4 Externalities and Water Pricing

4 Externalities and Water Pricing 4.1 The Full Cost of Water The full cost of water services includes several components (Rogers et al., 1998), including full supply costs, full economic costs and externalities (Figure 1). Externalities are costs and benefits of a transaction that are not fully reflected in the market price (Stiglitz, 1993). Pricing water based on its true cost, full cost pricing, will put resources to its most valuable uses. Effects of full cost pricing include demand reduction, efficient re-allocation of the resource, increased supply, improved equity, improved managerial efficiency and improved sustainability of the resource (Rogers et al., 2002). Figure 1 Components of Full Cost. Environmental Externalities Economic Externalities Opportunity Cost Capital Cost O&M Cost Full Economic Cost Full Supply Cost Full Cost Source: Rogers et al., 1998 Marginal cost pricing of water supply is based on the principle of efficient allocation of the community s scarce resources against competing wants. The marginal cost of water represents the sacrifice made by society to produce an extra unit of a good or service (opportunity cost and economic/externalities in Figure 1). Resources will be efficiently allocated when the price a consumer pays for an additional unit of output is equal to the marginal cost of providing it (Warner, 1995). The marginal cost can be defined as the change in total cost that results from increasing production or output by an additional unit (Warner, 1995). These principles suggest that prices should be set with reference to the marginal cost of water supply to provide efficient signals about costs of service provision. The marginal cost can be calculated from either a short-term or long-term perspective: Short Run Marginal Cost (SRMC) can be defined as the cost of meeting an incremental change in demand, holding capacity constant; 9

Long Run Marginal Cost (LRMC) reflects the cost of meeting an incremental change in demand assuming all factors of production can be varied. LRMC comprises the sum of marginal operating costs and the marginal capital costs associated with bringing forward (or delaying) planned increases in capacity to meet an increase in forecast demand (ESC, 2005). Marginal cost pricing in the water industry should encourage: Efficient investment decisions by water businesses; Efficient procurement and provision decisions; and Matching by consumers of marginal benefits of an additional kilolitre of water consumed with the costs of providing the water (ESC, 2005). In calculating marginal costs, it is necessary to be clear about: The relevant consumption decision, for example, the cost of additional consumption by an existing consumer versus the cost of connection of a new consumer; Marginal cost to whom? The ESC suggests that for prices to encourage efficient decision-making, the relevant cost to be considered is the full cost to society, including any social and environmental costs or externalities (ESC, 2005). The latter point recognises that external costs should be accounted for to achieve social efficiency. If a market fails, only private costs are compensated and social costs (opportunity costs to society) remain unaccounted for. 4.2 The Cost of Externalities Full-cost water pricing guidelines generally reflect two perspectives on how to define the cost of externalities associated with water supply and/or use: the economic perspective and the costrecovery perspective (Dwyer et al., 2006). The approach taken in this study has been to explore pricing for externalities as defined in cost recovery terms. The Economic Perspective The economic definition of externalities was adopted by the High Level Steering Group on Water (2000): Externalities are the indirect or accidental consequences of actions associated with economic activity. When two parties (e.g. water business and customer) undertake a transaction (e.g. provision of water), there may be unintended spill-over impacts on third parties (e.g. river health may be affected, which affects users of recreational spaces near rivers). An externality is the impact that occurs on this third party. If there are externalities associated with water use, the social marginal cost will exceed the private marginal cost (cost to water businesses). 10

