Guidelines for the Costing and Pricing Of Retail Water Services Provided by South Australian Councils July 2015

Transcription

1 Guidelines for the Costing and Pricing Of Retail Water Services Provided by South Australian Councils July 2015 ECM

2 Contents Background... 3 Introduction... 3 Purpose of these guidelines... 4 Pricing Principles... 5 Pricing Policy... 9 Criteria for Differential Pricing Customer Criteria Infrastructure Criteria Other Benefits Cost Implications for Differential Pricing Costing for Internal Use The Cost of Risk Conducting a Cost Benefit Analysis Includable and Excludable Costs Economies of Scale Appendix A Applicable Legislation, Principles and Guidelines Prepared by: David Hope Principal Consultant Skilmar Systems Pty. Ltd. Office: 20 Katoomba Road BEAUMONT SA 5066 Phone: Mobile: david@skilmar.com.au July 2015 Page 2 of 19

3 Background In 2012 the Local Government Association (LGA) commissioned a report on Councils and Stormwater Harvesting 1. The report recommended, inter alia, [t]hat the LGA commission a report on the methodology for the pricing of harvested stormwater for internal use by Councils and for sale to other parties. Given the need for compliance with Essential Services Commission of South Australia (ESCOSA) requirements in relation to pricing for Community Wastewater Management Scheme (CWMS) the report also include pricing for those services and the sale of treated effluent. In December 2013 (revised January 2015) the LGA released Costing Principles for Local Government 2 which provided broad advice on the costing of services and included examples which specifically related to CWMS activities. NOTE: This guideline has been prepared to provide complementary material to the LGA document Costing Principles for Local Government. They should both be read and used in conjunction with one another as this guideline specifically addresses the issue of a methodology for the pricing of retail water services under the Water Industry Act 2012 only. Councils should take into account pricing frameworks established by the State Government as per Costing Principles for Local Government. Introduction The provision of water retail services in South Australia is licenced and regulated by ESCOSA. Licence categories are defined as follows: Major retailer Intermediate retailer Minor retailer A retailer which provides retail services to over 50,000 connections A retailer which provides services to more than 500 and up to and including 50,000 connections A retailer which provides services to up to and including 500 connections All current licences provided to Councils in South Australia are in the categories of minor or intermediate retailer. As well as the power to licence water retailers ESCOSA has the power to regulate economic aspects of the water retail industry in South Australia, in particular the setting of prices and the regulation of price fixing factors. For the period up until 30 June 2017 ESCOSA has stated that it will be a light handed approach to the regulation of minor and intermediate retailers by using a combination of pricing principles and a price monitoring framework. To this end ESCOSA has issued Water Industry Guideline No. 3 entitled Water Regulatory Information Requirements for Minor and Intermediate Retailers. It has recently been revised and re-issued as a third edition (WG3/04) 3 in August The guideline sets out the financial, performance and pricing reporting requirements for retailers. The guideline is 1 LGA (2012), Report on Councils and Stormwater Harvesting, 2 LGA (2013), Costing Principles for Local Government, 3 Essential Services Commission of South Australia (2014), Water Regulatory Information Requirements for Minor and Intermediate Retailers Water Industry Guideline No. 3 (WG3/04) InformationRequirementsGuidelineNo3-MinorIntermediateRetailers-WG3_04.pdf July 2015 Page 3 of 19

4 accompanied by an Explanatory Memorandum 4 which provides a plain English explanation of the guideline. Water Industry Guideline No. 3 requires Councils to, among other things: Maintain specific accounting records and to prepare financial information based on specific principles. Part B of WG3/04 sets out principles and information requirements and Schedule 1 to Part B sets out the financial reporting pro formas to be completed by Councils. The financial information is required to be provided to ESCOSA within five months of the end of each financial year (refer clause of WG3/04) Monitor and report on service performance as set out in Part C of WG3/04 by 30 November each year Provide information on prices and pricing policy including a pricing policy questionnaire, a pricing schedule and a pricing policy statement by 30 November each year as required by Part D of WG3/04. The pricing schedule needs to include current year and previous year prices and the percentage change in the prices. Note that the policy statement and pricing schedule are required to be on a Council s website in the same timeframe. The guideline, although subject to amendment by ESCOSA at its discretion, effectively provides a transitional environment for the period up to 30 June 2017 to allow Councils to move from their current pricing regime to one in line with the National Water Initiative Principles. Clearly, the response and compliance of South Australian Councils to the development and the provision of the information requested in Water Industry Guideline No. 3 will have some impact on the regulatory regime to apply after 30 June Councils need to fully comply with the regulatory regime to encourage ESCOSA to continue the existing light-handed approach. Purpose of these guidelines The purpose of these guidelines is to provide South Australian Councils with a framework for setting prices for the supply of recycled water. This includes some additional information relating to the costing of the operations and infrastructure used to provide the water not specifically covered in the LGA s Costing Principles for Local Government. (Note: the term recycled water used throughout this document refers to water sourced from sewerage systems and water sourced through stormwater reuse.) 4 Essential Services Commission of South Australia (2014), Water Regulatory Information Requirements for Minor and Intermediate Retailers Water Industry Guideline No. 3 (WG3/03) Explanatory Memorandum July 2015 Page 4 of 19

