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Focus: Productivity Commission reports on Australia's urban water sector

12 May 2011

In brief: The Productivity Commission has recently released its Draft Report on Australia's urban water sector – the sector responsible for the provision of water, wastewater and stormwater services in metropolitan and regional urban areas. Partner Anna Collyer (view CV) and Senior Associate Kate Axup report.

How does it affect you?

  • The Productivity Commission's call for the alignment of supply augmentation decisions, pricing and conservation mechanisms with the common objective of delivering water services in an economically efficient manner, and for the assignment of responsibilities to the appropriate institutions, is likely to lead to regulatory and institutional reform in the urban water sector.
  • The Commission's critique of a one-size-fits-all approach to urban water management paves the way for increased diversity in the provision of water supply and disposal services.
  • The Commission's recommendations could provide opportunities for smaller scale augmentation projects and create incentives for the development of conservation technologies.
  • The Commission's proposal to limit the use of water restrictions to circumstances of force majeure and to enable customers to purchase different levels of service depending on their individual preferences and willingness to pay represents a significant shift away from the current management of supply and demand in the urban water sector.

Background

The state of Australia's urban water system is an issue of increasing significance for government, industry and households. The capacity of Australia's water systems to satisfy demand in urban areas has been tested by extended droughts, growing populations, ageing infrastructure and climate change.

In July 2010, the Federal Government directed the Productivity Commission to examine the case for microeconomic reform in the urban water sector, and to identify opportunities and options for efficiency gains in the structural, institutional, regulatory and other arrangements in the sector. The Commission was asked to propose a work program that prioritises areas where the greatest efficiency gains can be achieved and where early action is most practicable.

In carrying out its task, the Commission has been liaising with, and drawing upon the work of, other organisations which are also undertaking projects covering similar issues, such as the National Water Commission and CEDA (Committee for Economic Development of Australia).

Key findings and recommendations

The Draft Report presents a strong case for microeconomic reform.

The Productivity Commission found that conflicting objectives and unclear roles and responsibilities of institutions in the urban water sector have contributed to an inefficient allocation of water resources, inefficient investment, undue reliance on water restrictions and costly conservation programs. Significantly, the Commission notes that efficiency gains are most likely to come initially from improving the performance of institutions in relation to governance, regulation, procurement of supply and pricing, rather than by an attempt to create a competitive market (as exists in the energy sector).

The Productivity Commission's proposed reform program consists of two streams:

  • Stream 1 requires governments to set an overarching objective for utilities to deliver water, wastewater and stormwater services in an economically efficient manner so as to maximise the net benefits to the community. Stream 1 also includes the alignment of supply augmentation decisions, pricing and conservation mechanisms with this overarching policy objective and the assignment of responsibilities to the appropriate institutions.
  • Stream 2 calls for the consideration of structural reform on a case-by-case basis in metropolitan and regional urban areas.

The Productivity Commission assigns the highest priority to Stream 1 reforms on the basis that these reforms have the greatest scope for efficiency gains, can be accommodated within existing industry structures and are a necessary pre-requisite to any effective future structural reform efforts.

Within the framework of this broad work program, we set out below more detail on the draft findings and recommendations of the Productivity Commission with respect to supply augmentation, water restrictions and pricing and structural reform.

Supply augmentation

The Productivity Commission finds that the urban water sector is characterised by a high degree of political involvement, largely due to public perceptions of water as different from other utility services (ie electricity, gas, telecommunications and mail) as it is considered 'essential for life'. This politicisation has placed pressure on governments to take up objectives, policies and institutional arrangements unlike those adopted in other utility sectors.

The Draft Report highlights that consumers bear large costs as a result of inefficient resource allocation and investment decisions. The Productivity Commission notes that, as a result of the recent investment in large climate independent supply augmentation projects in most metropolitan areas, further major supply augmentations are not expected to be needed until the 2020s in some areas.

The Productivity Commission is particularly critical of state governments' 'overinvestment' in expensive desalination plants, stating that much of the recent investment in those projects could have been 'smaller in scale and from a source other than desalination, without jeopardising security of supply.'1

On a practical level, the Productivity Commission recommends that:

  • policy bans on water sources such as indirect potable re-use and rural-urban trade be put back on the table; and
  • responsibility for procurement decisions be given to retail-distribution utilities, on the basis that they understand the preferences of urban water consumers, are in a position to facilitate contestability for the provision of new water supplies and services, and are best placed (and have incentives) to manage the commercial risks of procurement.

Water restrictions

The prolonged use of water restrictions are strongly critiqued by the Productivity Commission. The Draft Report notes that, while generally well tolerated by consumers, water restrictions imposed by state governments are extremely costly in terms of loss of amenity and the lost value of consumption. In metropolitan areas, the Productivity Commission finds that water restrictions should only be invoked in emergency or force majeure circumstances where water shortages arise unexpectedly.

