Pannell Discussions

No. 41, 28 February 2005

Fresh water for Perth 3: myths and misconceptions

Policy makers attempting to address the "shortage" of water in Perth are in desperate need of some simple economics. Clear thinking about prices, costs, values and incentives would go a long way.

All over the world, responsible public water management is inhibited by public attitudes to water. Water is seen as:

•  too important

•  too fundamental

•  an intrinsic right

•  “free”

•  already committed

so reforms are extremely difficult. In 2000, the World Water Council said “There is a water crisis today. But the crisis is not about having too little water to satisfy our needs. It is a crisis of managing water so badly that billions of people - and the environment - suffer badly.” As a generalisation, and notwithstanding outrageous election promises (see PD#40), water is better managed in Australia than in many other countries, but there is still great scope for improvement.

Sound pricing is only one part of water management, but it is an important part. It is also politically challenging. “There are many ways to promote equity, efficiency and sustainability in the water sector and water pricing is probably the simplest conceptually, but it may be the most difficult to implement politically” (Rogers et al. 2002).

Part of the problem is the need to overcome a number of popular myths and misconceptions, as follows.

Water is not free

Yes, it falls from the sky, but getting it from where it lands to your tap can be an expensive business. Those expenses are relevant to the community's decisions about water and how best to provide it.

Water is not infinitely valuable

Of course if we had no water, the value of getting some water would be very high indeed. However, that is not our starting position. In considering proposals to provide additional water, the relevant value is the value of that additional water, not the value to someone dying of thirst in the desert.

No particular use of water is intrinsically superior to other uses

The relevant value of water used for consumption is what consumers are willing to pay for it. When it comes to water values, irrigation does not hold any trump cards. If a domestic consumer is willing to pay more for a kilolitre of water than an irrigator is, it reflects that the value of that water is higher in the domestic use. There is no basis for considering water use for irrigation to be intrinsically superior.

Pricing water is not immoral

Certainly water is important, but that is no reason to exempt it from sensible pricing. Indeed, if it is so important, why would it not be seen as immoral to give it away at a subsidised price? That runs the risk that it will be wasted on low-value uses, or the risk that viable opportunities to conserve water will not be taken up because it is cheaper just to buy more.

If you set the prices cleverly, you can create a situation where water consumers behave in a way that they do not wish to use more water than is available, and they maximise the overall value from water usage. In other words, when they consider the benefits and costs to them of a use of water, they make a decision that maximises the overall net benefits to the community. You achieve this by the simple means of setting the price equal to the relevant measure of the cost of the water (or by using markets to do so if that is feasible).

In addition to overcoming those myths and misconceptions, there are some insights that water managers need to grasp to make good pricing decisions for water. 

The relevant cost of water

If additional water infrastructure is not on the agenda, the relevant cost to use as the basis for pricing is the variable cost of delivering the water: the amount it costs the water utility to deliver the last kilolitre of water to your tap.

If attention is focused on developing additional water sources, sound pricing gets complicated by the need to consider costs of additional infrastructure. In considering whether additional infrastructure (e.g. a 3700 km canal) is worthwhile, we need to consider how consumers would respond if they were charged the full cost, including full costs involved in developing the infrastructure. We should do this because people's responses to higher prices is the best indication we have of the value of the extra water.

If we think that there would still be sufficient demand for water at that higher price, the benefits of the infrastructure would exceed the costs. We need to be careful about this because typically new water sources come in large lumps. (The mooted channel from the Kimberly to Perth would, it is claimed, provide 200 GL/year). There may be a worthwhile demand for say the first 50 GL, but not for the remaining 150 GL.

If additional infrastructure is actually built, you should probably use fixed charges (or tax revenues) to recover construction costs, rather than building them into the volumetric prices. The latter would result in people using less water than desirable/justified on a benefit-cost basis, given that a big portion of the infrastructure costs are sunk costs and unaffected by the future level of water consumption. You would still use a realistic variable cost as the minimum basis for pricing.

If it turns out that the additional infrastructure is not worth building, you can use pricing as a mechanism to reduce demand. This has a lot of advantages over the sorts of approaches typically used (education, subsidising water-efficient dishwaters!). For example, pricing affects all water users, not just socially responsible ones, it most affects those who use the most water, and it achieves water savings in the least-costly way for the community.

Consumers respond to marginal price, not average price

Western Australian domestic water consumers face a reasonably high average cost for water but a low marginal cost because about half the cost consists of fixed charges (i.e., charges that do not vary with water consumption). In a situation where water demand is outstripping supply, this represents a severely bad approach to water pricing, as it provides only a weak incentive for conservation. What creates an incentive to conserve is the price of the last kilolitre, not fixed costs that are unaffected by consumption. It would make more sense to set the fixed charge to zero and increase prices per kilolitre accordingly.

[Side comment: If there is water trading among irrigators, the price they respond to isn't necessarily the price they were charged for the water by the supplier. It could be the price they would get if they sold it (e.g. from one irrigator to another). The potential for water trading among irrigators reduces the problems from selling water very cheaply to irrigators, although the inability to trade between sectors (e.g. between irrigation and domestic) means that irrigators could still end up facing a market price that is significantly lower than the value of water in other uses.]

Recognising the different effects of marginal prices and fixed charges for water empowers the water supplier to do some innovative things. They could jack up marginal prices (to reduce demand) and compensate with reduced fixed charges (to reduce political resistance to the higher marginal prices) or they could even provide a fixed amount of free water, as they used to in WA . They would need to make sure that people did not expect compensation to be linked to current or future consumption, or that would defeat the purpose.  

Overall, the potential to use pricing for better water management is great, but largely untapped (sorry).

David Pannell, The University of Western Australia,

p.s. Reader Neil Barr was very interested in the proposed channel from the Kimberley 3700 km to Perth (see PD#40), and has been doing path-breaking research on the subject (involving an atlas and a ruler). He suggests that Adelaide is only a little further from the Kimberly than Perth is, and so an additional channel to Adelaide should be considered. Neil's detailed and fully costed feasibility study has identified a number of advantages from this approach. It would free Adelaide from reliance on the fast disappearing water resources of the Murray-Darling Basin, and would provide Western Australia with a good case for joining the Murray-Darling Basin Ministerial Council, which would be terrific fun. Neil is clearly a man of vision. So too is Alistair Watson who suggests a shorter pipeline from the Ord to Katherine in the Northern Territory, where the water could be loaded onto the new train to Adelaide, thereby combining two visionary infrastructure projects.

Further Reading

Rogers, P., de Silva, R. and Bhatia, R. (2002). Water is an economic good: How to use prices to promote equity, efficiency and sustainability, Water Policy 4: 1-17.

Pannell Discussions are brief pieces on issues and ideas in economics, science, the environment, natural resource management, politics, agriculture and whatever else.

40.  Fresh water for Perth 2  21 Feb 2005

42.  Research meets policy  7 Mar 2005

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