BENEFIT COST ANALYSIS OF WATER SUPPLY OPTIONS FOR QUEENSLAND GOVERNMENT DEPARTMENT OF WATER RESOURCES

Transcription

1 BENEFIT COST ANALYSIS OF WATER SUPPLY OPTIONS FOR QUEENSLAND GOVERNMENT DEPARTMENT OF WATER RESOURCES David Rodgers EXECUTIVE SUMMARY The Queensland Government Department of Water Resources is in the process of deciding between two projects, the Elizabeth River Dam Project and a desalination project involving the French company Aqua Vite, that are intended to meet increases in South East Queensland s urban water demand over the next quarter century. Benefit cost analysis indicates that the dam project represents the lower cost option for Queensland as a whole (comprising the Queensland Government & Queensland community), and for the Department of Water Resources budget. Both projects involve large environmental and social costs that will be borne by the Queensland community. The analysis suggests that the dam project involves larger costs of this type, although there is much uncertainty surrounding such costs in respect of both projects. If the desalination project were to be pursued, the commercial arrangement with Aqua Vite would need modification, as it does not currently offer a high enough return and involves too much risk, to be viable from their perspective. This may involve an increase in the price of water, an upfront subsidy, or some form of risk sharing by the State Government. There is also potential for financial support from the Commonwealth Government should the desalination project be selected, as it involves a significant increase in Commonwealth tax revenues. Extensive risk and sensitivity analysis based on the key inputs and external costs of the projects confirms the conclusion that the dam project is the lower cost option, however it reveals that the cost of each of the projects is highly variable. The conclusions in this report are heavily dependent upon rainfall and water demand assumptions, and are made independently of the benefits of the projects. These issues, and the external costs of the projects, warrant further investigation. Page 1

2 1. INTRODUCTION This report is intended to assist the Queensland Government Department of Water Resources ( DWR ) in a choice between two options to increase South East Queensland s urban water supply to meet forecast increases in demand over the next quarter century. The relevant forecast increase in demand is 6,000ML per annum each year from 2011 until The first proposal under consideration is the construction of a dam on the Elizabeth River during 2009 and 2010, which would satisfy additional demand up until 2024, at which stage the dam wall would be raised to meet the additional demand through to The second proposal is a commercial arrangement with a French company, Aqua Vite, under which it will construct four desalination plants between 2009 and 2028 and sell water to the DWR over the period until Aqua Vite s proposal requires the DWR to purchase the desalination plants at the end of The costs of maintaining the water supply from whichever project is selected during the period from 2035 to 2058 is also a significant consideration. The choice that the DWR ultimately makes is expected to be largely driven by the relative costs of the two projects to key stakeholders, namely the Queensland Government and the Queensland community, and to an extent the Commonwealth Government. Another important consideration is the return to Aqua Vite from the desalination project, as they have signalled that they will not undertake the project unless they receive at least a 9% real rate of return. 2. METHODOLOGY 2.1 Social Benefit Cost Analysis This report utilises the Campbell and Brown (2003) Social Benefit Cost Analysis methodology. This methodology analyses the benefits and costs of a project to both society as a whole and to discrete groups. The primary tool utilised to do this is discounted cash flow analysis which uses specified discount rates to compare streams of costs and benefits over time through conversion to net present values ( NPVs ). In accordance with directions from the DWR, NPVs in this report have been calculated at real discount rates of 4%, 6% and 8%. In this report NPVs are used primarily to consider the total costs of the two projects, with the Page 2

