Sydney Water s Methodology for Determining its Economic Level of Water Conservation

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1 Sydney Water s Methodology for Determining its Economic Level of Water Conservation Issues Paper 29 April 2016

2 SW265 04/16 Sydney Water. All rights reserved.

3 Table of Contents Executive summary... iv 1 About this report Purpose of this report Structure of this report Making a submission List of questions Purpose of water conservation programs New requirements for water conservation and ELWC Purpose of water conservation requirements Current approach to water conservation Sydney Water s current requirements and approach Sydney Water s previous water conservation programs Effectiveness of water conservation targets Metropolitan Water Plan Our approach to and principles for developing ELWC ELWC principles Our approach and project plan How we will evaluate potential ELWC methods Question One: Criteria for assessing ELWC Methodology Defining the economic level of water conservation Developing an ELWC definition Why do we need to determine an Economic Level of Water Conservation? Proposed ELWC Definition The level of water conservation Assumptions in Sydney Water s proposed definition Question Two: ELWC definition Proposed approach for estimating the economic value of water conserved Information we will use to develop a value of water conserved Short run marginal cost Simple long run marginal cost estimates Principles for developing a value of water conserved Value of water should change with scarcity Value of water should change with demand Value of water should change with the overall system storage Potential approaches to determining a value of water conserved OPTION A Using SRMC OPTION B Using the retail water usage price / LRMC OPTION C Using LRMC for long-term projects, SRMC for temporary projects OPTION D Using a combination of LRMC and SRMC OPTION E Using market values Economic Level of Water Conservation - Issues Paper Page ii

4 5.3.6 OPTION F Least cost planning Summary of value of water approaches Question Three: Value of water conserved Costs and benefits of water conservation projects Water conservation projects costs and benefits What costs and benefits won t we include? Assessing costs and benefits Challenge of calculating water conservation costs and benefits & need for evaluation Sydney Water costs and benefits Sydney Water costs may vary across the network Question Four: Sydney Water costs and benefits Customer costs and benefits Question Five: Customer costs and benefits Social and environmental costs and benefits Extra river flow benefits of water conserved will be seen in SRMC and LRMC Social and environmental costs of the existing water supply system Social and environmental costs of water conservation projects Question Six: Social and environmental costs and benefits Applying our ELWC Applying ELWC to different water conservation activities Identifying potential water conservation projects What projects will be assessed by our ELWC methodology? Question Seven: Applying our methodology and reporting water savings Implementing and funding water conservation projects Potential to not implement water conservation projects Funding water conservation projects Funding projects from savings Projects that can t be funded from short-term savings Where should the funds come from? Funding water conservation projects through our water prices Other funding opportunities Accounting for lost water sales Positive regulatory incentive Baseline level of investment in water conservation Question Eight: Funding Sydney Water s Water Conservation Program Deciding when to start and stop projects Establishing bands of value of water conserved Project start and stop triggers Question Nine: Implementing our Water Conservation Program Appendix A: MetroNet model Glossary References Economic Level of Water Conservation - Issues Paper Page iii

5 Executive summary Purpose of the Economic Level of Water Conservation The purpose of Sydney Water s Economic Level of Water Conservation (ELWC) is to enable Sydney Water to determine the optimal future mix of, and right amount of investment in, water conservation activities. This will help us contribute to a sustainable supply-demand balance. We are developing our ELWC Methodology in response to a requirement in our Operating Licence. Our aim is to develop a methodology that will give us a structured and transparent way of assessing the benefits and costs of different water conservation projects. Our ELWC Methodology should guide us to implement water conservation projects when the benefits outweigh the costs. Objective of this paper This paper presents our preliminary views on how we can approach the key components of the methodology. It also reviews some of the key issues we must consider when we develop and apply the methodology, and use it to justify water conservation activities. We have posed questions throughout the paper on issues where we particularly seek stakeholder feedback. Defining the Economic Level of Water Conservation Our proposed definition is: The Economic Level of Water Conservation is the level of water conservation achieved when the additional social benefits from water conservation activities are equal to their additional social costs. If we achieve our economic level of water conservation, the net social benefits of water conservation will be maximised. The primary objective of water conservation projects is to save water. In our methodology we will need a way to determine the value of water conserved, as this is the key benefit of such projects. Options for valuing water conservation There are several options to determine the value of water conserved from water conservation activities. Options include: the short run value of water the long run value of water a combination of both values the Metropolitan Water Directorate s modelling capabilities to select and prioritise projects. The most comprehensive approach would be an adaptable value of water that takes account of the short-term benefits of saving water, as well as the long-term benefits of constraining Economic Level of Water Conservation - Issues Paper Page iv

