to the low-hanging fruit principle, water markets may satisfy their demands by preferring easier and cheaper supply-side solutions that are not financially viable or environmentally sustainable in the long-run. Water markets may also help shift the financial burden of infrastructure maintenance from government agencies to private water rights sellers and buyers and could potentially decrease the barriers of entry for high capital and operating cost water conservation infrastructure.

However, the establishment of the privatisation of water can be seen as a denial of basic human rights on behalf of state and federal governments. Profitisation of this basic resource can lead to inefficiencies in societal growth as seen through a lack of reinvestment of profits, as markets will often seek more lucrative rates of return.

4. Investment in water infrastructure, storage, conservation and distribution, should be undertaken when societal benefits outweigh societal costs

For this assumption, we again consider the scenario that water demand exceeds supply. In deciding whether to invest in water infrastructure, all aspects of costs and benefits, public and private, should be considered.

5. Water rights and entitlements reflect the value of access to water infrastructure

Land which is serviced by access to water supply will have a higher value even if no water is being drawn from that infrastructure. In Australia, water rights and entitlements have been unbundled from land values. This sought to recoup the cost of public infrastructure from the land benefited and is contrasted with infrastructure pricing which attempt to recover all fixed costs of infrastructure from levies on immediate users.

Water entitlements are defined in perpetuity as an entitlement to a proportion of any allocations assigned to a water resource pool. Entitlements and allocations are tradable in the water markets. Overall the assessment from an individual water use perspective is that the unbundling from land rates has been successful. As a Nation however, Australia would have been better off if it had solved the water accounting and over-allocation problems before it introduced water trading.

6. Water rights reflect environmental costs and benefits of societal activity

There is a trade-off between environmental degradation through societal use and efforts to conserve water and increase availability. Those whose water rights are increased in value thanks to better water infrastructure pay more and vice-versa. The external gains and losses are internalised in net water values and net government revenues.

4. Assessment of Current Water Restrictions

After making the previous assumptions, we can critically assess the current state of water restrictions within Australia and its water policy.

Analysing the policies surrounding water in Australia, a trend has emerged in recent decades:

  1. Obstructing the construction of new dams
  2. Detailed regulation and restrictions to limit and control urban water use
  3. Increasing water prices
  4. Profitisation of Water Utilities

4.1 Obstructing the Construction of New Dams

Australia has a long history of dam building, with our biggest single effort being the Snowy Mountains scheme, one of the largest hydraulic engineering projects of its day. Elsewhere, projects have been more modest. Dams need reliable water inflows, suitable landscapes to create a reservoir, and water users either near the dam or downstream. Australia has plenty of potential water users, but has typically fallen down on the first two considerations.

As a result, Australia’s rapid rise in dam construction from the 1960s to the 1980s petered out in the 1990s (although so did the worldwide trend).

Figure 4.1.1 Number of Dams constructed by year. Source: Global Reservoir and Dam (GRanD) Database.

As dam construction has faltered, overall water storage capacity has flatlined within Australia. It may be that, given the requirements of inflow, landscape and customers, Australia is simply running out of feasible locations for new dams, however, an Agricultural Competitiveness green paper released in 2014 has proposed 27 new potential water and irrigation projects.

A trend in past water policy implies that there is an acceptance by policymakers that the environment would be catastrophically destroyed by new dams, violating Assumptions 1 and 4.

An example would be the Tillegra Dam proposed by the Hunter Water Corporation in the 1970s, however, was deferred indefinitely in the 1980s due to the success of user pays pricing, violating Assumption 2 and emphasising the initial financing issue. In 2010, the proposition was refused and finally cancelled based on both the potential for environmental damage and the lack of proper consideration of alternative water security measures. After the state government had already spent $100 million on the project. There seems to be an implicit assumption that the environment is an absolute value and nothing further should be done by humans to change it.

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It is plausible to argue that new dams are not available as a policy option because of negative environmental externalities, however, this would not hold true and apply everywhere. Denying Sydney of water infrastructure would not lessen the Murray-Darling salinity issue. There is a lack of full cost-benefit studies on environmental costs, due to damage of the environment, weighed against urban users’ valuation of their living amenities, parks and gardens. Without a genuine and logically consistent attempt to weigh up the social and economic costs and benefits in each case (including weighing up competing environmental claims), a veto on augmentation of urban water supply is simply an irrational dogma.

Taking the ACT as another example, if the social (public and private) costs of cutting consumption by quantitative water restrictions are a recurring annual $71 million per annum, then at a discount rate of 5%, it would pay to spend up to $355 million to build sufficient water storage infrastructure to be able to abolish the restrictions. The cost of reducing consumption, by a Government-mandated further 25% to 2023, is estimated at $323 million. As the cost of a new dam at Tennet Creek is estimated at $238 million, it makes logical sense to construct it. The admitted costs of reducing consumption and increasing water restrictions are greater than the cost of a new dam. This is a violation of Assumption 4.