Figure 2 Negative externalities (external costs) emerge when Marginal Private Costs (MPC) and Marginal Social Costs (MSC) are misaligned. Unit Cost or Price (P) Marginal Social Cost (MSC) NEGATIVE EXTERNALITY Marginal Private Cost (MPC) Social Cost (Negative externality) Value of the externality Marginal Benefit Quantity Produced (Q) Figure 3 Positive externalities (external benefits) emerge when Marginal Private Benefits (MPB) and Marginal Social Benefits (MSB) are misaligned. Unit Cost or Price (P) POSITIVE EXTERNALITY Marginal Cost Value of the externality Social Benefit (Positive externality) Marginal Social Benefit (MSB) Marginal Private Benefit (MPB) Quantity Produced (Q) In theory, the price would need to be set to reduce water supplied/used to the socially optimal level. However, as noted by the High Level Steering Group on Water (2000), when 11

employed exclusively, pricing will not necessarily manage externality costs effectively. The Steering Group suggested that a variety of tools should be used to address externalities associated with water supply and use. The Cost Recovery Perspective In the guidelines for water pricing endorsed by CoAG and the Agriculture and Resource Management Council of Australia and New Zealand (ARMCANZ), defined the cost of externalities as (NCC, 2001): The environmental and natural resource management costs attributable to and incurred by the water business. These pricing guidelines determined there was no one best way of achieving full cost recovery, due to the varying circumstances of service providers (Whitten et al., 2002). The guidelines provided a range of cost recovery levels that would satisfy the full cost recovery requirement (Table 1). The minimum level was the price required to maintain a viable business including the payment of interest to debt providers and the provision of dividends. The maximum price was one that recovered all costs, including externalities. Table 1 Pricing for Full Cost Recovery Minimum Level (Viable Business) Maximum Level (All Costs Recovered) Operational Costs Maintenance Costs Administration Costs Externalities Taxes Provision for asset replacement Interest cost on debt Operational Costs Maintenance Costs Administration Costs Externalities Taxes Provision for cost of asset consumption Cost of capital Dividend Source: (Whitten et al., 2002) Applying the CoAG guidelines would suggest that the price of water equals the LRMC, i.e. the costs of supply (operation, capital, maintenance, etc) plus the costs of externalities. The guidelines do not, however, specify how to assess what environmental and natural resource management costs are attributable and incurred by the water businesses, what an appropriate proportion of costs is, nor the extent to which environmental problems should be mitigated. Furthermore, as the ESC noted in its pricing guidelines (ESC, 2006), the Commission is not responsible for deciding on the environmental, water quality and other obligations or priorities placed on businesses. 4.3 Types of Externalities Externalities can be categorised in many ways. For example, without providing detailed definitions, Bowers and Young (2000) suggest the following categories: 12

Production externalities; Property damage externalities; Fisheries externalities; Recreation externalities; Amenity externalities; Health externalities; Wildlife and biodiversity externalities. Water use externalities occur throughout the water cycle. The High Level Steering Group on Water (2000) for managing externalities categorises them as follows: Extraction and storage externalities caused by the extraction, harvesting, diversion or storage of water; Return externalities caused by the return of (usually) contaminated water and/or wastewater; Stormwater and overland run-off externalities caused by land use practices that change the rate, quantity, quality and timing of flows. Van Bueren & Hatton MacDonald (2004) categorise water externalities depending on whether they have a direct or indirect impact on people and ecosystems, and which stage of water provision activity they are generated by (i.e., catchment management activities, extraction, storage, use, distribution, disposal). 13

Table 2 Types of Water-Related Externalities. Catchment management activities Direct impacts + Biodiversity protection + Pollution Indirect impacts + Recreation in catchments + Visual amenity Water extraction - Flushing of floodplains - Creation of sulfidic material Water storage + Flood mitigation - Degraded stream bank vegetation - Aquatic weeds - River salinity - Barriers to fish - Habitat disturbance at dam Water use - Soil salinity due to rising groundwater Water distribution - Disease transfer - Flow-related damage - Amenity - Biodiversity + Recreation on dams + Dam heritage value + Boating on dams - Amenity - Fishing opportunities downstream - Agricultural yield loss - Infrastructure damage - Threats to fish populations - Temperature pollution Water disposal - Algal blooms - Degraded stream bank vegetation - Damage to seagrass - Recreation - Fishing - Amenity Source: Van Bueren & Hatton MacDonald, 2004. Externalities have been classified as tangible or intangible (Bowers & Young, 2000). Pain, grief and suffering are examples of intangible externalities because there is no market to which reference can be made to achieve a valuation. Impacts to wildlife and biodiversity can be categorised as intangible. Where an externality is tangible, the assets affected are traded in markets and have market values and it is therefore possible to apply monetary values to the impacts (e.g., the cost of cleaning up pollution). The distinction between tangible and intangible externalities is further elaborated in Section 5.2. 14