6 demand and delaying potential augmentation. Such an approach could help us avoid overinvestment in water conservation during times of abundance, or under-investment when our water supplies are becoming scarce. However such an approach may be more difficult to develop and implement, and we need to assess if we can achieve it in the time we have available to meet our Operating Licence requirement. Sydney Water also conducts a range of other projects that aren t pursued for water conservation reasons, but sometimes have secondary water conservation benefits. These secondary water conservation benefits could also be valued with our chosen value of water approach. Assessing the benefits and costs of water conservation Apart from determining a value of water conserved, our methodology will also require us to assess other costs and benefits of water conservation projects, including: Sydney Water costs and benefits customer costs and benefits broader environmental and social benefits. We will consider costs and benefits on a project by project basis. Our general approach will be to: count Sydney Water and customer financial costs, but exclude transfer payments between us and customers and avoid double counting benefits and costs not include customer time and effort to participate if programs are voluntary count externalities (whether they be positive or negative) only when existing regulations or business practices don t internalise the costs or benefits - for example, environmental protection licences internalise the social costs of pollution as a private cost to customers through increased wastewater bills include any benefits of environmental flows when they are introduced in updated long run cost estimates. Our water conservation program Our Operating Licence also includes a complementary requirement to develop a Water Conservation Program. As we develop our Water Conservation Program we will identify a range of candidate water conservation projects. We will assess the costs and benefits of potential projects with our methodology, and decide what feasible projects should be included in our Water Conservation Program. Our understanding of the interaction between the ELWC and Water Conservation Program is shown in Figure 1. Economic Level of Water Conservation - Issues Paper Page v

7 Sydney Water develops or reviews ELWC methodology Identify potential water conservation projects; pilot high potential projects Assess candidate projects with ELWC Methodology Include beneficial programs in Water Conservation Program Determine overall level, or amount of expected water savings Implement beneficial projects that we can fund Evaluate our programs, estimates and assumptions. Figure 1 Process for determining ELWC and our Water Conservation Program If we use a variable value of water in our methodology, our level of investment may change according to water availability. This may raise practical challenges for implementing projects and forecasting our likely funding requirements. When we apply our ELWC Methodology it may also indicate that some water conservation activities are cost effective and justifiable in all circumstances. All projects that we plan to complete and are funded will be included in our Water Conservation Program, and we will transparently report on their progress and success. However, implementing projects is not a strict requirement of our Operating Licence. We might not implement projects that have a positive assessment from our ELWC Methodology, if we can t fund them or don t have the resources to complete them. Next Steps We invite all stakeholders to give us feedback on the issues considered in this report. We will consider feedback as we develop our Draft Methodology Report, which we plan to release for public comment around September Economic Level of Water Conservation - Issues Paper Page vi

8 1 About this report 1.1 Purpose of this report The purpose of this report is to gather feedback from stakeholders on the: definition approach and principles inputs and building blocks scope, and application of our methodology to determine our Economic Level of Water Conservation (ELWC). We are seeking feedback on all the issues raised in this paper from our customers, customer representatives, stakeholders, regulators and other water industry representatives. This is in line with our commitment to developing the methodology in a transparent manner. The issues we discuss in this paper, and the feedback we receive, will help us finalise our methodology by the end of Structure of this report This report is structured as follows: Chapter 2 explains why we have a requirement to develop an economic level of water conservation, and the reasons why we conserve water. Chapter 3 outlines our approach and principles for developing our ELWC methodology. Chapter 4 outlines our preferred definition of an economic level of water conservation and explains what we mean by a level of water conservation. Chapter 5 explains why we want to value the water we conserve through our water conservation projects. We give an overview of the information we ll use to determine a value of water conserved, and possible ways we can calculate a value. Chapter 6 explains how we will approach other costs and benefits of water conservation, including Sydney Water and customer costs. Chapter 7 considers the types of water conservation projects we will assess with the methodology. Chapter 8 considers issues we will encounter when we implement projects that have been assessed by our ELWC methodology and included in our Water Conservation Program. The chapter discusses funding opportunities for projects we wish to implement.

