Australia's Urban Water Sector

Productivity Commission Australia’s Urban Water Sector Draft Report

April 2011

This is a draft report prepared for further public consultation and input. The Commission will finalise its report after these processes have taken place. © Commonwealth of Australia 2011 This work is copyright. Apart from any use as permitted under the Copyright Act 1968, the work may be reproduced in whole or in part for study or training purposes, subject to the inclusion of an acknowledgment of the source. Reproduction for commercial use or sale requires prior written permission from the Productivity Commission. Requests and inquiries concerning reproduction and rights should be addressed to Media and Publications (see below). This publication is available from the Productivity Commission website at www.pc.gov.au. If you require part or all of this publication in a different format, please contact Media and Publications (see below).

Publications Inquiries: Media and Publications Productivity Commission Locked Bag 2 Collins Street East Melbourne VIC 8003 Tel: (03) 9653 2244 Fax: (03) 9653 2303 Email: [email protected]

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An appropriate citation for this paper is: Productivity Commission 2011, Australia’s Urban Water Sector, Draft Report, Canberra.

JEL code: Q and R.

The Productivity Commission The Productivity Commission is the Australian Government’s independent research and advisory body on a range of economic, social and environmental issues affecting the welfare of Australians. Its role, expressed most simply, is to help governments make better policies, in the long term interest of the Australian community. The Commission’s independence is underpinned by an Act of Parliament. Its processes and outputs are open to public scrutiny and are driven by concern for the wellbeing of the community as a whole. Further information on the Productivity Commission can be obtained from the Commission’s website (www.pc.gov.au) or by contacting Media and Publications on (03) 9653 2244 or email: [email protected]

Opportunity for further comment

You are invited to examine this draft report and make written submissions to the Productivity Commission by Wednesday, 18 May 2011. The final report will be prepared after submissions have been received and public hearings held, which will be forwarded to the Government by 31 August 2011.

Public hearing dates and venues Location Date Venue Hobart Friday, 20 May 2011 Mercure Hotel Hobart – Wellington Room 156 Bathurst Street, Hobart Adelaide Monday, 23 May 2011 Mercure Grosvenor – Glenroy Room 125 North Terrace, Adelaide Perth Tuesday, 24 May 2011 Novotel Perth – Langley Room 221 Adelaide Terrace, Perth Sydney Tuesday, 31 May 2011 Adina Apartment Hotel – Fitzroy Room 359 Crown St, Surry Hills Brisbane Wednesday, 1 June 2011 Rydges, South Bank – Boulevard Room Cnr Grey and Glenelg Sts, South Bank Canberra Monday, 6 June 2011 Productivity Commission – Hearing Room Level 2, 15 Moore St, Canberra Melbourne Friday, 10 June 2011 Rendezvous Hotel – Ballroom B 328 Flinders St, Melbourne If you wish to appear at a public hearing, please register online at www.pc.gov.au/projects/inquiry/urban-water or advise Carole Gardner (telephone (03) 9653 2194 or email [email protected]).

Commissioners

For the purposes of this inquiry and draft report, in accordance with section 40 of the Productivity Commission Act 1998 the powers of the Productivity Commission have been exercised by: Wendy Craik Presiding Commissioner Warren Mundy Commissioner