4.4 Identifying Externalities Defining the Urban Water System An important first step in assessing the cost of externalities is to identify impacts that potentially lead to externalities. This will require definition of the (urban) water system under consideration. Defining a system not only involves a geographical demarcation, but will also involve decisions as to which elements of the urban water supply system to include as well as the time scales to consider. Typically, complex subjects and tasks are broken down into smaller units to make problems more manageable (Senge, 1990). This creates the impression that the world faced by the decision-maker is created of separate, unrelated factors, which in turn makes it hard to see the consequences of actions and changes. Systems thinking (Checkland, 1981; Midgley, 2003) is about considering the relationships between factors to develop a holistic picture of the reality in which complex decisions are to be made. In the urban water context, a systems approach ensures that all relevant parts of the water supply chain (supply, wastewater, stormwater) receive adequate attention in the cost analysis, at the proper scale (allotment, sub-division/suburb and city/region). Even when understood as a single entity, different definitions of the (urban) water system are possible. Examples include: the drinking water catchment, the dam, the water treatment plant, the community, the sewage treatment plant and waterways 1 ; water supply, stormwater management and wastewater infrastructures (Clarke et al., 1997; Pinkham 1999); an adaptive socio-technical network (Guy et al., 2001); all natural, modified or built water and hydrological systems in an urban region (NZ PCE, 2000); and the technological infrastructure, the organisational structures and the users of that infrastructure (Urban Water, 2002). For this paper, we adopt the following definition of a water system (Fane, 2005): A system is a set or assemblage of things connected, associated, or interdependent, so as to form a complex unity. System definitions are inherently dependent on the mental models of observers, and what infrastructure managers perceive as the water system will have profound planning, assessment and analysis implications. When managers and analysts conceptions are limited, the options and alternatives available also will be limited. For example, if water supply, sewage and stormwater infrastructures are viewed in isolation, then potentially synergistic strategies that can have advantages across infrastructures, such as rain tanks or local reuse of wastewaters may not be recognised. Similarly, if planners perceive the boundary of the urban water supply system to be the property boundary, then demand management programs will not be considered as an alternative to increasing bulk supplies. Likewise, whether or not recycling nutrients back to agriculture is seen as a necessary 1 http://www.waterquality.crc.org.au/consumers/consumersp5.htm (last accessed March 2007). 15

function of the water system will impact on decision-making about what constitutes effective wastewater management. Impacts of Water Service Provision Addressing urban water externalities calls for a sound knowledge of the cause and effect relationships between water supply and sewer activities and ecosystem damage (Van Bueren & Hatton MacDonald, 2004). These effects occur at different spatial scales and can emerge both in the physical and socio-economic realm. For example, visual amenity will change only locally when a dam is constructed, but the greenhouse gas emissions resulting from the dam construction will have a global effect. Affordability issues arising from pricing are an example of a socio-economic effect, whereas greenhouse gas emissions are a biophysical effect which ultimately can lead to socio-economic effects as well. Local and regional effects The potential biophysical impacts of water service provision on its local system environment include pollution of aqueous ecosystems, flooding damage and waterborne infections in the community. Socio-economic impacts of urban water provision include: changes in amenity (positive or negative, e.g., protected reservoir areas providing recreation space, water treatment resulting in reduced coastal amenity); recreation (changes to fish stocks due to water levels in rivers, or through reduced connectivity of river systems); economic wellbeing (pricing and equity of pricing structures, housing affordability property values due to land use); culture (items of heritage value protected or lost, traditional use and relationship to place) and mobility (any impacts on transport systems). Global effects From a global biophysical perspective, urban water infrastructures utilise resources and energy, and produce or induce greenhouse gases. In addition, as discussed by Otterpohl et al. (1997) and Esrey et al. (1998), sewage management practices have the potential to impede the long-term sustainability of food production systems at a global level. Currently, non-renewable components, in particular phosphate from human excreta, are not recycled to their origin in agricultural soils and therefore, global food production systems are reliant on inputs of phosphate from fossil reserves. The issues of limited water resources and related regional impacts are conceived as a global concern (GWP, 2003). Methods for Identifying Impacts There are many ways to identify the impacts of a given project, strategy, process or option (e.g., Hollis et al., 1997). Ideally, system modelling would be undertaken to identify the key biophysical impacts of a particular activity. System modelling is preferable because experts typically hold different perceptions of what the system s impacts might be. In many cases, existing information about impacts is at the wrong scale or is not relevant to policy decisions: Biophysical scientists are not generally able to provide damage functions mapped in the correct dimensional space for use by economists or natural resource managers. Further, 16