9 1.3 Making a submission We welcome your comments. To make a submission on this Issues Paper: make a comment on Sydney Water talk a submission to elwc@sydneywater.com.au post a submission to: Sydney Water Attn: ELWC Issues Paper submission PO Box 399 Parramatta NSW If your comments relate to a particular question please note the question and its number in your submission. A list of questions is summarised below. We plan to make all submissions public on our Sydney Water Talk website as soon as possible after the closing date for submissions. If you do not wish your submission to be made public, please indicate this at the time of making a submission. The deadline for responses to this Issues Paper is Friday 3 June List of questions The questions posed throughout this document are summarised below. Question One: Criteria for assessing ELWC Methodology a) Do you agree with our criteria for evaluating different options for our ELWC Methodology? Question Two: ELWC definition a) Do you agree with our proposed definition for the economic level of water conservation? b) If you don t agree, can you propose an alternative definition? Question Three: Value of water conserved a) What approach to determining the value of water conserved is the best? b) Can you suggest an alternative approach to valuing the water we conserve? Question Four: Sydney Water costs and benefits a) Is our suggested approach to determining Sydney Water costs and benefits adequate? b) Can you suggest any other approaches to determining Sydney Water costs and benefits? Question Five: Customer costs and benefits a) Should we include customer costs and benefits? Economic Level of Water Conservation - Issues Paper Page 2

10 b) If we do, should we account for things such as customer effort or inconvenience? Question Six: Social and environmental costs and benefits a) Do you agree with our approach to accounting for externalities (other costs and benefits of our water conservation programs that wouldn t normally be internalised in Sydney Water s decision-making)? b) Are there any other costs and benefits of water conservation programs that we should consider in our project assessment? Are these costs and benefits already captured by the value of water, or other regulations? Is there a robust method available to identify and quantify them? c) Should we include a cost of carbon that is consistent with the Metropolitan Water Plan? Question Seven: Applying our methodology and reporting water savings a) Should we use our ELWC methodology only to assess projects whose main objective is water conservation? b) Should we include estimated water savings from all Sydney Water projects in our forecast economic level of water conservation (whether or not projects have a primary water conservation objective)? Or should we only include forecast savings from projects whose primary objective is water conservation? Question Eight: Funding Sydney Water s Water Conservation Program a) How should Sydney Water recover the cost of water conservation projects, including lost revenue? b) When should Sydney Water be allowed to recoup the cost of water conservation projects? c) Should Sydney Water have a baseline level of investment in water conservation? If so, how should it be funded? Question Nine: Implementing our Water Conservation Program a) Do the potential difficulties of project planning and implementation negate the benefits of using a variable value of water? b) Is it reasonable for Sydney Water to address difficulties in project implementation by using value of water bands, or project stop and start triggers? Can you suggest another approach? c) Is our suggested approach to project triggers a reasonable trade-off between accuracy and the ability to practically implement the methodology? Economic Level of Water Conservation - Issues Paper Page 3

11 2 Purpose of water conservation programs The purpose of water conservation activities is to prevent water losses, or wastage, and help customers use less water without diminishing the end service they receive. 1 Water conservation programs can also help manage the overall level of water demand in Sydney, to reduce the likelihood that we will have to impose water restrictions, or build new water supplies. 2.1 New requirements for water conservation and ELWC Sydney Water s Operating Licence includes a number of new water conservation requirements. These include requirements for Sydney Water to: develop a methodology for determining its ELWC develop a five-year rolling water conservation program that is consistent with the ELWC methodology report annually on its progress against the water conservation program. Sydney Water must develop the new methodology and have it approved by IPART (the Independent Pricing and Regulatory Tribunal) by 31 December The Operating Licence requires the ELWC to apply to the following water conservation activities, at a minimum. a. water leakage b. water recycling, and c. water efficiency (including demand management). 2 The Operating Licence also specifies that once approved, that Sydney Water must notify IPART and seek its consent on any proposed significant changes to the methodology. 2.2 Purpose of water conservation requirements IPART s stated purpose for including water conservation requirements in Sydney Water s Operating Licence is to: avoid the need for inefficient augmentation of our water supply system, and ensure customers do not face unnecessarily long or frequent water use restrictions. 3 1 Water is often valued for the service it helps deliver such as cleaning or waste transport. For example, a water efficient dishwasher will deliver the same end service of clean dishes, but use less water use than a conventional model. 2 IPART, Sydney Water Corporation Operating Licence , August 2015, p 7 3 IPART, Cost Benefit Analysis of Proposed Changes to Sydney Water Corporation s Operating Licence, 2015, p 26 Economic Level of Water Conservation - Issues Paper Page 4