3 relevant decision rule being to select the project with the lowest value (relevant costs are expressed as positives in the analysis). This methodology entailed the construction of several different yet complementary analyses covering the two projects: Project Benefit Cost Analysis: This analysis shows the total market cost of constructing and operating each of the desalination project and the dam project, not accounting for taxes and financing, and without distinguishing the bearer of such costs. Private Benefit Cost Analysis: This analysis builds on the Project Analysis by showing the benefits and costs, allowing for taxes (including depreciation) and financing, to the private entities involved (and thus was only constructed for the desalination project). This analysis abstracts from the effects of the project upon the environment, the labour market, government revenues and other non private parties (excepting the DWR). Specifically, this analysis shows the net benefit of Aqua Vita, and total cost to the DWR over the life of the desalination project. In addition, this analysis includes a calculation of Aqua Vite s Internal Rate of Return ( IRR ) from the project. The IRR is the discount rate which reduces a net present value to zero. Efficiency Benefit Cost Analysis: The efficiency benefit cost analysis generally shows the aggregate net benefit or cost of the project to all affected parties, and thus shows whether the project is economically efficient (in that it involves a net increase in aggregate welfare). Instead of using market prices or prices that are actually paid, this analysis uses shadow prices which represent the opportunity costs of project inputs (which may be equal to market prices). For both of the projects the only relevant difference between market and efficiency prices was that caused by payroll tax and the Goods and Services Tax. As neither of these taxes is considered to be corrective in nature, the costs of capital and operating inputs of each project were discounted by amount of the relevant taxes to arrive at shadow prices that accurately represent the opportunity costs of these inputs. In this case the efficiency analysis does not indicate whether or not the projects are economically efficient, as only the efficiency costs of the projects are calculated, that is the value of the increased water supply is not calculated. Referent Group Analysis: The referent group analysis reports the aggregated and disaggregated costs to the group(s) the welfare of which the relevant decision maker is Page 3

4 concerned. In this report the referent group is composed of the Queensland Government and the Queensland community, with the Commonwealth Government being an additional relevant party. 2.2 Key Assumptions The variables used are as provided by the DWR (see Appendix 1) and the accuracy of this report is obviously highly dependent upon their provenance. Several assumptions incorporated in these variables are questionable and are thus subject to sensitivity analysis. The first is the rate of energy price increase, which is considered to be far too conservative given anticipated structural changes to Australia s energy market. The second is the provided values for external (social and environmental) costs of the projects, which are considered to lack a high degree of precision given the methodology behind their construction. It is also considered that increases in prices of labour and materials are likely to vary outside of the rate of inflation assumed by the benefit cost methodology. All of these assumptions are subject to some degree of sensitivity analysis below. Other assumptions underpinning the variables provided that are not subject to sensitivity analysis include constant tax rates and set capital costs of the projects. In respect of tax rates, it is unlikely that they will remain unchanged over the period under consideration, particular business income tax, given the Commonwealth Government review of taxation currently underway (Treasury, 2008). The accuracy of capital costs predicted a significant distance into the future is also highly questionable, however it is noted that this problem is more relevant to the desalination project, under which it will largely impact upon Aqua Vite only. Several other assumptions concerning the variables needed to made to facilitate the efficiency analysis. The shadow pricing outlined above indicates that the materials and labour components of operating inputs, and similar components of capital inputs, are in addition to current supply. This is an unrealistic assumption (regardless of the DWR direction to the contrary), but nevertheless has consequences only for the result of the efficiency analysis. In addition, this assumption about labour indicates that the opportunity cost of previously unemployed workers should be taken into account. Given that no data on such prospective employees was provided, this opportunity cost was ignored in the efficiency Page 4

5 analysis. Given the lower relevance of the efficiency analysis to the decision between the projects, these assumptions were also not subject to any sensitivity analysis. Apart from the accuracy of the variables noted above, there are several other important assumptions underpinning the analysis in this report. The first is that the DWR is not, and will not in the future be, subject to any budget constraints relevant to the expenditure required for either of the projects. The second is that rainfall is sufficient over the relevant period to allow the dam project to meet the required output. The final, and related, assumption is that water demand adheres to forecasts. 3. ANALYSIS The dam project is clearly the preferred option under the State Government s 6% decisionmaking discount rate, as it involves a saving of approximately $885M present valued 2009 dollars 1 over the desalination project. This difference is significantly greater for the 4% discount rate, and the cost to Queensland of the two projects is approximately equal under the 8% discount rate. TABLE 3.1: Total Cost to Queensland ($ Million NPV ) Discount Rate 4% 6% 8% Desalination Project $6, $4, $3, Dam Project $4, $3, $3, This result is driven primarily by the cost of the projects to the DWR, which is higher for the desalination project under all discount rates, as can seen from Table 3.2. TABLE 3.2: Cost to DWR ($ Million NPV ) Discount Rate 4% 6% 8% Desalination Project $5, $4, $3, Dam Project $3, $3, $2, In contrast to the major conclusion above, it should be noted that the external costs of the dam are significantly higher under all discount rates, as can be seen from Table All monetary values are expressed in 2009 dollars henceforth, unless otherwise noted. Page 5