5 Pricing Principles The key driver of the principles for the pricing of recycled water is the National Water Initiative (NWI) Pricing Principles. 5 These principles have been developed to help jurisdictions meet their obligation under the NWI Agreement. It is important in some cases when interpreting the pricing principles, to revisit the objectives and principles of the NWI Agreement itself. Overarching objectives of the NWI include the promotion of economically efficient and sustainable use of water resources and water infrastructure assets, ensuring sufficient revenue streams to allow efficient delivery of the required services, and to give effect to the principle of user-pays and achieve pricing transparency. Note that the pricing principles for recycled water state that the principles have been prepared to assist states and territories in meeting their commitments to paragraph 66 (ii) of the NWI. This paragraph makes reference to congruency with pricing policies for potable water (which have a strong emphasis on cost recovery principles (see principles 1 and 3) and efficient water use. There are nine pricing principles for recycled water. They are set out in the following table along with comments to aid understanding. It should be noted by Councils that these principles underpin ESCOSA s approach. Principles Principle 1: Flexible regulation. Light handed and flexible regulation (including use of pricing principles) is preferable, as it is generally more cost-efficient than formal regulation. However, formal regulation (e.g. establishing maximum prices and revenue caps to address problems arising from market power) should be employed where it will improve economic efficiency. Principle 2: Cost allocation. When allocating costs, a beneficiary pays approach typically including direct user pay contributions should be the starting point, with specific cost share across beneficiaries based on the scheme s drivers (and other characteristics of the recycled water/stormwater reuse scheme). Principle 3: Water usage charge. Prices to contain a water usage (i.e. volumetric) charge. Comment The current regulatory regime for minor and intermediate water retailers in SA features a combination of pricing principles and a price monitoring framework. This will be the case until 30 June The regulatory regime after that date will depend on how Councils apply the pricing principles, respond to the price monitoring framework and develop an appropriate and equitable pricing policy. Two examples on page 7 demonstrate that care needs to be exercised to identify who the beneficiaries are and what portion of the costs should be borne by each beneficiary. Volumetric charges based on a metered approach provide a mechanism to ration a scarce resource. However, it is important to assess the cost of metering and ensure that the benefits from metering outweigh the costs. See example below. In the discussions and consultation by ESCOSA on the potential for a Water Metering Code ESCOSA made it clear that the cost of metering must be considered in the metering decision. 5 National Water Initiative (2010), National Water Initiative Pricing Principles July 2015 Page 5 of 19

