Date created: 3/5/07
Last modified:3/5/07
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John Quiggin

Cheap water's high costs

John Quiggin Australian Financial Review

28 September 2006

In most Australian cities, water restrictions have become a seemingly permanent fact of life. Populations are growing steadily, and with them the demand for water. At the same time, it is becoming increasingly evident that the hotter, drier weather we are experiencing in south-eastern Australia is not just another fluctuation around a stable long-term level of rainfall.

Rather, the evidence suggests that we are experiencing the onset of climate change driven by human activity, a trend which will inevitably continue for decades to come. A sensible water policy must start from the assumption that inflows of water to our main catchments will continue to decline.

In the short run, with the drought having caught us unawares, there is little alternative to restrictions. Yet as John Howard has observed, permanent water restrictions make no more sense than permanent electricity restrictions. Permanent restrictions are bound to lead to distortions, with some low-value uses of water escaping the restrictions while higher value uses are prohibited. In the long run, prices are the best mechanism to deal with scarcity.

A substantial increase in water prices is needed to get supply and demand back into balance. On the supply side, with most of the cheap water options exhausted, we need to look at alternatives such as recycling or desalination. These options are comparatively expensive, with typical costs of delivered water from $1.20 to $1.50 a kilolitre or more, depending on local circumstances.

On the demand side, sensible use of water will only be achieved in the long run if users pay a price that reflects the social cost of the water they use. For some people, uses that are currently restricted, such as watering gardens, may be worth $1.50 a kilolitre. In other cases household water users may be able to find water saving options, which could be as simple as changing guttering to direct flows onto gardens or into water tanks.

The big problem with raising water prices is the perception that since water is a basic necessity of life, an increase in its price must be bad for poor families. At current consumption levels, this view does not appear to be supported by the data, which suggests that household expenditure on water grows roughly in line with income. Nevertheless, at lower levels of consumption, water demand is probably inelastic.

Moreover, large increases in prices would involve transfers of wealth to owners of existing water infrastructure and water rights, without any necessity for additional investment. The problem, therefore is to increase the price of water at the margin, without greatly increasing total expenditure.

The preferred solution to this problem so far has involved increasing block tariffs, in which the cost of water increases. Although the idea is right, there are some big problems with the way it has been implemented. One problem is that the use of three or more blocks adds complexity, and potential inequity, but does not really improve the incentives generated by the pricing scheme relative to a two-price system. Variations in household circumstances are sufficiently great

A more important criticism is that the increasing block system discriminates against large households. Even without wasting water, a large household can easily find itself paying high prices.

There is a relatively simple way of resolving both problems. Instead of applying a multipart tariff to households, water could be supplied at a uniform price, equal to marginal cost of around $1.50 a kilolitre.

In place of a free or low cost initial block allocation to households, every person in the community could be given a free allocation of water, sufficient to meet basic needs for drinking, bathing, washing and so on. An allowance of 200 litres a week or around 75 kilolitres a year could be considered.

Such a scheme would raise some practical difficulties. It might also be inconsistent with the COAG approach to water pricing, which seeks to impose a cost-reflective connection charge. However, given that connection to the water supply is effectively compulsory, such a requirement makes little economic sense.

The water crisis is a political problem and requires a political solution. A pricing scheme that recognises the special status of water as a basic human need, while ensuring that effective prices are in line with economic and social costs, seems like a natural solution.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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