6 TABLE 3.3: Total External Cost to the Queensland Community ($ Million NPV ) Discount Rate 4% 6% 8% Desalination Project $ $ $ Dam Project $ $ $ The desalination project, under the current commercial proposal, does not provide Aqua Vite with a sufficient rate of return for them to undertake the project. The projected IRR for Aqua Vite is 8.92% versus their stated requirement of 9%. Though the efficiency costs of the projects are not directly relevant to the State Government s decision, the fact that the efficiency cost of the desalination project is less than that of the dam project (see Table 3.4) suggests that there might be scope for the negotiation of monetary transfers so as to induce the State Government to choose the desalination project. This is because the differences between the total cost to Queensland and the efficiency cost of the desalination project are the net benefits to Aqua Vite, the Commonwealth, and Aqua Vite s foreign lender. This suggestion is however not fulfilled, as it is clear from the IRR stated above that Aqua Vite would be unwilling to forego any benefits, the foreign bank is likely to be inflexible on the 8% interest rate, and, as can be seen from Table 3.4, the transfer of the maximum amount of tax revenue (business income tax and GST) the Commonwealth would be willing to forego will not alter the cost ranking of the projects. TABLE 3.4: Efficiency Costs and Intergovernmental Transfers ($ Million NPV at 6% discount rate) Desalination Desalination - Project Dam Project Dam Total Efficiency Cost $3, $3, $ Commonwealth Tax Revenues $ $62.87 $ [Total Cost to Queensland] [Commonwealth Tax Revenues in Excess of those Received from the Dam Project] $3, $3, $ Page 6

7 3.1 Sensitivity Analysis 2 This section examines whether the conclusions above hold under differing assumptions about certain key variables discussed in section 2.2. It also examines how the commercial proposal for the desalination plant can be altered to make it viable for Aqua Vite Energy Prices and External Costs In isolation, no change in energy prices is sufficient to alter the conclusion that the lowest cost project for Queensland is the dam project, as even when the energy component of operating costs is reduced to zero, the cost of the desalination project continues to exceed the cost of the dam project by over $820M (NPV at a 6% discount rate). The foreseeable range of yearly increases in energy prices is considered to be 0 12% above the growth in the Consumer Price Index (that is, assuming an average CPI over the period of 3%, a nominal increase of 3 15%). This range is considered appropriate given the Commonwealth Government s commitment to a mandatory renewable energy target of 20% (Department of Climate Change, 2008) and the declining excess capacity of the Australian Electricity Market. These structural changes are considered to rule out use of historical data as done for labour and materials prices in section The contingent valuation methodology used to arrive at the values for the external costs of the projects involves a high degree of uncertainty, which suggests that these variables are imprecise estimates of the true parameters. In addition, it has been discovered that several important factors were excluded from the valuation methodology. In respect of the desalination project, the significant loss of recreational and visual amenity arising from the desalination plants has not been included in the $400/ML. In addition, it must be noted that the primary driver of the damage, the output of highly saline water, has been considered to be of negligible effect for similar facilities (GCD Alliance, 2006). For these reasons variations to the external costs of this project in the range of ±100% are considered to be possible. In respect of the dam project, the flood mitigation benefits flowing from the dam have not been included in the calculation of the $40M per annum external cost. Given the estimates of damage arising from recent floods in Queensland, it is considered that this cost may be 2 A list of the spreadsheets used in this section and the corresponding filenames can be found in Appendix 2. Page 7