6 Principle 4: Substitutes. Regard to the price of substitutes (potable water and raw water) may be necessary when setting the upper bound of a price band. Principle 5: Differential pricing. Pricing structures should be able to reflect differentiation in the quality or reliability of water supply. Principle 6: Integrated water resource planning. Where appropriate, pricing should reflect the role of recycled water as part of an integrated water resource planning (IWRP) system. Principle 7: Cost recovery. Prices should recover efficient, full direct costs with system-wide incremental costs (adjusted for avoided costs and externalities) as the lower limit, and the lesser of stand alone costs and willingness to pay (WTP) as the upper limit. Any full cost recovery gap should be recovered with reference to all beneficiaries of the avoided costs and externalities. Subsidies and Community Service Obligation (CSO) payments should be reviewed periodically and, where appropriate, reduced over time. Notes: Direct costs include any joint/common costs that a scheme imposes, as well as separable capital, operating and administrative costs. This definition of direct costs does not include externalities and avoided costs. Principle 8: Transparency. Prices should be transparent, understandable to users and published to assist efficient choices. Principle 9: Gradual approach. Prices should be appropriate for adopting a strategy of gradualism to allow consumer education and time for the community to adapt. In any market it is important to assess the price of other products a consumer might purchase as an alternative to the product offered. Competitive market forces can impact on the price consumers are prepared to pay for recycled water. Recycled water can be treated to lower or higher standards and the price of the water should reflect the different costs of different levels of treatment. Pricing of recycled water should be such that it enhances the likelihood that the objectives of an integrated water resource planning system will be achieved. Alternative water supply options should be utilised to balance demand and supply for water, while minimising systemwide costs. Sources of water for an integrated water system should be carefully considered with regard to the costs and benefits for consumers and the optimisation of water supplies at the lowest sustainable cost. The LGA s Costing Principles for Local Government provide guidance on determining the full cost 6 of providing a service. The lower limit of a price should be the marginal cost of providing the service, i.e. the cost to produce an extra kilolitre of recycled water and the upper limit determined by the lesser of full cost of producing a kilolitre of water or by what consumers are willing to pay. The aim should be that the price each consumer should pay reflects the full cost of providing the service, but this will only be achieved by the reduction and elimination, over time (wherever possible) of subsidies and CSO s. CSO s should be met by Council not the water reuse scheme. Note that the cost must be net of any avoided costs, i.e. the costs of avoided wastewater treatment disposal costs. The pricing schedule and pricing policies should be freely available and published on a Council s website. Pricing policies and prices can be adjusted over time to achieve full cost recovery as the community becomes aware of the benefits of water reuse, the need to ration a scarce resource and the avoidance of restrictions on demand. 6 The term full cost is not specifically defined in the Costing Principles for Local Government document although reference is made to the definition of full cost attribution in the Local Government (Financial Management) Regulations For the purposes of this guideline the full cost of a good or service is defined as all of the direct and indirect costs that are consumed by the good or service. Indirect costs should be allocated on a consistent basis and there needs to be some reasonable basis for their allocation. Costs include depreciation and the cost of capital. July 2015 Page 6 of 19

7 Beneficiary Pays Approach Example 1 The District Council of Mount Barker operates a CWMS. This generates a large volume of effluent and there is a cost to providing a disposal path for this effluent. The Council has chosen to initiate a water reuse scheme as a strategy to dispose of the effluent. The CWMS is the beneficiary of the portion of the costs of the water reuse scheme that reflect the disposal path for the effluent and it is appropriate that the CWMS bear those costs. Comment: If the disposal path for effluent from a CWMS scheme was to construct a pipeline, settling pond, treatment station and then pump the treated effluent into a watercourse (with the relevant approvals) then those costs belong to the CWMS scheme even if what is actually constructed is part of the water reuse scheme. They represent costs avoided by the water reuse scheme. Beneficiary Pays Approach Example 2 The City of Charles Sturt has embarked on a major project - Waterproofing the West to reduce the impact of localised flooding, improve stormwater management and provide for the reuse of treated stormwater. Council has made a careful assessment of the infrastructure being employed in the project to ensure that the infrastructure costs are correctly allocated on the basis that where the beneficiary of the assets is better stormwater management and a reduction in localised flooding then the cost of those assets belongs to that part of the project. Only those assets that contribute to water reuse form part of the cost basis for reused water. Comment: In any project that has more than one objective some of the infrastructure costs will clearly be attributable to one or other of the objectives. However, there will also be elements of the infrastructure that meets more than one objective. There needs to be some reasonable and defensible basis for allocating these costs across the different objectives. Note: ESCOSA has dealt with this issue at some length in Section 7.6 of its Final Decision (June 2013) on the Economic Regulation of Minor and Intermediate Retailers. 7 7 Essential Services Commission of South Australia (2013), Economic Regulation of Minor and Intermediate Retailers of Water and Sewerage Services: Final Decision June July 2015 Page 7 of 19

8 Water Usage Charge Example The City of Salisbury has determined that where residential properties are constructed on small allotments (up to 300m²) then the volume of recycled water used is so low that it has little impact on demand for the water reuse scheme and does not justify the cost of installing and reading meters to calculate a volumetric charge. Council applies a fixed charge for recycled water, based on whether the supply is for the outside of the dwelling only or both inside and outside the dwelling. Comment: As noted above, ESCOSA has effectively endorsed this approach in considerations for a Water Metering Code, making it clear that the costs and benefits of metering must be considered. ESCOSA has explicitly stated in Section 7.3 of its Final Decision on Economic Regulation of Intermediate Retailers that it proposes to allow recycled water and stormwater retailers to not apply a user charge if it is not cost effective to do so. 8 Differential Pricing Example The District Council of Mount Barker categorises its recycled water supply as primary water taken before processing and, tertiary water taken after treatment. It applies differential charging for the water based on the reduced cost of providing untreated water. Comment: Different pricing approaches may be applied to different customers see below for guidance on differential pricing. Importantly, care must be taken to ensure that appropriate calculations are made to ensure that cost recovery is equitable. ESCOSA has provided some guidance to Councils on how it will apply the pricing principles to retail services of reused water. In Section 7.1 of its Final Decision (June 2013) on the Economic Regulation of Minor and Intermediate Retailers it makes the following key points: 9 There will be appropriate transitional arrangements to provide time to retailers to meet their obligations. The consistent application of all of the NWI principles may require some trade-offs as there appears to be some competition between the various principles. The principles should not minimise the ability of a retailer to enter into contractual obligations, provided the long-term interests of all customers are considered. 8 As for Footnote 8 9 As for Footnote 8 July 2015 Page 8 of 19