OPPORTUNITY FOR III FURTHER COMMENT

Terms of reference

Productivity Commission Inquiry into examining the case for microeconomic reform in Australia’s urban water sector I, Nick Sherry, Assistant Treasurer, pursuant to Parts 2 and 3 of the Productivity Commission Act 1998 hereby request that the Productivity Commission undertake an inquiry into examining the case for microeconomic reform in Australia’s urban water sector. Background The urban water sector is responsible for providing sustainable, secure and safe drinking water and wastewater services. These services include: water harvesting; water manufacturing (e.g. desalination); storage; treatment and distribution; and wastewater removal and treatment. At times urban water utilities are also responsible for stormwater and flood mitigation services. Additionally, the sector has a role in encouraging the responsible use of water and water conservation. Urban water services are generally provided by state and territory government owned entities or by local councils. In recent times, the ability of our urban water systems to meet demand for water in our cities and towns has been challenged by severe droughts, climate change, increasing urban populations and ageing water infrastructure. Ensuring long term water security requires effective arrangements that encourage timely investment in diversified water supplies and improve the efficiency of water use. Reforms aimed at improving efficiency in the urban water sector began in the 1990s following the adoption of a water framework by the Council of Australian Governments (COAG) in 1994, which elevated better management of Australia’s water resources to achieve positive social, environmental and economic outcomes to a national issue. Reform was further encouraged through the Intergovernmental Agreement on a National Water Initiative in 2004. In recognition of growing urban water supply challenges, the COAG national urban water reform framework was enhanced in November 2008. While the urban water sector has made progress towards reforms, there is scope for further changes. This inquiry will assist COAG to advance urban water reforms in Australia by identifying pathways to achieve improved resource efficiency through reforms in arrangements that govern the urban water sector.

Scope of the inquiry The Commission is to report within twelve months on: 1. Opportunities for efficiency gains in the structural, institutional, regulatory and other arrangements in the Australian urban water and wastewater sectors; 2. Options to achieve the efficiency gains identified in point 1. The options are to be subjected to a rigorous cost benefit analysis, including using quantitative assessments to the fullest extent possible, to identify: a. the economic, social and environmental impacts; b. the impacts on Australian governments, business and consumers; and c. the propensity to facilitate supply and demand planning and decision-making in the medium and long term. 3. A proposed work program including implementation plans for the options, identifying: a. practical actions that the Commonwealth, state and territory governments and local councils can undertake to implement options for reforms, including any transitional arrangements;

IV TERMS OF REFERENCE

b. priority areas where greatest efficiency gains are evident and where early action is practicable; and c. quantitative and qualitative indicators for efficiency gains in the urban water and wastewater sectors.

Considerations In conducting the inquiry, the Commission is to have regard to: 1. A definition of urban that encompasses cities, towns and regional centres / villages; 2. The importance of long term water security — taking into account changes in climate, population and economic activity — without compromising social, health and environmental outcomes; 3. The roles of the Commonwealth and state and territory and local governments with respect to urban water and wastewater policy, supply and management; 4. The different circumstances across Australia, including: o Variability between water catchments, supply alternatives and demand; o Relationships between urban water users and other water users, including consideration of water resource planning and allocation frameworks; o Committed and planned investment to augment urban water supplies; o Current urban water reforms, such as planning, pricing and third party access; and o Emerging competition, including in the provision of water supply services. 5. Emerging water management practices, such as the integrated management of water, wastewater, recycled water and stormwater; 6. Lessons from reform in the rural water and natural resource management sectors and from overseas reform; 7. Lessons learnt from reforms in other utility sectors in the Australian economy. This should take into account differences in the intrinsic values of water compared to other products and operational differences between the industries, including product storage, availability, and transport costs; 8. The COAG 1994 reform outcomes, the national competition policy arrangements, the National Water Initiative provisions applying to urban water, the third party access provisions of the Trade Practices Act Part IIIA, competition and access regimes and the 2006 intergovernmental Competition and Infrastructure Reform Agreement; and 9. Current and recent review activity relating to urban water issues in Australia, including those undertaken by regulatory bodies.

In undertaking the inquiry, the Commission is to advertise nationally inviting submissions, hold public hearings, and consult with relevant Australian Government, state and territory government agencies, local government, water utilities, other key interest groups and affected parties.

The Commission is to provide both a draft and a final report. Both reports are to be published.

NICK SHERRY [Received 22 July 2010]

TERMS OF REFERENCE V

Contents

Opportunity for further comment III Terms of reference IV Abbreviations XI Overview XV Draft recommendations, findings and information requests XLIII 1 Introduction 1 1.1 Background to this inquiry 1 1.2 What has the Commission been asked to do? 3 1.3 Scope of the Inquiry 4 1.4 The Commission’s approach 4 1.5 Conduct of the inquiry 6 1.6 Guide to the report 8 2 About Australia's urban water sector 9 2.1 Water supply 10 2.2 Water consumption 21 2.3 Recent supply augmentation and demand management initiatives 25 2.4 Performance of the urban water sector 38 2.5 Structure, institutions, governance and regulatory arrangements 46 3 Objectives for the urban water sector 59 3.1 What objectives? 60 3.2 Economic efficiency as an overarching objective 72 4 The role of governments 75 4.1 Market provision 76 4.2 Government involvement 80 4.3 Conclusions 83