8 entirely offset by the flood mitigation effects of the dam (Attorney General s Department, 1998, 2001, 2005, 2008). In addition, this estimate is substantially based upon the expected decrease in biodiversity arising from the dam, and the difficulty of fully capturing the future cost of such changes is noted. For these reasons changes of ±100% are also considered possible for this variable. TABLE 3.5: Cost to Queensland of the Projects (Dam / Desalination) ($M NPV at 6% discount rate) under varying energy prices and external costs Rate of Energy Price Increase Above Inflation 0% 1% 12% $0 per annum / External Costs of $0 per ML $3, $4, $3, $4, $3, $5, Projects $40M per annum / (Dam/Desalination) $400 per ML $3, $4, $3, $4, $3, $5, $80M per annum / $800 per ML $4, $4, $4, $4, $4, $6, Table 3.5 shows the cost to Queensland of the two projects under nine different external cost and energy price scenarios. Considering first the rate of energy price increase above inflation, it is clear that increasing energy prices raise the cost of the desalination plant to a far greater extent than they do the dam project. For example, moving from a 1% to a 12% rate of increase above inflation, raises the cost of the dam project by $300M and the cost of the desalination project by $1,197M. For external costs the opposite is true as a proportionately equal increase in the rate of external costs increases the cost of the dam project more than the desalination project. A doubling in the rate of external costs of both projects increases the cost of the dam project by $591M versus only $447M for the desalination project. Clearly the projected costs of both projects are quite sensitive to changes in energy prices and external costs. The major conclusion that can be drawn from Table 3.5 is that in each of the nine scenarios presented the cost to Queensland of the dam project is less than that of the desalination project. The relevance of this observation clearly rests upon the questionable assumption that the external costs of the two projects vary in a corresponding manner, a proposition that draws support from the similar methodology of the calculation of these two variables Page 8

9 and the fact that large components of both account for the value of lost biodiversity and human amenity. That is, if one is wrong in a particular direction it is expected the other will also be wrong in the same direction. On the other hand, it is also clear from the table that the cost of the desalination plant will be less than that of the dam project only if the external costs of the dam project are actually double the expected rate while the external costs of the desalination project are actually nil, and provided that energy prices do not increase at a rate significantly above that expected. That is, only at the 0% and 1% rates of energy price increase above inflation where external costs of the dam project are $80M per annum and those of the desalination project $0 per ML, does the desalination project have a lower cost to Queensland (the difference is approximately $150M (NPV)) Labour and Materials Costs Due to the energy intensive nature of desalination processes, energy makes up a higher proportion of operating costs of the desalination project than the dam project; 30% versus 10%. As noted above in section 2.2, the assumption of increases in the price level of the remaining components of operating inputs, labour and materials, equal to inflation is not realistic. Given that these components make up differing proportions of operating costs of the two projects, sensitivity analysis can be undertaken to discover whether changes in the price level of these inputs other than in accordance with inflation affects the relative costs of the projects. The ranges of price increases above inflation shown in Table 3.6 are considered to completely encompass the range of possible price increases (see the distribution of these variables constructed below in section 3.1.4). TABLE 3.6: Costs to Queensland of the projects (dam / desalination) ($M NPV using 6% discount rate) under varying labour and materials prices Increase in materials price above inflation Increase in labour price above inflation 2% 5% 5% $3, $4, $4, $4, % $4, $5, $4, $5, % $6, $6, $6, $7, The most immediate observation arising from Table 3.6 is that under all scenarios presented the cost of the dam project is less than that of the desalination project. Also, in accordance with expectations, increases in the rate of price increase of labour and materials above Page 9

10 inflation decrease the difference in cost between the two projects. This effect is however not strong enough over the foreseeable range of price increases to alter the conclusion that the dam project is cheaper. For example, even under the most extreme scenario of 5% and 12% increases in the real prices of labour and materials (respectively), the cost of the desalination project exceeds that of the dam project by more than $450M Making the Desalination Project Viable for Aqua Vite As noted above, the current commercial proposal does not provide Aqua Vite with a sufficient rate of return to induce it to undertake (its part of) the desalination project. Should it be decided to proceed with the desalination project it will be necessary to alter the commercial proposal in order to induce Aqua Vite to proceed. Simple sensitivity analysis shows that a water price of $5275 per ML (2009 Dollars) is sufficient to give Aqua Vite its required rate of return of 9%. This change obviously increases the cost of the desalination project to the DWR and thus Queensland. Similarly a $9M cash payment to Aqua Vite in 2009 or a $100M increase in the 2034 surrender value of the desalination infrastructure (to $200M total) will give the required rate of return, while both also increasing the cost to Queensland of the desalination project. Even with a 9% rate of return, AV may not be willing to undertake the desalination project, because increases in the prices of energy, labour and materials, all of which are considered likely to vary significantly from the base case, impact heavily upon Aqua Vite s IRR. This conclusion is supported by the analysis carried out in section Figure 3.7 shows how increasing energy prices impact significantly upon Aqua Vite s IRR, given the foreseeable range of yearly increases in energy prices and a water price of $5275. Figure 3.7 Page 10