9 For the information of Councils the pricing determination for Minor and Intermediate Retailers of Recycled Water and Stormwater Retail Services as set out in Section 7 is: 10 Final Decision The Commission s final decision is to require Minor and Intermediate Retailers to apply all of the NWI Pricing Principles for recycled water and stormwater to their recycled water and stormwater pricing during the first price determination period. The following points are of particular note to the pricing of recycled water and stormwater by Minor and Intermediate Retailers: Minor and Intermediate Retailers must be transparent in disclosing their prices for all recycled water and stormwater services, the costs that make up prices, and any subsidies applied; Minor and Intermediate Retailers will have flexibility in whether to apply usage charges, where it is not economical to do so; Benchmarking prices for recycled water and stormwater to substitutes is acceptable, but Minor and Intermediate Retailers must ensure this does not result in significant under or over-recovery of scheme costs; Minor and Intermediate Retailers are expected to use a primary beneficiaries approach when allocating costs between recycled water and sewerage customers; and Minor and Intermediate Retailers' recycled water and stormwater pricing practices will transition gradually to compliance with the NWI Pricing Principles. 11 Pricing Policy It is important that the provision of retail water services is covered by a policy framework. The development and application of a policy framework has a number of benefits. It provides: Consistent understanding by employees of the basis for pricing; Consistent and equitable application of pricing principles to customers; Sound basis for negotiating discounts and rebates; and Provides transparency for customers and ratepayers. The aim of an effective pricing policy is to ensure that, wherever possible, a Local Government recovers the full cost of providing recycled water to consumers, that cross subsidies within the water business are avoided and that, generally, ratepayers do not subsidise the retail water business. Where the retail water business is subsidised it should be transparent to ratepayers what the level of subsidy is and what benefits accrue to ratepayers from the subsidy. Under that broad aim there is scope for a range of prices to be applied, dependent on a number of considerations. 10 As for Footnote 8 11 As for Footnote 8 July 2015 Page 9 of 19

10 A typical pricing policy might cover: Overview purpose of policy, scarce resource, current and future operations; Water supply expected supply volumes, peak and off-peak supply, demand management; Pricing issues base price, criteria for rebates, special category pricing (e.g. unmetered properties), individual contracts; Annual review; and Pricing schedule. Setting a Base Price The District Council of Mount Barker s pricing policy sets a base price for recycled water and this is the price that consumers can expect to pay for supply. However, the pricing policy also allows for rebates of up to 80% of the base price based on a range of factors set out under the heading Criteria for Rebates in Council s policy. The policy is further amplified where it is made clear that customers who have negotiated a net price (base price less rebate %) based on a particular demand level will be required to pay the base price for recycled water if they use more than 5% greater than the negotiated demand level. This amplification reinforces that water is a scarce resource. Criteria for Differential Pricing Generally, all customers should pay the cost reflective price (full cost) for recycled water. However, there is a range of criteria that can be assessed and included in considerations for differential pricing. They come under the broad headings of customer, infrastructure and other. There needs to be clear and transparent rules around each of the criteria on the nature and size of discounts/rebates, their timing and their longevity. In addition, there needs to be a level of overall consistency in the application of discounts and rebates. Rebates and discounts should be explicitly considered by Council. Wherever possible, non-commercial rebates or discounts should be provided by Council, not from the retail water scheme. As mentioned in the comments on Principle 5 of the NWI the quality of recycled water and the reliability of supply are also criteria for differential pricing. Customer Criteria Foundation customer customers who were instrumental in the scheme s early days and who may have received significant discounts to attract them to the scheme may warrant some continuation of a discount. There may be a contractual basis for continuing discounts. Significant customer customers who have significant demand for water may seek volume discounts and it may be in the interests of the overall scheme to encourage high volume users. July 2015 Page 10 of 19