monitoring programs often have not been in place long enough or maintained over large enough geographic areas to provide more than cautious advice. In some cases, the science has not been targeted to answering policy relevant questions (Van Bueren & Hatton MacDonald, 2004). Modelling can be undertaken for both biophysical and socio-economic systems. Biophysical modelling, for example, might map the local characteristics and inter-relationships between geology, hydrology, freshwater, terrestrial and coastal ecosystems, climate, anthropogenic systems such as industry and its outputs, extraction, water treatments and so on. Social systems modelling (as it is relevant to social impact assessment) might include network mapping (a form of assessing social capital), institutions mapping (a way to assess political and social processes relevant to the issue), or research into housing affordability, distributional effects of options, transport impacts and such. Although systems modelling may be the ideal, in reality the resources required to undertake biophysical/socio-economic analysis are rarely available. Less resource-intensive approaches to identifying the likely externalities of the system can be adopted in these cases. The following section summarises quantitative and qualitative methods commonly used to identify system impacts. Dose-Response Modelling Dose-response modelling (DRM) involves modelling physical relationships between cause and effect. For example, for wastewater resulting in eutrophication of the water system, a dose-response model would predict the degree of eutrophication from the volume of dirty water discharged and any other key variables that affect the outcome. To be useful in the context of externalities, DRM has to extend from the actions of the individual or body that is causing the externality, to the response of the individuals or bodies that perceive the external effect (Bowers & Young 2000). Life Cycle Assessment For manufactured products, a life cycle assessment (LCA) is a useful way to identify impacts and externalities. LCA might involve separate stages such as compilation and evaluation of the inputs, outputs and potential environmental impacts of a product system throughout its life; a list of emissions, resource uses, land use, etc. needs to be collected before impact assessment is applied (Wrisberg & De Haes, 2002; Goedkoop et al., 2006). Existing lists of impacts Referring to existing policy statements or geographic/system specific reports is a simple way to generate an initial list of impacts. Checklists and matrices When comprehensive systems modelling (e.g., using DRM or LCA) cannot be undertaken, and existing lists are not readily available, checklists and matrices can be used to prompt thinking and to ensure that less obvious impacts are not omitted. There are different kinds of checklists, ranging from simple (a list of environmental parameters with no guidelines on how they are to be measured and interpreted), descriptive (includes an identification of environmental parameters and guidelines on how to measure data on particular parameters), scaling (like a descriptive checklist, but with additional information on 17

subjective scaling of the parameters) and scaling weighting (similar to a scaling checklist, with additional information for the subjective evaluation of each parameter with respect to all the other parameters) (Lohani et al., 1997). Stakeholder Engagement Stakeholder engagement is another way to identify impacts. This may be the most effective method when comprehensive systems modelling and existing policy statements/research findings are absent or not possible. A workshop setting allows for deliberation and a wide range of perspectives, and enables participants to respond to other points of view and build new perspectives. This will result in the identification of impacts that might have been missed when seeking individual responses. Stakeholder engagement is likely to add a sense of transparency and democratic legitimacy to the process, at least for the stakeholders represented. 18