When prices rise due to scarcity and when demand exceeds supply, new supplies should be developed, as a free market would only ration existing supply for a brief period of time. A rising cost of water increases the cost-benefit ratio towards investing in new dams. To argue otherwise, would be inferring that the installation of water tanks and extra plumbing in every household would be more cost effective.

4.2 Reliance on Water Regulations and Restrictions

Water restrictions are a violation of Assumption 3, as they deny the legitimacy of markets in allocating resource use and claim superior economic wisdom for the policy or regulation maker. Rationing obscures, rather than reveals, preferences, just as petrol rationing did in the 1940s. Outside of price signalling, economic measures that control consumption are not rational and do not produce the desired results.

Like other forms of rationing, water restrictions, are not an economically ideal solution for facing shortages of water supply.

4.3 Increasing Water Prices

Water scarcity, due to both a lack of investment and climate change, has led to water price increases in both rural and urban areas. Whereas rural irrigators operate under existing water markets, urban water prices are regulated under “demand management” authorities. Price fluctuations are inconsistent with water prices in rural areas.

Where rural users can expect an average of $50/ML, Sydney water users, as an example, can face charges of over $2,000/ML. During the 2018 drought period, Sydney users experienced a price rise of 7%, whereas, rural users saw an increase in over 3000%, from an average of $50/ML to over $1500/ML.

In an ideal free market, as prices respond to scarcity, users will reduce consumption, however, will also seek further investment in water storage and recycling infrastructure. However, the Sydney desalination plant only operates and covers 5% of the total Sydney urban consumption level. This violates Assumption 4.

4.4 Profitisation of Water Utilities

User pays is a pricing approach in economics, based on the idea that the most efficient allocation of resources occurs when end users cover the full cost of the utilities that they consume. Whilst the basic idea is that those who do not use the service should not be forced to pay, it should be assumed that you will get what you paid for. In reality, water restrictions bypass this assumption and the lack of water infrastructure investment combined with rising water prices, indicate that profitisation is occurring in the marketplace.

In the past, water infrastructure was financed through land rates amortizing Water Board loans and land developers often had to contribute construction free of charge to the relevant authorities. This makes logical economic sense, that value generated for land is charged against the fixed costs of infrastructure and water usage is charged at the optimum marginal cost pricing rule, which ensures optimal usage.

The NSW Water Reform Action Plan, and other states that followed, has meant that water users are being double charged for costs already recovered by the Government. One example is the Burdekin Dam, which was already financed through taxpayers, now charges users an additional fee by the Queensland Government.

The Council of Australian Governments and National Competition water reform policies indicated that:

  1. Water resources in Australia were unprofitable and generated low rates of return on investment
  2. The rate of return should match private sector investments

It is easy to point out that not all public infrastructure investment should create a rate of return in the form of monetary reimbursement. Although investments that lead to socio-economic benefits have been historically proven to generate future monetary increases due to societal growth, accounting such benefits are difficult. Public sector accounting for water regulators often portray false or misleading figures showing low profitability. We argue that water infrastructure should not be portrayed as “investments” but rather public utilities that benefit the public.

Water authorities also utilise a system of “depreciated optimized replacement cost” to justify charging users on the basis of what it would cost to replace their assets.

The NSW Government applied new accounting charges in the 2017-2018 budget requiring water utilities, including Sydney Water, Hunter Water and Water NSW, to pay almost $1.5 billion extra in dividends over the next four years.

Figure 4.1.1 Number of Dams constructed by year. Source: Global Reservoir and Dam (GRanD) Database.

Currently, the NSW Government is attempting to take an additional $100 million in dividends from Hunter Water, in addition to the $44 million budgeted. As Hunter Water does not have the cash and cash equivalent available ($20.75 million in 2018), the water authority will have to borrow the $100 million from NSW Treasury Corporation, adding to outstanding liabilities of approximately $1.1 billion. It is perfectly rational for a company to borrow money and pay dividends as long as it isn't borrowing money in order to pay dividends.

Similarly, Sydney Water has a serviceable debt to the state treasury of approximately $8.1 billion and is paying higher dividends instead of servicing debt.

Although water utilities are profitable in nature, because of the large dividends payable to the NSW Treasury, water companies only maintain current infrastructure and are not able to analyse and commission necessary water utilities. The construction of these water utilities is thus politicised in nature, focused on profitisation.

Contrasting to private enterprises, it is evident that none of these additional rates have led to increased investment in further water infrastructure. Currently, State governments are increasingly relying on end users to provide and fund for their own water infrastructure, in the forms of reservoirs, water tanks and trigger nozzles. Farmers experiencing hardships are provided loans and personal water infrastructure is rebated at a rate of 25%, leading the majority of the costs onto the end user and further entrenching these farmers into their situations, ignoring the sunk cost fallacy. Coupled with the fact that additional small-scale water relief infrastructure merely supplement farming water supply, if the current drought period matches the Millennium drought (1996 to 2010), then incurring additional loans is not the optimum solution for farmers.