11 Customers committing to long term contracts - a long term contract may provide stability and certainty for the continued development of the scheme. Nature of the customer other governments, non-government organisations and community groups may be considered for a rebate based on their not-for-profit status though, as mentioned above, such rebates should be provided by Council and not from the retail water scheme Cross Council boundary sales to another Council there might be a range of issues that affect the price of sales to another Council such as avoided duplication of infrastructure, availability of recycled water and existing recycled water price structure in the other Council. Bulk Water Supply involving a 3rd Party Distributor/Retailer In instances where Council provides only part of the full water supply service, such as the bulk supply of recycled water to a customer who then acts as the distributor/retailer of that water to a residential consumer, then a discounted price may be appropriate to reflect the level of service actually provided by the Council. Infrastructure Criteria Infrastructure built by the customer and retained in customer s ownership which provides capacity for other potential customers to be supplied consideration can be given to the avoided maintenance cost of the infrastructure and avoided capital cost of the trunk reticulation facility. Infrastructure built by the customer and donated to Council which provides capacity for other potential customers to be supplied - consideration can be given to the avoided capital cost of the trunk reticulation facility. Infrastructure built by the Customer to enable use of recycled water where the customer needs to construct infrastructure (e.g. recycled water storage facilities) on their property a discount/rebate may be provided to allow the customer to recoup the investment in recycled water infrastructure. Infrastructure built/funded by the Customer and donated to Council Prospective customers may be willing to contribute to the construction of Council infrastructure (such as reticulation mains) in order to connect to the recycled water network. A discount or rebate may be required in order for the customer to get a payback on this investment. Additional infrastructure provided by Council to deliver water to the site such additional costs may be considered for a surcharge to the customer. July 2015 Page 11 of 19

12 Other Benefits Social/Environmental/Economic Where such benefits will accrue to Council and its community then this could form the basis for a discount/rebate. The benefits should be well-documented and the impact of the benefits carefully considered in determining the level of discount/rebate. There should be a consistent framework applied over time to the consideration and application of discounts/rebates. Off Peak Supply of Recycled Water In some areas serviced by Council, peak demands on recycled water may push the system to its limits. A rebated price for offpeak water could be used as a mechanism to migrate customer water usage out of peak times. Cost Implications for Differential Pricing It is critical that Council has a clear and deep knowledge of every element of the cost structure of its water retail business. It will be difficult to negotiate with customers on the retail price unless the implications of the negotiated price vis-à-vis the cost of supply is well understood. The following figure below identifies the price-stack components: 4. Return on investment (including cost of capital - equity) 3. Depreciation and cost of capital - debt 2. Administration and other indirect costs 1. Direct costs - labour, material, energy, chemicals, etc. Each element of the costing stack reflects a different level of costs as well as a potential pricing point. 12 Level 1 represents the direct costs of operating the recycled water service labour costs (including direct labour overheads), energy costs, material, chemical and other direct costs. These are the costs which immediately increase with greater volumes of recycled water being supplied and they are known as short-run marginal costs (SRMC) because, in the short run, they are they only costs that change (though not necessarily every item of direct costs as some may be fixed for a broad range of output) with changes in volumes of 12 Note: For further information on costs and costing refer to the LGA s Costing Principles for Local Government, paper which can be accessed at July 2015 Page 12 of 19