12 We see the primary role of the water conservation requirements in our Operating Licence is to help maintain a sustainable and cost effective supply-demand balance. This aligns with the positioning of the requirements in the Water Quantity chapter of the licence. While water conservation activities may also have other desirable effects, their primary purpose is to conserve water. Accordingly, our primary focus, especially in the first iterations of the ELWC methodology, will be to ensure consistent and robust measurement of the value of water conserved from these activities. IPART s specific objectives for the ELWC methodology are to: promote transparency and accountability around Sydney Water s water conservation and planning activities avoid overly prescriptive targets or requirements that may result in under-investment or over-investment require Sydney Water to determine its most efficient mix of water conservation activities. 4 When we have completed our work to comply with the new requirements, they will replace existing fixed targets and water conservation requirements in our Operating Licence. IPART did not set new targets in the Operating Licence, because a fixed target might lead to us over or under invest in water conservation. 5 As our water usage prices are typically set with reference to the long-run marginal cost, and until the most recent Draft Determination the usage price has not varied within the four-year regulatory periods to account for the relative scarcity of water, prices have not provided customers the right signals for efficient water conservation. The move to pass-through in the next regulatory period some costs associated with the Sydney Desalination Plant (SDP) onto usage prices is effectively a first step towards price signalling to customers that the value of conserving water is higher as it is less abundant. Many customers have told us they favour water conservation. When we provide targeted and practical water conservation information it helps customers make beneficial water use decisions. This includes changing water use behaviour, and enabling customers to understand when it is worthwhile investing in water efficient appliances and fixtures. Determining our ELWC will give us better information, and set better incentives, to achieve the optimal level of investment in water conservation and the most effective portfolio or mix of activities. IPART has noted that a challenge with prescriptive, static water usage and leakage targets are the lack of flexibility to adapt to changing circumstances. For example, should the water usage target during drought conditions be the same as that in non-drought conditions? 6 4 IPART, Cost Benefit Analysis of Proposed Changes to Sydney Water Corporation s Operating Licence, IPART, Sydney Water Corporation Operating Licence End of Term Review - Report to the Minister, Power, Hanna, Lobb, Moffatt, Economic Level of Water Conservation, 2016 Economic Level of Water Conservation - Issues Paper Page 5

13 2.3 Current approach to water conservation Sydney Water s current requirements and approach Until Sydney Water develops its ELWC and new water conservation program, we must maintain our existing water conservation requirements. They require Sydney Water to: 7 maintain water use at or below 329 litres per person per day (LPD) ensure leakage does not exceed 121 ML per day (this is equivalent to the upper limit of the previous leakage level of 105 ± 16ML/day) undertake and promote water efficiency programs promote, foster and encourage the production and use of recycled water in our area of operations, where it is financially viable to do so. These requirements apply until the ELWC methodology is approved by IPART. Sydney Water currently determines the level of activity in water conservation using the following criteria: Leakage we use the Economic Level of Leakage approach described in Chapter 5. Demand management since the end of the drought we have reduced investment because per capita water use is below the water usage level in our Operating Licence. Overall water use remains low because: o o o o many customers have maintained water use behaviours developed during the drought schemes such as WELS have improved the water efficiency of customers appliances and fixtures BASIX requirements, and an increase in high density housing is reducing average water demand in new dwellings and there has been a decline in industrial water use. As a result, we have switched our focus from broad programs to those with additional benefits such as those that complement our hardship programs. Recycling generally, we continue to operate existing recycled water schemes. We continue to consider recycling as an option when considering the most cost efficient way to service the new growth areas. 2.4 Sydney Water s previous water conservation programs Sydney Water began water conservation activities in 1995, to meet water usage targets that were included in our first Operating Licence as a way to manage the supply demand balance. Our first Water Conservation Program included a mix of water efficiency, leak reduction and water recycling. We increased water conservation activities significantly in the 7 IPART, Sydney Water Corporation Operating Licence , August 2015, ], p 7 Economic Level of Water Conservation - Issues Paper Page 6

14 late 1990s, in response to Government and stakeholder concerns about the increasingly severe drought in Sydney, Sydney Water: implemented multiple water efficiency programs for businesses, residents, and government organisations enforced water restrictions on behalf of the Government increased active leak detection in our water pipes, and conducted a pressure reduction program in the water network to reduce system losses implemented new water recycling schemes, some of which were as a result of Government direction. 8 Between 1999 and 2011, through implementing these programs about 12GL of water was saved a year. We invested $730 million in water conservation between 1999 and When we designed our water conservation program, we chose programs that would be most likely to save water at the lowest implementation cost, calculated on the net levelised cost ($/kl). We also considered stakeholder and community acceptance, implementation certainty, and environmental benefits over the lifecycle of the program if they could be quantified. We scaled back our water conservation activities significantly when it became harder to generate substantial extra water savings. This was partly because we had effectively rolled out programs to much of our customer base, and because customers water use behaviours changed significantly during the millennium drought. The impetus for investment also declined when good rainfall in Sydney s catchments replenished dams and we had achieved our Operating Licence water use target. Feedback from our customers surveys shows that over half our customers want Sydney Water to play an ongoing role in water conservation. Some focus on the importance of ensuring Sydney has a good water supply for the future, and others want Sydney Water to be responsive when issues like leaks arise. Some customers are interested in water conservation because it saves them money, and others because they believe scarce resources should be conserved Effectiveness of water conservation targets Sydney Water has had water conservation requirements in its Operating Licences since Operating Licence requirements are designed to protect the interests of customers in the absence of a competitive market, so that Sydney Water might be able to make good investment choices to manage the cost effective supply and demand of water, based on market prices Sydney Water documented its water conservation approach in many publications. For example, Sydney Water, Water Conservation and Recycling Implementation Report, Sydney Water, Values Study, IPART, Cost Benefit Analysis of Proposed Changes to Sydney Water Corporation s Operating Licence, 2015 Economic Level of Water Conservation - Issues Paper Page 7