11 3.1.4 Monte Carlo Analysis This method of repeated random sampling within defined distributions allows the construction of probability distributions over the key parameters estimated in this report based on all variables previously considered changing simultaneously. 3 In the case of the rate of energy price increase and the external costs, triangular distributions were constructed using maximum, minimum and mean values from section For rates of labour and materials price increase (above inflation) relevant indexes of these values over the last decade were constructed using ABS data series, and distributions fitted using distribution fitting function. 4 The minimum, mode and maximum of the triangular distribution used for labour prices were.04,.02,.02, and.06,.01 &.15 in the distribution used for materials prices. This analysis was carried out using a water price of $5275. The probability distributions arising from this analysis establish a 90% confidence interval for the cost to Queensland of the desalination project of $4,378M to $5,790M with a mean of $4929M, and $3,331M to $4,931M, with a mean of $3,951M, for the dam project (NPVs at a 6% discount rate). The probability distributions of the projects exhibit similar, significant, standard deviations ($492M for the dam project and $437M desalination project). Figure 3.8 shows the probability distribution of a variable equal to the cost to Queensland of the desalination project minus that of the dam project. It shows that the probability that the desalination project will be the cheaper option is extremely small, and establishes a 90% confidence interval for this variable of $422M to $1,562M. Clearly the projects both exhibit a high degree of variance in cost (and thus similar degrees of risk), and the desalination project is almost certain to have a higher cost. 3 Undertaken in this case use Excel add (c). 4 See Appendix 3 for further detail. The major assumption underpinning this technique is that the distribution of this variable over the last 10 years approximates the distribution of the average growth rate over the next 25. Page 11

12 Figure The 90% confidence interval arising from the generated probability distribution over Aqua Vite s IRR is 4.49% to 9.09%, and the mean of the distribution is 7.51%. This reinforces the idea that even under the increased water price Aqua Vite may not be willing to undertake the desalination project, as its expected return is less than required and is subject to considerable downside risk Figure 3.9 IRR / Aqua Vite % 90.0% 5.0% IRR / Aqua Vite Minimum Maximum Mean Std Dev Values 9907 / Errors Conclusion The dam project almost certainly represents the lower cost water supply option to Queensland as a whole (State Government and community). The cost difference is in the order of $885M at the State Government s preferred discount rate. In addition, the dam project entails a lower cost to the DWR under all discount rates. This main conclusion has been subject to sensitivity and risk analysis in respect of various input prices and external costs, and remains unaltered. Page 12

13 The dam project does involve a higher cost to the Queensland community, in the order of $150M. It is recognized that, depending upon the segments of the community upon which these costs impact, this may be an important factor in the decision between the projects. If the desalination project is selected, there is an opportunity for increased financial support from the Commonwealth Government, as this project entails a significant revenue increase for the Commonwealth Treasury (in the order of $650M). If the desalination project is selected the commercial proposal will need to be altered to entice Aqua Vite s participation. Analysis has revealed their return to be insufficient in the base case scenario and subject to significant downside risk. Aqua Vite may require a higher rate of return through an increased water price or other subsidy, or that the State Government bear a proportion of the risk arising from certain variables. Given the significant degree of public ownership and control of the various components of the electricity industry in Queensland, it could legitimately be argued that the State Government is the most efficient party to bear the risk of energy price increases. Sensitivity analysis has revealed that foreseeable variations in the input costs and external costs of the projects entail large changes in their total costs to Queensland. Independently of the choice between projects, further quantification of these variables is recommended as it will allow a more accurate estimate of the cost of the project selected. This is considered essential as this report has not included any consideration of the benefits flowing from the projects, and prior to proceeding with either project it is strongly recommended that an accurate calculation of the net benefits be considered. The assumption stated above that the DWR is not and will not at any time be subject to any relevant budget constraints may not be correct given current economic conditions. If the assumption about sufficient rainfall is incorrect then the costs and benefits of the dam project may change significantly, as this could necessitate further works and/or reduce outflow. Similar effects could arise if the assumption concerning the accuracy of forecast water demand is not correct, as this could necessitate changes in the investment timetables of the projects. As these assumptions could significantly alter the results of this analysis, they should be subject to further investigation prior to the State Government deciding between the projects, or commencing with the chosen project. Page 13