13 recycled water supplied. From a pricing perspective SRMC could be used to price a temporary, one-off or short term (one year or less) supply of recycled water to a new customer, but the principle of cost reflective pricing should be applied wherever possible. Level 2 represents the indirect costs of operating the recycled water service administration costs, such as billing and collection of revenues, and other indirect costs, such as the costs of supervision and oversight. These costs are relatively stable, but are likely to increase as the business grows. Level 1 and 2 costs represent the costs to provide recycled water and service the customers and they are known as long-run marginal costs (LRMC) because in the long run they reflect the cost of providing recycled water, exclusive of depreciation and financing costs. From a pricing perspective, LRMC may represent the minimum price that long term customers should be charged. Level 3 represents, from an accounting perspective, the full cost of the assets employed in of the recycled water service by including depreciation costs and financing costs (the debt component of the cost of capital). 13 These costs are not likely to change significantly as the business grows unless additional infrastructure is required to provide the service or there is a change in real interest rates. Level 1, 2 and 3 costs represent the total cost of providing the recycled water service, from an accounting perspective, and they are known as long-run average costs (LRAC) because they reflect the average total cost to provide the recycled water service over time. From a pricing perspective LRAC should be the target costs to be recovered to provide, from an accounting perspective, for the full recovery of all costs of running the service. Level 4 represents, from an economic perspective, the full cost of providing the service by including a return on investment to Council from providing the recycled water service. Return on investment includes the equity component of the cost of capital, any allowance for risk not already included in expenses, governance costs and any accounting profit. Pricing which covers levels 1, 2, 3, and 4 returns the full economic cost of running the service to Council. It is important to distinguish between the economic concept of return on investment and the accounting concept of profit. Simply, profit, in the accounting sense, can be defined as the excess of revenues over expenses for a particular period. 14 The economic perspective of return on investment reflects the economist s view that it is the real or full economic cost of activity that needs to be considered against the investment in capital, whether through debt or equity (own funds), over the life of the project. This enables an assessment of whether the cost of the project is optimal compared to the opportunity to invest funds and receive a return from another project. 15 When negotiating with individual customers the price should normally cover at least the long run marginal cost (LRMC) as that covers all costs except for deprecation and cost of capital. However, there may be situations where an even lower price needs to be negotiated. In 13 The cost of capital comprises two components debt and equity. The debt component is the interest cost, averaged over time at the real interest rate, of any external financing (borrowings) undertaken for the service. The equity component relates to any financing provided from internal sources and represents the opportunity cost of those sources (investment interest foregone). 14 Profit is not necessarily simple to define or calculate and much of the effort of standard-setters has been to try and narrow down the definition so that all entities calculate profit similarly a somewhat difficult task! 15 Economists treat a reasonable return on investment (ROI) as a cost; accountants treat ROI as profit. Where the whole of a project is financed through debt there will be little difference (over time) between the economists' view and the accountants view of costs. July 2015 Page 13 of 19

14 those cases it is critical that the price negotiated is not less than the short run marginal cost (SRMC) the extra cost in delivering the extra volume of water (the incremental cost) - unless there are other indirect or strategic benefits from so doing or discounts or rebates for non-commercial reasons are being applied. Any price below the SRMC is adding to the costs of the water retail business. It is important to recognise that while it is necessary to achieve revenue that exceeds the long run average cost to provide a return to Council, the LRAC is very sensitive to volume. Depreciation is a significant cost component, if not the largest single cost component and is reasonably constant over the medium term. This means any additional sales at prices above the long run marginal cost (LRMC) provide a greater contribution to covering the depreciation expense and therefore towards covering the LRAC. The overall impact of discounts and rebates needs to be carefully assessed. Locking Council into long-term discounts and rebates may mean that there is the potential that the overall business does not achieve revenues to cover the long run average cost. The aim with discounts and rebates should be to reduce or eliminate them over time to minimise the impact on full cost recovery, but at a pace that meets business and customer objectives. In all of the considerations about price-setting it is important to consider what prices are in the market place. If the prices set are not competitive and there are substitutes in the market then sales prospects may be unfavourable. However, the NWI principles encourage the use of cost reflective pricing and this should be the baseline for considering the development of a water retail business. Initially it was considered that the supply of recycled water was a user charge and not caught by Section 155 of the Local Government Act in relation to service rates and charges. The LGA received legal advice (April 2015) that indicates that the provision of a retail water service clearly falls within the ambit of Section 155. Section 155(5) states: (5) A Council must not seek to recover in relation to a prescribed service an amount by way of service rate, annual service charge, or a combination of both exceeding the cost to the Council of establishing, operating, maintaining, improving and replacing (including by future capital works and including so as to take into account the depreciation of any assets) the service in its area (being a cost determined taking into account or applying any principle or requirement prescribed by the regulations). This enables a Council to recover the full economic cost of providing the service and to cover the cost of future capital works through the fee charged. However, Section 155 (5a) provides that if ESCOSA has made a determination under another act that is inconsistent with the principles set out in Section 155(5) then the ESCOSA determination will prevail. It should be noted that ESCOSA has made a price determination for recycled water and stormwater retail services see the section on Pricing Principles on page 5. The discussion in the Final Decision relating to pricing mentions profit and ESCOSA s industry consultation has always stated that making a profit is acceptable, although the price determination does not use the word "profit". The base price for water should be set to recover the long run average cost (LRAC) and a return on investment (ROI). This price recovers the full economic cost of providing the recycled water, (including any reasonable profit on equity in an accounting sense). July 2015 Page 14 of 19