15 The water conservation projects we implemented to achieve our water usage targets were effective in contributing to significant and long-term reductions in customer demand. We met our water use target in 2007, and our leakage target in Leakage has been in line with our target since then, and water use has been significantly lower than target. Targets continue to help justify activity in active leak detection but do not currently justify much new investment in customer demand management programs. 2.5 Metropolitan Water Plan Sydney s Metropolitan Water Plan (MWP) identifies the most cost effective portfolio of supply and demand measures to ensure a secure and sustainable water supply both for the short and long-term (in the absence of additional price signals). The goal of the MWP is to deliver a secure and sustainable water supply for greater Sydney. This will be achieved through a cost effective portfolio of water supply and demand management measures that: secures potable water supplies for our growing city helps protect the health of affected rivers supports liveable and resilient urban communities. The plan s demand strategies aim to manage the water security risks posed by population growth, rapid rises in demand, major supply interruptions and drought. To facilitate robust planning, the Metropolitan Water Directorate (MWD), which is part of the NSW Department of Primary Industries (Water), has developed a combined hydro-economic model of Sydney s water supply system called MetroNet. Sydney Water uses water supply and demand measures in line with the trigger levels established in the MWP. Measures include use of water from WaterNSW that is pumped from the Shoalhaven River system, water restrictions, and use of the desalination plant. The plan also has a focus on protecting the health of rivers affected by water supply dams. Water conservation may also enable the government to realise this policy objective. Objectives for water conservation targets in our first Operating Licence included accommodating the introduction of environmental flows in the Hawkesbury-Nepean river system. 11 Environmental flows from the Upper Nepean system were introduced in 2010, and environmental flows from Warragamba Dam are being considered in the current review of the MWP. Environmental flows will improve the river's ecosystem and be beneficial for swimming, boating, fishing, and riverside amenity. However, the introduction of environmental flows will reduce the yield of the water supply system. 11 Sydney Water, Sydney Water s submission for the mid-term review of its Operating Licence, 2002 Economic Level of Water Conservation - Issues Paper Page 8

16 3 Our approach to and principles for developing ELWC The ELWC principles are broad guidelines to define what an acceptable ELWC will look like, and how it will work. They are guiding us as we consider and evaluate different options for the ELWC Methodology. IPART approved Sydney Water s approach and principles for developing the ELWC methodology in December ELWC principles The ELWC methodology will: 1. enable costs and benefits of potential water conservation activities to be consistently assessed, and thereby help to inform what activities may be included in Sydney Water s Water Conservation Program 2. be flexible and robust, recognising that: a. different types of water conservation activities have different timescales b. whether a water conservation activity is beneficial may change with changing circumstances 3. promote transparency of Sydney Water s water conservation investment: a. by establishing a clear and common methodology for assessing water conservation activities. This means: basing the methodology on sound economic principles, such as the promotion of economic efficiency using simple and accepted techniques, where possible using a consistent measure for benefits and costs, where possible, so as to avoid subjective judgements being used to assess activities b. by helping to: inform stakeholders and the public facilitate IPART s assessment of proposed expenditure 4. be designed to assess practical water conservation options. Our proposed definition, outlined in Chapter 3, is consistent with these principles. 3.2 Our approach and project plan Our approach sets out our key milestones and timeframes to develop the ELWC Methodology. It aims to ensure we communicate with stakeholders on foundation issues and have time to consult on our draft methodology. Our key milestones are shown below. Economic Level of Water Conservation - Issues Paper Page 9

17 Figure 2 Key milestones Milestone 1 Dec 2015 Initiate Stage Two Milestone 2 April 2016 Issues Paper for public commment Milestone 3 August/ September 2016 Draft methodology report Milestone 4 December 2016 Final report Table 1 Key milestone activities Milestone Milestone 1 Milestone 2 Task Initiate Stage Two, in late 2015 / early Stage Two will culminate in the approval of our ELWC Methodology by IPART in December Issues analysis, including: definition of the ELWC scope and key building blocks of the ELWC Methodology consideration of how ELWC will interact with the development of the Water Conservation Program and other internal business processes development and publication of an Issues Paper for public comment. Milestone 3 Prepare a draft ELWC Methodology, including: options analysis of alternative approaches development of preferred methodology consideration of feedback from the Issues Paper development and publication of a Draft Methodology Report for public comment. Milestone 4 Finalise methodology for IPART s approval by December This Issues Paper is part of Milestone How we will evaluate potential ELWC methods Our criteria for assessing options for the ELWC Methodology will be: accuracy flexibility robustness transparency our ability to implement the methodology. Economic Level of Water Conservation - Issues Paper Page 10