14 Reference List Australian Bureau of Statistics ' Consumer Price Index, Australia'. June Visited, 16 October, Australian Bureau of Statistics ' Producer Price Indexes, Australia'. June Visited, 16 October, Australian Government Attorney General s Department EMA Disasters Database: Flash Flooding: Mackay, QLD. bc80dca2573fc001684b9?opendocument February Visited, 16 October, Australian Government Attorney General s Department EMA Disasters Database: Brisbane, Sunshine and Gold Coasts, QLD: Flash Floods. 77babca256d330005aeec?OpenDocument March Visited, 16 October, Australian Government Attorney General s Department EMA Disasters Database: Southeast QLD and northeast NSW flash floods and storms. a6824ca d761?opendocument June Visited, 16 October, Australian Government Attorney General s Department EMA Disasters Database: Townsville Cairns Regions, Qld: Flash Floods dca256d e25?OpenDocument January Visited, 16 October, Australian Government Department of Climate Change Australia s Renewable Energy Target. August Visited, 16 October, Australian Government Treasury Australia s future tax system. May Visited, 16 October, Campbell, Harry F. and Brown, Richard P. C Benefit cost analysis: financial and economics appraisal using spreadsheets. Cambridge University Press: Cambridge. Gold Coast Desalination Alliance Material Change of Use Application ERA 16, 19 & 7. December Visited, 16 October, Page 14

15 Appendix 1 Base Case Benefit Cost Analysis Spreadsheet An electronic version of this spreadsheet can be found in the folder Appendix 1 with the filename Results. Page 15

16 Appendix 2 Sensitivity Spreadsheets Electronic versions of these spreadsheets can be found in the folder Appendix 2. Spreadsheet Filename Section Energy Prices and External Costs Zero energy operating costs (pp 7) (1) 0% energy price increase, $0 per annum / $0 per ML external costs (TABLE 3.5 pp 8) 1% energy price increase, $0 per annum / $0 per ML external costs (TABLE 3.5 pp 8) 12% energy price increase, $0 per annum / $0 per ML external costs (TABLE 3.5 pp 8) 0% energy price increase, $40M per annum / $400 per ML external costs (TABLE 3.5 pp 8) 1% energy price increase, $40M per annum / $400 per ML external costs (TABLE 3.5 pp 8) 12% energy price increase, $40M per annum / $400 per ML external costs (TABLE 3.5 pp 8) 0% energy price increase, $80M per annum / $800 per ML external costs (TABLE 3.5 pp 8) 1% energy price increase, $80M per annum / $800 per ML external costs (TABLE 3.5 pp 8) 12% energy price increase, $80Mer annum / $800 per ML external costs (TABLE 3.5 pp 8) (2) (3) (4) (5) (6) (7) (8) (9) (10) Section Labour and Materials Costs 2% increase in real labour price, 5% increase in real materials price (TABLE 3.6 pp 9) 2% increase in real labour price, 10% increase in real materials price (TABLE 3.6 pp 9) 2% increase in real labour price, 15% increase in real materials price (TABLE 3.6 pp 9) 5% increase in real labour price, 5% increase in real materials price (TABLE 3.6 pp 9) 5% increase in real labour price, 10% increase in real materials price (TABLE 3.6 pp 9) (1) (2) (3) (4) (5) 5% increase in real labour price, 15% increase in real (6) Page 16

17 materials price (TABLE 3.6 pp 9) Section Making the Desalination Project Viable for Aqua Vite Water price of $5272 per ML (pp 10) (1) $9M cash payment to Aqua Vite in 2009 (pp 10) (2) $100M increase in 2034 surrender value (pp 10) (3) The sensitivity analysis in Section Labour and Materials Costs was done using modifications to the Variables and Project sheets that allowed the prices of labour and materials operating inputs to vary in the same manner as the price of energy operating inputs. Page 17

18 Appendix 3 Monte Carlo Analysis An electronic versions of this spreadsheet, outputs and ABS data series, can be found in the folder Appendix 3 with the filename To view this file must be open and variables on the Variables ABS Data and At Risk Outputs sheets re entered (place cursor in cell and press enter). Page 18