Why introduce urban water markets?

The ubiquitous use of restrictions, the introduction of IBTs and poor investment in infrastructure reflect significant shortcomings in the current regulatory and planning framework. There is clearly scope for reforms that would improve the performance of this industry. Central to any such reform of the water industry must be an implementation of an efficient volumetric rate for water.

In order to achieve an efficient (or least-cost) provision of urban water it is necessary for consumers to face an efficient volumetric rate. Allocative efficiency can only be guaranteed by having an efficient volumetric rate. This rate clears the market in each period and thus there is no need for costly water restrictions. An efficient volumetric rate must reflect not only the current availability but also the expected availability of water (Sibly 2006a). Australia’s erratic rainfall patterns mean that large storages are needed if cities are to be provided with water from surface water. The efficient volumetric rate generates an efficient inter-temporal allocation of water, and thus the optimal storage at each time. An efficient volumetric rate is also needed to assess the efficient type and timing of infrastructure investment.

Australian water markets are not likely to be static. Future climate variability and unexpected demographic changes will require frequent adjustments to the operations of urban water markets. As well as being subject to the distortions described above, the current arrangements do not exhibit sufficient flexibility to adapt efficiently to changing circumstances. The natural inclination of economists would be to introduce competitive markets for urban water. Competitive markets are (unlike the current arrangements) self-correcting mechanisms. They ensure that all market participants face to true costs and benefits of their actions, and thus provide market participants with appropriate incentives to develop innovations. A competitive market would be distanced from the political process, and therefore not subject to the distortions described above. However, a competitive market requires a substantial number of suppliers. The following section considers proposals about how this could be achieved.

It might be wondered whether the current arrangement of a regulated urban water monopoly overseen by a regulator could be modified to overcome the problems identified above. For instance, perhaps it is possible to enhance the independence of state-based regulators, and ensure they are distanced from political pressures. The independence from the political process of the Reserve Bank’s interest-rate decisions could be a model for this type of institution. Such a regulator would be charged with setting the optimal scarcity price for the monopoly supplier. No doubt this reform would result in an improved performance of urban water authorities.

However, there are limitations to the ability of regulation to enhance efficiency, even in the absence of political pressures on decision-making. Markets have the ability to aggregate decentralised, diffuse information in a way that regulators cannot. Regulated industries, particularly those facing price caps and rate-of-return regulation, have a poor incentive to innovate because they often cannot capture the full returns to their innovation. As noted above, the ability to respond flexibly to change is likely to be of increasing importance in providing urban water to Australian cities. Regulation is thus an inferior option to competition, provided competition is feasible. The question therefore becomes whether it is realistic to introduce a competitive market for water in Australia cities and, if so, how this is best done.