15 Important Note: The classification of user charges for reused water as a service rate or charge under Section 155 of the Local Government Act requires that the declaration of the charge must be published in the SA Government Gazette and a newspaper circulating in the Council area within 21 days of the charge being declared as required by Section 170 of the Act. Costing for Internal Use While it is not essential Council s pricing policy sets out the price Council will be notionally charging itself for recycled water Council should have made a policy decision on its internal pricing policy which effectively considers the issues set out in this paper. It is important that Council considers the impact of its pricing decision for internal supply of water on the water reuse business and the equity of that pricing decision on the other customers of the scheme, e.g. it would be inappropriate for Council to take the water without charge. The Cost of Risk A key element of any activity undertaken by a Council is the management of risk associated with the particular activity. Risk management is the process of identifying, analysing, evaluating and treating risk. Risk management should be a key element of the information used to evaluate the costs and benefits of running a water recycling business. The on-going cost to treat risks should be part of the costs of running the water recycling business and included in the considerations on pricing of water. Typically, the cost of risk includes, but is not limited to: Insurance of elements of the water recycling business; Additional infrastructure to minimise the likelihood of adverse events occurring; Inspection and testing regimes; and Where residual risk has been accepted, the cost of responding to adverse events. Note that the cost of risk should be a consideration in pricing the cost of recycled water. It may be reflected in a higher return on investment, particularly where risks are evident but not readily quantifiable. Conducting a Cost Benefit Analysis 1. Identify and specify objectives and policy alternatives. Before embarking on the creation of a water recycling service it is critical that the costs and benefits of providing such a service are carefully assessed. Simplistically, determining whether the benefits exceed the costs is a key element of such an analysis. However, in the public sector environment the issues are more complex. Typically, a cost benefit analysis should cover the following points. What is the issue? What are the available methods to address the issue? What are the constraints in relation to each potential solution? In the case of water reuse the issue could be what to do with effluent from a CWMS or the increasing cost of water to Council or promoting economic development or some other reason. It is important to fully identify the reason or reasons that underlie the objectives and fully canvass the alternative policy alternatives as this will provide a sound basis for the analysis. July 2015 Page 15 of 19

16 2. Determine standing. What or whose costs and benefits should be included in the analysis? The relevant costs and benefits should be determinable from the objectives and policy alternatives considered. For example, if the objective is to solve a problem with the disposal of effluent from a CWMS scheme then it is likely that the cost of the disposal path belongs to the CWMS scheme, not to the recycled water scheme. However, it may be that the solution to dispose of the effluent through a water reuse scheme is not the optimal disposal solution and the question would then arise of what portion of the costs and benefits are attributable between the CWMS and the water reuse scheme. 3. Identify and catalogue the impacts of the project and its alternatives. What are the costs and benefits of the project? Costs and benefits should be classified as either direct or indirect and tangible or intangible. a. Direct costs and benefits (primary) are those which are directly related to the objectives of the project e.g. disposal of effluent, reduced cost of water; indirect costs and benefits (secondary) are those that are incidental to the project e.g. greater use of parks and gardens as a result of greening. b. Tangible costs and benefits are those which have a monetary value or to which a monetary value can be readily assigned or determined from market prices or some generally accepted basis for quantifying; intangible costs and benefits are those which generally cannot be readily assigned a monetary value. 4. Determine the timeline of the costs and benefits. The cash flows associated with the costs and benefits will occur at different times in the life of the project and it is important to understand when the cash flows will occur and to plot a timeline of the flows. 5. Estimate the monetary values of the costs and benefits. It is often easier to determine the likely costs of a project, in particular the capital costs. Quantifying the benefits is more challenging, particularly when there is a product to sell (recycled water) and the overall likelihood of sales volumes is difficult to determine. The market for recycled water is uncertain and subject to competition from other suppliers. It is further affected by the willingness to pay of potential customers which can have the effect of either reducing (or increasing) the likely revenue for sales. Potential customers may express a willingness to pay (stated preference) but this may not be the case when the scheme is up and running (revealed preference). All costs and benefits identified as tangible need to have a monetary value for the analysis. There is a school of thought that states that intangible benefits should also be assigned a monetary value. Should this approach be adopted there needs to be careful and complete explanation for the assignment of a monetary value. On the other hand, intangibles may be considered outside of the financial analysis and may involve significant political considerations in a public sector environment. July 2015 Page 16 of 19