18 3.4 Question One: Criteria for assessing ELWC Methodology Question One: criteria for assessing ELWC Methodology a. Do you agree with our criteria for evaluating different options for our ELWC Methodology? Economic Level of Water Conservation - Issues Paper Page 11

19 4 Defining the economic level of water conservation 4.1 Developing an ELWC definition Our requirement to develop an ELWC Methodology is a new requirement, and our Operating Licence does not define what an economic level of water conservation is. We are including our proposed definition in our Issues Paper so that stakeholders can give us feedback Why do we need to determine an Economic Level of Water Conservation? Economics shows that market mechanisms can drive the socially optimal allocation of scarce resources. This is the case where consumers have full information about the market, there is no ability to exercise market power, there are no price or quantity controls (for example, distortionary taxes or subsidies), and there are no additional costs and benefits to society that not accounted for by the individual s actions (i.e. externalities). In such circumstances, the private benefits and costs to individuals also represent the overall benefits and costs to society. In the presence of externalities though (positive or negative), simply considering the private benefits and costs does not allocate scarce resources in a way that generates greatest social welfare. Where there are broader benefits or costs to society of individual s actions that are not accounted for in the market price, it will result in either under-supply or overconsumption of a particular product. The typical example of an externality highlighted in economic textbooks is where manufacturing activities cause pollution. This imposes broader health and clean-up costs on society. If these costs are not taken into account (or internalised) by the private manufacturer, then customers will pay too low a price and there will be over-production and over-consumption of the product. To ensure such broader costs to society are taken into account or internalised, and efficient allocation of scarce resources occurs, policy makers are often encouraged to tax or assign property rights to pollution activities. 12 Water conservation is about ensuring that water, which can be a scarce resource particularly during times of drought, is not over-consumed. In considering what the optimal level of water conservation is, in addition to private costs and benefits, Sydney Water must assess whether there are any externalities that should be taken into account. (Chapter 5 considers some of the costs and benefits of water use and conservation to the customer, the environment and broader community in more detail.) 12 The idea of setting taxes/subsidies at the marginal external cost/benefit to generate the efficient outcomes, was dealt with by Pigou in his 1920 paper, The Economics of Welfare (Macmillan and Co, London). The alternative idea of allocating a property right over pollution to yield the efficient outcome arose from the work by Ronald Coase, in his 1960 paper, The Problem of Social Cost, (Journal of Law and Economics, Volume. 3, October 1960). Economic Level of Water Conservation - Issues Paper Page 12

20 The impact that the presence of positive externalities can have on the optimal level of water conservation is highlighted using the stylised example in Figure In this stylised example we only assume there is a marginal external benefit from water conservation. 14 Figure 3 illustrates that if only the private benefits of water conservation are taken into account, the consumer will only invest in water conservation of Q p, where the marginal benefit from the investment is equal to the marginal cost. However, the diagram shows that given the greater benefit to society associated with an individual s water conservation activities, this is below the socially-optimal amount of water conservation Q s. By pricing water too low, or conversely setting a per unit price for water conservation that is too high, consumers underinvest in water conservation or alternatively, don t conserve enough water. This results in inefficient under-investment in conservation activities. That is, the costs of the additional resources to society from conserving the quantity of water from (Q s Q p ) is equal to area cbq s Q p, which is less than the additional value derived by society from investing in the additional water conservation activity (Q s Q p ) of abq s Q p, leading to an overall efficiency loss of area abc. In the presence of a positive externality, a move to the efficient level of water conservation of Q s in the stylised exampled in Figure 3 could be induced by providing a subsidy on water conservation activity equal to the amount P p bde. This subsidy would maximise the net social benefits. 13 In Figure 3, we show marginal cost as a straight line for simplicity. As we discuss elsewhere in the Issues Paper, there are situations where marginal cost of supply increases most obviously during drought when dam levels fall and we use more expensive supply options. 14 This implies there is no marginal external cost associated with water conservation and that the marginal private cost and marginal social cost of water conservation are equal. Economic Level of Water Conservation - Issues Paper Page 13

