Can Urban Water Markets Work? An Optimistic View

Hugh Sibly[1]

Table of Contents

State of Play: Politicisation
Why introduce urban water markets?
Implementing urban water markets

Until recently there has been a common perception that urban water provision is a natural monopoly and, as such, must either be government-owned business, highly regulated, or both. Since the mid 1990s the urban water authorities have been run as a corporatised (state or local) government business, regulated by a state government regulator using traditional price caps and rate-of-return regulation.[2] However, it has become apparent over recent years that the urban water sector is not as efficient as it might be. Thus there has been a growing acceptance that there is some scope for the introduction of competitive urban water markets.

In their paper, Crase, O'Keefe and Dollery (2008) correctly observe that there are two catalysts for growing enthusiasm for the development of urban water markets: (i) success in rural water markets and (ii) success in other utility reforms. They focus on the former, and argue that the preconditions for success in the rural water markets are not present in the urban water sector. They thus present a somewhat pessimistic view of the prospects for urban water reform.

In contrast, this paper considers reform of the urban water sector from the point of view of ‘utility reform’. This is worth considering, in conjunction with Crase, O'Keefe and Dollery’s arguments, because all utilities are ‘network’ industries. For instance, the value chain in an urban water network is in many respects qualitatively similar to an electricity network (though clearly the technicalities of the engineering are very different). In particular, water (electricity) is supplied to consumers through a water network (grid) by a bulk water supplier (generator). Thus common issues arise, relating to the efficiency of their operation, across different types of utilities.

Because urban water is a network industry, an urban water market would look different from the existing rural water markets. In rural water markets, participants exchange their entitlements at a market-clearing price until they exhaust all gains to trade. Entitlements are diffuse and a participant’s role as either a buyer or seller may change across seasons. In the urban water sector there are a relatively small number of sources (which are always suppliers) supplying a large number of consumers (who are always buyers) connected by a common network. Nonetheless, in both rural and urban water sectors the efficient allocation of water can only occur if participants face an efficient price. It is agued below that urban water allocation in Australian cities is particularly inefficient because the current regulatory framework has not set the efficient price for water. Introducing competitive urban water markets represents the best option for establishing an efficient price and thereby an efficient (least-cost) urban water sector.

This paper therefore presents an optimistic view of the prospects for urban water reform. It does so by first arguing that the current performance of the urban sector is quite poor. Using this analysis, a case is made for the introduction of urban water markets in Australian cities. Some options for the introduction of competition into the urban water sector are then canvassed. The final section considers potential impediments to the proposals to implement urban water markets discussed earlier in the paper.

State of Play: Politicisation

When one asks whether urban water markets will work, one must also ask ‘work relative to what?’ The implicit assumption is often that the current ‘command and control’ regime is working satisfactorily. This is not the case. There are no commercial or management decisions made by water authorities that are not politicised. This has resulted in significant distortions of the urban water market in Australia.

There are three sources of distortion in Australian urban water provision. First, price signals for urban water are almost completely absent (Sibly 2006a). This absence is in spite of the fact that any increase in the volumetric rate would only increase the bills of high users. This is because a water authority’s charges are regulated so as to satisfy a revenue-raising requirement. Thus an increase in the volumetric rate should be accompanied by a corresponding reduction in the fixed charge. Equity issues could be addressed by providing rebates on the fixed charge for the disadvantaged.

The resultant price inflexibility results in rationing (‘water restrictions’) as a ubiquitous response to drought. Water restrictions cause a loss of allocative efficiency (see, for example, Sibly 2006b). The extent of this cost has only recently become apparent. Grafton and Ward (2008a) estimate the cost of water restrictions in Sydney, and find this is a little less than half the household water bill. This is consistent with Brennan et al.’s (2007) finding that households would pay between $374 and $870 per season to avoid water restrictions. Mansur and Olmstead (2007) estimate the efficiency loss from a two-day-per-week watering restriction used in 11 urban regions in the US and Canada. They found that this one restriction caused an efficiency loss equal to a quarter of the household’s water bill.[3] Thus, as setting a market-clearing price for water yields the same allocation as water trading, Crase, O'Keefe and Dollery’s view that “there are relatively modest welfare gains from trade between households per se” does not appear to be correct.[4]

Increasing block tariffs (IBTs) are the second distortion created by the politicisation of the urban water market. Instead of implementing an efficient (flexible) volumetric rate in response to the current drought, state regulators have implemented IBTs. While the implementation of IBTs is often portrayed as a ‘price response’ to the drought, they are better described as a political response to the drought. IBTs are easy to justify politically, because their implementation is aimed at ‘water hogs’. In Australia, the tiers of the IBTs are set so as to insulate the typical consumers from facing the cost of decreased availability of water. In fact, volumetric rates (at the margin) for most consumers have varied very little over the course of the drought. Hence, the implementation of IBTs give the illusion of a response to decreased availability without actually delivering the required increase in the volumetric rate to most consumers. Thus IBTs are a contributing source of the current allocative inefficiency in Australian urban water provision (Sibly 2006a). Recognition of the inefficiency of IBTs has caused the National Water Commission to call for their replacement with a flat ‘scarcity price’ of water (National Water Commission 2008).

The third distortion created under the current regime is the underinvestment, or inappropriate investment, in infrastructure. Urban water-infrastructure developments are highly controversial, being the subject of much ill-informed and ideological discussion. The resultant political decision-making is likely to be excessively risk averse. With such obstacles to planning infrastructure development, efficient projects are likely to be subject to costly delays or even replaced with less-efficient projects. There are many examples of this process. As a result of the Toowoomba referendum,[5] the relatively cheap recycling option was replaced by a relatively expensive option to build a 40km pipeline to pump water up from Wivenhoe Dam. The cost of this relatively expensive option will presumably be carried by the Queensland taxpayer rather than solely by those who voted for it. Similarly, following years of indecision on how best to augment the Sydney water supply, a decision to build a desalination plant was made in 2007. Grafton and Ward (2008b) have argued that the desalination plant under construction for Sydney could have been delayed for many years if flexible pricing had been used (an option which is apparently never considered when making such decisions). They estimate the expected cost of these inefficient policies to be more than $1 billion. Given these and other similar events, it is difficult to believe that the current planning regimes yield an optimal investment in urban water infrastructure.

[1] School of Economics and Finance, University of Tasmania,

[2] Water bills usually include a volumetric and fixed charge. Regulators set the fixed charge to ensure that a water authority makes a target rate of return.

[3] The efficiency loss is measured relative to the case in which price is used to curb demand by an equivalent amount.

[4] To realise these gains the institution framework must be one in which there are relatively low transaction costs. See the proposals below.

[5] In July 2006, a 62 per cent ‘No’ vote was recorded in the City of Toowoomba’s referendum on recycling ‘waste water’ (sewage) as drinking water.