17 6. Determine the net present value of the project and its alternatives. The timeline of the cash flow associated with the costs and benefits will show that the cash flows are irregular, occurring over varying time frames. Typically, benefits are likely to flow later than costs and there are often large expenditures early in a project s life. It is well established that there is a time preference by consumers for earlier rather than later enjoyment. To provide a better assessment of the costs and benefits of a project a discount rate needs to be applied to costs and benefits that occur later in the project. Determining the discount rate has been the subject of much discussion, as has the application of a single rate over very long projects. However, a discount rate needs to reflect the likely cost of funds over the life of the project and typically, rates such as the long term government bond rate or the average expected real rate of interest over the life of the project are used. Projects with a positive net present value or the alternative with the highest net present value provide the best outcomes for Council. 7. Allow for uncertainty. Estimating future costs and benefits is inherently uncertain. Often, the costs and benefits might spread across a particular range. For example, estimates of sales of recycled water for a particular project might range from 15 GL to 23 GL. Canvassing a range of opinions on the likely sales might provide the following: Sales of 15 GL likelihood 20% Sales of 19 GL likelihood 65% Sales of 23 GL likelihood 15% Using this information allows an expected value (EV) to be calculated as follows: EV = 15* * *0.15 EV = 17.3 GL 8. Perform a Sensitivity Analysis. Some of the assumptions or variables about the project will have more impact on the project costings than others. In other words, the project outcome may be sensitive to, perhaps, small changes in the quantum of the variable or assumption. It is important to try and identify which assumptions and variables have this characteristic and to highlight those assumptions and variables that have greater influence on the project outcomes to decision-makers. 9. Make a Recommendation. Based on the outcomes of the cost benefit analysis a suitable recommendation can be made to Council. The financial analysis should be accompanied by some assessment of the impact of intangible costs and benefits on the project. July 2015 Page 17 of 19

18 Includable and Excludable Costs What costs should be included in the cost benefit analysis, in pricing decisions and as part of the cost of the water recycling business? For the direct costs of the water recycling business - labour costs (including direct labour overheads), energy costs, material, chemical and other direct costs this is a relatively simple decision. For indirect costs, which are effectively an allocation of costs which apply to a range of Council services and activities, the decision on which costs, and what proportion, to include in the costs structure of the water recycling business is more challenging. Generally for an indirect cost to be allocated to the water business there needs to be a causal link between the indirect cost and the water recycling business. What this means is that the water recycling business causes the consumption of resources the cost of which is captured in the indirect cost item. For example, if Council s billing processes are used to bill customers of the water recycling business then that has caused the consumption of resources (labour, paper, envelopes, postage, computer time etc.) by the billing process which needs to be allocated to the water recycling business on some reasonable basis (the number of invoices processed as a proportion of total invoices processed, perhaps). It may not always be possible (or cost beneficial) to clearly establish the causal link or to allocate the costs on a reasoned basis and costs may be allocated on a more arbitrary basis but there must be some rationale to the allocation of indirect costs. If there is no causal link then, generally, the costs must be excluded. The issue of cost allocation is also dealt with, in relation to financial reporting, in Section 3.3 of ESCOSA s Water Industry Guideline No Economies of Scale Economies of scale occur where there is spare capacity within a business to provide additional volumes of supply without the need for increasing fixed costs. For example, Council may have the capacity to provide 20GL of recycled water per year with its current infrastructure but only be providing 10GL. It has the capacity to provide a further 10GL to customers without additional infrastructure costs. The acquisition of new customers using the additional water available has the potential to reduce the costs of water to all customers as administration costs, depreciation and cost of capital can be spread over more customers. Alternatively, Council can improve the return on its investment. From both a costing and pricing perspective it is important to consider the likely level of supply based on the current level of infrastructure and the potential for growing the customer base within the current infrastructure base. 16 Essential Services Commission of South Australia (2014), Water Regulatory Information Requirements for Minor and Intermediate Retailers Water Industry Guideline No. 3 (WG3/04) InformationRequirementsGuidelineNo3-MinorIntermediateRetailers-WG3_04.pdf July 2015 Page 18 of 19

19 Appendix A Applicable Legislation, Principles and Guidelines Legislation Essential Services Commission Act ACT%202002/CURRENT/ UN.PDF Essential Services Commission Regulations REGULATIONS%202004/CURRENT/ UN.PDF Water Industry Act NT/ UN.PDF Water Industry Regulations /CURRENT/ UN.PDF Principles National Water Initiative Pricing Principles 4e7633c151ed/files/nwi-pricing-principles.pdf Pricing principles for recycled water and stormwater reuse data/assets/pdf_file/0003/10965/waterlines_31_pricing_principl es.pdf Costing Principles for Local Government 0Government.pdf Guidelines Water Regulatory Information Requirements for Minor and Intermediate Retailers Water Industry Guideline No. 3 (WG3/04) InformationRequirementsGuidelineNo3-MinorIntermediateRetailers-WG3_04.pdf Water Regulatory Information Requirements for Minor and Intermediate Retailers Water Industry Guideline No. 3 (WG3/03) Explanatory Memorandum Minor_IntermediateRetailers-ExplanatoryMemo.pdf July 2015 Page 19 of 19