21 Figure 3 Marginal social benefit of water conservation Price PS = what society will pay, for the quantity Qp produced a By considering externalities and increasing water conservation activities we remove inefficient under-investment in water conservation activities. Potential welfare gain from considering positive externalities of water conservation Pp c b Marginal cost e d Marginal social benefit Marginal private benefit Qp Qs Quantity Q p - water conservation absent externalities being accounted for Q s - Socially efficient amount of water conserved 4.2 Proposed ELWC Definition The above consideration of costs and benefits including potential externalities from water conservation projects, has formed the basis of our proposed definition of ELWC. Our proposed definition is: Definition of Economic Level of Water Conservation The Economic Level of Water Conservation is the level of water conservation achieved when the additional social benefits from water conservation activities are equal to their additional social costs. If we achieve our economic level of water conservation, the net social benefits of water conservation will be maximised. In our proposed definition social costs and benefits are economic terms. As outlined in Section 4.1 and in our stylised example in Figure 3, this definition includes the private costs and benefits to Sydney Water and our customers, as well as any externalities that arise from social and environmental costs and benefits that not already internalised through other mechanisms. Economic Level of Water Conservation - Issues Paper Page 14

22 In other words, social costs and benefits include: costs and benefits to Sydney Water costs and benefits to our customers where possible and practical, impacts to the environment and the community that might otherwise be external to our decision-making. This definition is consistent with IPART s views on economically efficient investment in drought management programs and the setting of socially optimal fares for public transport. 15 It is important to note that the Operating Licence requirement is to determine Sydney Water s economic level of water conservation, as opposed to a whole of society economic level of water conservation. This may have implications for how we determine some costs and benefits. That said, the methodologies developed as part of this project could be applied by other parties when making their own decisions about water conservation. The costs and benefits of water conservation may change according to our water supply situation. A potential benefit that will be addressed by our ELWC methodology is our ability to make decisions about water conservation that reflect water abundance or scarcity. Currently, the usage price Sydney Water pays for bulk water does not vary when it is scarce. The amount we pay for bulk water only varies if we have to use the more expensive supply measures, such as desalination, and these costs are passed through to our customers. Given the cost pass-through arrangements though, Sydney Water has very little private financial incentive to influence customers water use to avoid expensive augmentations to the bulk water supply system. That is, if we could reduce demand to defer socially costly augmentation, we would have no incentive to do so, as such schemes would impose unaccounted costs on us, and are likely to reduce revenue more than our costs. Customers also do not have strong private incentives to conserve water during drought due to the way the water usage price for water is set over a four-year period. Until IPART s recent Draft Determination on Sydney Water s prices 16 there was previously no change in the usage price customers pay for water as supply decreases. The Draft Determination now provides some price signal to customers about the relative scarcity of water within a regulatory period, as it provides for some of the costs of SDP turning on to be recovered through a higher usage price to consumers. This price signal is though quite limited, as price will not increase further, even if dams were to fall to very low levels over the course of the pricing period The level of water conservation The economic level of water conservation is the cumulative amount of water we expect to save from justifiable individual projects that we can implement in any one year (or over the 15 IPART, A new methodology for setting fares public transport fares in Sydney and surrounds, 2015, and IPART, Drought program evaluation framework, IPART, Draft Determination Sydney Water Corporation Maximum prices for water, sewerage, stormwater drainage and other services from 1 July 2016, Economic Level of Water Conservation - Issues Paper Page 15

23 period of any one Water Conservation Program). This is consistent with how Sydney Water describes its Economic Level of Leakage. 17 Total Annual Water Savings (kl) Year 1 projects Year 2 projects Project 1 Project 2 Project 3 Project 5 Project 5 Figure 4 The economic level of water conservation can change Figure 4 shows how the amount of water conserved could change from year to year under the ELWC Methodology. This is because costs and benefits of projects can vary over time, because of changes to our supply costs, changes to the relative abundance or scarcity of water, and changes to other project costs. Tracking the changing costs and benefits of water conservation will allow us to respond to changing circumstances more flexibly than if we were simply responding to fixed targets. 4.3 Assumptions in Sydney Water s proposed definition Our definition relies on several assumptions. These include that: we can identify and value external costs and benefits, including the value of water at different dam levels and different points in time other laws or regulations that help us make decisions are the most effective way of addressing that issue our forecast water savings from individual projects, and when we will realise them, are reliable enough to enable us to determine a robust level of water conservation. 4.4 Question Two: ELWC definition Question Two: ELWC definition a. Do you agree with our proposed definition for the economic level of water conservation? b. If not, can you propose an alternative definition? 17 Sydney Water, Determination of ELL - Report to IPART Final, 2011 Economic Level of Water Conservation - Issues Paper Page 16