Economic Analysis of Water Relief Schemes

Economic Analysis of the Water Relief Schemes will be structured around project cost (CAPEX and OPEX), Net Present Value (NPV) and payback period. The following assumptions are used for the calculation of the water relief schemes:

  • Water Costs of $50 for 1ML
  • Lifespan of 50 years
  • 2% uniform discount rate for all options
  • All capital costs estimates are exclusive of land value
  • Water benefits are assumed based on water that farmers can avoid paying for at market rates

Future work on this thesis involves the inclusion of variables within these assumptions. The current assumption of $5000 for 1ML of water will not be feasible as this price is only exhibited when the water markets are constrained by the effects of droughts localised in a few areas. Whilst general consumers pay in a major city pay around $2.08 a kL ($2080/ML), farmers and companies generally pay significantly less. The values for the Economic Benefits are calculated through Table C4.1.

From Table C4.2, we can observe that none of the schemes analysed will provide a positive NPV ratio between costs and water provided in dollar value. This is inline with comparative studies on other current infrastructure initiated by the Australian government. For example, the Rookwood Weir currently under development has a Economic Benefit-Cost Ratio of 63%, showing the vast superiority of the large scale scheme. However, this assumption neglects the inclusion of the economic benefits of water as detailed in Table C3.1. Factoring that into consideration, as shown in table 4.5.2, we see that when the economic benefits are modelled, the large-scale schemes provide a net positive NPV, as well as, rain water harvesting.

Figure 4.5.1 NPV Comparison of Water Costs/Benefits for MAR

Figure 4.5.2 NPV Comparison between Small and Large Scale Water Relief Schemes

The net positive NPV nature of the large-scale scheme, compared to the small-scale schemes, is a direct resultant from the ability for the large-scale scheme to provide water to more profitable sectors, such as mining and manufacturing. Both, evaporation reduction and grey water harvesting have net negative NPVs due to their relatively high associated costs. The only outlier is rain water harvesting, as it has relatively low costs, it’s Economic-Cost Ratio is vastly superior.

The major drawback of this analysis is the reliance on the government provided assumption of $50/ML. As shown below in the NPV comparison between water costs and benefits for the MAR scheme, when the price of water rises above $380, the NPV of the project will be net negative. It can also be concluded that all schemes are net positive when including the economic benefits of additional water.

A further consideration enhancing the value of groundwater is its great potential to grow over time. It is likely that both the use values and the value of production supported will increase substantially over time due to several factors, most notably:  There is available capacity to increase the resource use, evidenced by the sustainable yield of groundwater being substantially higher than the current use volume.  Increasing future water demand at a time of surface water resources already being scarce and, in some cases, over allocated. Expected increase in economic activity in areas where there are ample groundwater resources, especially in northern Australia. Groundwater will be important to the future economic growth of such areas because of insufficient or unreliable surface water, itself a function of either low or seasonal rainfall and a lack of suitable dam sites. A final consideration relevant to the future value of groundwater is that much of it is a renewable resource, so long as use remains below the sustainable yield. The exception to this is, of course, fossil water which takes many years to accumulate in aquifers and is therefore not quickly replenished. The renewable proportion of groundwater, however, can continue to add economic value on a perpetual basis, unlike many of the non-renewable natural resources that the economy also depends upon.

From an economic point of view, the large and small water relief schemes are both viable options as projects that the Australian Government can initiate. They are in line with expectations of current projects under construction or consideration, as it is standard for the government to undertake negative NPV projects for the good of the population. The large water relief scheme is, on a statistical level, a better choice over the small scheme due to the fact that the additional water provided can be used in significantly more sectors which provide a better return on value, for example, the mining and industrial industry.

Interestingly, the small-scale scheme achieves a better NPV when the cost of water rises significantly, showing that these projects are better suited during times of low water availability and higher associated costs of water. This is in line with current government subsidies and grants during droughts. However, as the deployment of grey water recycling and evaporation reduction techniques are relatively low compared to rain water harvesting, more attention and knowledge should be provided to farmers and the government for these alternatives.

Figure 4.4.1 Comparison of Small Scale Scheme vs Large Scale Scheme

From the above graph, we conducted a Net Present Value (NPV) analysis of a large-scale scheme and compared it with small scale schemes expanded to the same cost. It shows that under general conditions, where water prices are less than $150, it is beneficial for societies to build large infrastructure.

If the current government water policies remain, where profits are more important than socio-economic benefits, then we will continue to see increased water prices over the future.


Negatives of this review:

This review assumes that money will solve all issues.

5. The Real Cost of Water

Estimating the cost of water involves a dissection of multiple factors, including plumbing infrastructure and location of water source. For the simplicity of this thesis, we will analyse

6. Conclusion

Through this analysis, we can show that there is a lack of economic justification for current water pricing and policy. It only removes profits from urban and rural consumers, restrict increased supply through investment in new infrastructure and will, inadvertently, push up private and public living costs.

I asset that water pricing and policy is not determined by realistic economics but merely another form of taxation, created through a lack of water infrastructure.

7. Future Work

It is important to realise that there are flaws in the assumptions and the following research will be finalised in the weeks to come:

  • Scarcity Pricing
  • Opportunity Cost of Water
  • Costs of Restoring Water

8. References

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