Similarly, the Productivity Commission criticises the imposition of mandatory water conservation measures and the use of subsidies, stating that such policies require the government to 'pick winners' in relation to water saving technologies. The Productivity Commission's position is that conservation measures (such as rainwater tanks, low-flow shower heads and water recycling schemes for non-potable uses) must be demonstrably justified by a careful cost-benefit analysis, and that this has not always occurred to date.

Water pricing

The Productivity Commission notes that approaches to water pricing differ across jurisdictions and, in some cases, within jurisdictions between metropolitan and regional urban areas. Despite these differences, the Draft Report calls for a significant overhaul of the current approach to water pricing.

At the bulk water pricing level, the Commission believes that more flexible pricing would facilitate better allocation of water resources and investment decisions, by ensuring that the price of water reflects its relative availability. In terms of retail pricing, while the Commission notes that consumer demand for water is not particularly responsive to changes in price, it sees merit in facilitating consumer choice in terms of service offerings, and considers that those with a preference to restrict their water usage should have the ability to do so on a voluntary basis. Conversely, consumers favouring increased water usage should have that entitlement, provided they are willing to pay.

At present, bulk water prices are set by governments or on a long-run marginal cost basis (LRMC). The Draft Report notes that LRMC prices are not flexible and encompass a price with a mark-up over the short-run marginal cost (SRMC) that is averaged out over time and fixed in all periods. According to the Commission, this can lead to inefficient outcomes in sectors where there is a high degree of uncertainty involved, such as the case with water sector reliance on rainfall. On the other hand, flexible pricing would allow the mark-up over SRMC to vary in line with changes in the supply-demand balance. Retail prices are essentially a pass-through to consumers of the price of each element along the supply chain, and generally include a two-part tariff, with both a volumetric and a fixed component.

The Productivity Commission calls for the introduction of a flexible pricing approach where prices would adjust to the supply-demand balance and, therefore, 'reflect the opportunity cost of water.'2 Under this proposed approach, retailers would be able to offer multiple tariffs, subject to the provision of a default two-part tariff in order to provide a degree of consumer protection.

According to the Draft Report, a major impediment to introducing more pricing flexibility is the regulated price setting environment that exists in most Australian jurisdictions. Here, the Commission goes further, recommending that state and territory governments move away from a system which regulates or sets water prices, to a system which instead monitors how utilities price water. Independent reviews could be conducted to determine whether utilities are abusing their market power. If misuse of market power is not established after five years, the Commission suggests that price monitoring should be replaced by a self-reporting regime. This suggested approach by the Commission represents a significant shift away from the standard approach to prices charged by monopoly service providers in Australia.

Structural reform

The Productivity Commission notes that structural reform can be an effective way to further facilitate competition in the sector. Specifically, structural reform can support competition if it involves vertical or horizontal separation.

In this light, the Commission examines structural urban water reforms implemented in Victoria and New South Wales. The Draft Report notes that, in each case, structural reform (which has often involved the corporatisation of utilities) delivered distinct outcomes in terms of the resulting vertical and horizontal industry structure, and in relation to the extent to which competitive approaches were subsequently used. The Draft Report notes that there is broad agreement that structural urban water reforms in metropolitan Sydney and metropolitan Melbourne and regional cities in Victoria have delivered considerable efficiency gains.

In recognising that there is not a one-size-fits-all solution to structural reform, the Commission identifies five options of potential benefit in metropolitan areas. Each option offers varying degrees of horizontal and vertical separation, with different opportunities for the facilitation of competition.

The first option involves a vertically integrated water utility, while option five proposes that supply and demand decisions be decentralised and coordinated using market prices. The remaining three options fall between these two extremes. The Commission sees particular merit in options two and three, stating that all state and territory governments should consider the merits of these options for large urban cities (to the extent that these reforms have not already been implemented).

Option two provides for the vertical separation of the bulk water supply function. In the Productivity Commission's opinion, this will facilitate contestability for the supply of bulk water services (supply, treatment, transfer and storage) as bulk water of different classes and from a variety of sources will compete on merit.

Option three extends vertical separation to wastewater treatment. The Commission considers that this would provide strong incentives for innovation by wastewater treatment service providers, including the production of recycled wastewater products.

Next steps

The Draft Report is open for public consultation. Written submissions are invited by 18 May 2011. The final report will be prepared after submissions have been received and public hearings held. It is anticipated that the final report will be forwarded to the Federal Government by 31 August 2011.

Footnotes
  1. Productivity Commission's Draft Report Australia's Urban Water Sector - Overview p xxv.
  2. Ibid. Ch. 7, Pricing of water and wastewater, p 154.

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