24 5 Proposed approach for estimating the economic value of water conserved The key reasons for water conservation requirements in our Operating Licence include avoiding the need for inefficient augmentation, and ensuring customers don t endure unnecessarily long or harsh water restrictions. Therefore, ELWC needs to help us make decisions about when to save water, and how much to save. By definition, all water conservation projects should be able to save water. The important question is: how much water conservation is the right amount? In an economic framework, we answer this by comparing the costs and benefits of a water conservation project, which includes any additional costs or benefits to society. Our definition of the ELWC states that the point at which the marginal social costs equals the marginal social benefits marks the economic level of water conservation. This is the point where the net benefit to society from water conservation is maximised. In order to quantify the social benefits of water conservation, we need to place a value on the water conserved. We propose that the value of water conserved include all quantifiable costs and benefits associated with supplying the next increment of water, not just the price Sydney Water pays for bulk water. This is consistent with the idea that our ELWC should include social costs and benefits. In doing so, we are seeking to put an economic value on every unit of water we save. We are not attempting to describe the intrinsic importance of water to society and nature. 5.1 Information we will use to develop a value of water conserved Sydney Water has access to information about the short-run and long-run marginal costs of water supply. We will consider this information to develop a value of water conserved Short run marginal cost The short-run marginal cost (SRMC) represents the costs of using different options already available in Sydney s current water supply system. These include the: network of dams that we rely on for water supply most of the time water that can be pumped from dams on the Shoalhaven River the Sydney desalination plant savings made during water restrictions other measures we might take to change customers behaviour and save water during droughts. When we need to use some of these options, it increases the cost of supplying the next unit of water within our existing supply system that is, the SRMC of water rises. Sydney Water and our customers will directly pay for some of the cost increases incurred as we use different sources of water. For example, when we need to use water pumped from the Shoalhaven River, or produced by the desalination plant, we will need to pay more to our Economic Level of Water Conservation - Issues Paper Page 17

25 bulk water providers. However, of these costs that will be passed through to our customers, only a very small amount will be paid for by customers through an increase in the usage price. The extra cost of Shoalhaven transfers and around one quarter of the desalination plant operating costs will be passed through in the fixed customer service charge. 18 Some other costs are external to Sydney Water. For example, the inconvenience of complying with water restrictions, or the impacts on gardens and sports fields as a result of reduced irrigation, are borne by customers and the community. The extra carbon emitted by water sources that require more pumping or treatment is an environmental cost that is also external to Sydney Water and the impact, if not internalised, will be borne by the broader society through the impact on the environment. The Metropolitan Water Plan (MWP) gives us a good idea of when the SRMC of our current water supply system is likely to change. Each of the supply options seen in Figure 5 cost more to use than the dam water that we rely on in times of water abundance. As dam levels fall and water becomes scarcer, more expensive options are triggered, and the marginal cost of water increases. The MetroNet model includes costs of some planning, or readiness activities for drought driven water supply options. Figure 3 is based on the 2010 Metropolitan Water Plan. The options and trigger levels are likely to change when an updated plan is released in To refine our calculation of SRMCs, we are considering working with MWD to determine if we can create even more data points of the short run value of water, which would show costs at different dam levels. 18 IPART, Draft Determination Sydney Water Corporation Maximum prices for water, sewerage, stormwater drainage and other services from 1 July 2016, Economic Level of Water Conservation - Issues Paper Page 18

26 Figure 5 Water supply options outlined in the 2010 Metropolitan Water Plan 100% 75% Shoalhaven pumping Tallowa Dam to -1m FSL) 70% Desalination stage 1 operation 50% 40% 35% 30% 25% 20% Level 1 water restrictions Level 2 restrictions Groundwater built and operating Tallowa Dam to -3m FSL Desalination stage 2 construction Halve environmental flows Level 3 restrictions Desalination stage 2 operation 5% Simple long run marginal cost estimates The long-run marginal cost (LRMC) estimate represents the cost of changing the capacity of the water supply system by building a permanent new supply source (such as a dam or a desalination plant). We can use the concept of LRMC to help us decide if a water conservation activity is cheaper or more expensive than the cost of building a permanent augmentation to our water supply. Sydney Water uses models to come up with a simplified value for LRMC. The simplified LRMC value is determined by considering overall system yield 19 and projected future 19 Yield is the sustainable amount of water that can be drawn from drinking water sources over the long-term. It is calculated by WaterNSW. Yield calculations take into account current system operating rules (such as the desalination plant on-off rules, forecast savings from water restrictions, and also include modelling of inflows into Sydney s dams, taking into account possible droughts. (SCA, Greater Sydney s Sustainable Water Supply Yield, 2012). The amount of water actually available from our water supply system in any year can be greater or less than the longterm sustainable yield. Economic Level of Water Conservation - Issues Paper Page 19

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