CONTENTS VII

5 Improving regulation of the urban water sector 85 5.1 What are the costs of regulation? 87 5.2 Sources of unnecessary regulatory costs 89 5.3 Promoting good regulatory practice 93 5.4 Weighing up the costs and benefits of regulatory proposals is important 96 5.5 When should regulation not be used? 98 6 Supply of water, wastewater and stormwater services 101 6.1 Making better supply augmentation decisions 102 6.2 Improving system operations and asset management 127 6.3 Other opportunities in the supply of wastewater and stormwater services 132 6.4 Achieving integrated water cycle management 135 6.5 Scope for efficiency gains in regional urban areas 145 7 Pricing of water and wastewater 149 7.1 Pricing of bulk water 151 7.2 Pricing of wastewater and stormwater services 159 7.3 Pricing of water and wastewater transmission and distribution networks 165 7.4 Final retail pricing 172 7.5 Assessment of NWI pricing principles 192 8 Non-price demand management 195 8.1 Water restrictions 196 8.2 Water use efficiency and conservation measures 203 8.3 Impediments to achieving efficiency gains 210 9 Achieving affordability and consumer protection objectives 215 9.1 Affordability of water and wastewater services 216 9.2 Consumer policy framework 240 10 Framework for reform 249 10.1 Objectives for reform 250 10.2 Reform options 255

VIII CONTENTS

11 Institution-centred reform 257 11.1 Introduction 258 11.2 Assigning roles and responsibilities 258 11.3 Governance of water utilities 260 11.4 Rethinking economic regulation of the urban water sector 272 11.5 Governance arrangements for regulators 286 11.6 Institutional and other changes to support improved water resource allocation 295 11.7 The Commission’s ‘Option 1’ 300 12 Structural reform options for large urban cities 303 12.1 Structural reform 306 12.2 Reform option 2: Vertical and horizontal separation of the bulk water supply function 327 12.3 Reform option 3: Vertical and horizontal separation of the wastewater treatment function 343 12.4 Reform option 4: Horizontal separation of retail-distribution 348 12.5 Reform option 5: Decentralised competition 362 13 Reform in regional areas 369 13.1 Regional water, wastewater and stormwater sector 371 13.2 Case for horizontal aggregation of utilities 392 13.3 Options for organisational structure 411 13.4 Other issues for regional areas 420 14 Implementing reform and monitoring progress 433 14.1 The reform package 434 14.2 The role of governments in implementing reform 438 14.3 Monitoring progress of reform 443 A Public consultation 445 B Further information on Australia's urban water sector 455 C Lessons from other water sectors 505 D Lessons from reform in other utility sectors 529 References 535

CONTENTS IX

Abbreviations

ABS Australian Bureau of Statistics ACCC Australian Competition and Consumer Commission ACG Allen Consulting Group ACOSS Australian Council of Social Service ADWG Australian Drinking Water Guidelines AEMO Australian Energy Market Operator AER Australian Energy Regulator AWA Australian Water Association BAE Binding alliance entity BASIX Building Sustainability Index CBA Cost–benefit analysis CHINS Community Housing and Infrastructure Needs Survey CIE Centre for International Economics CMA Central Market Authority COAG Council of Australian Governments CPI Consumer Price Index CSO Community Service Obligation CUAC Consumer Utilities Advocacy Centre DECCW Department of Environment, Climate Change and Water (NSW) DERM Department of Environment and Resource Management (Qld) DVA Department of Veterans’ Affairs (Cwlth) EPA Environmental Protection Authority EPBC Act Environmental Protection and Biodiversity Act 1999 (Cwlth) ERA Economic Regulation Authority

ABBREVIATIONS XI

ERRR Economic real rate of return ESC Essential Services Commission ESCOSA Essential Services Commission of South Australia ESD Ecologically sustainable development FERC Federal Energy Regulatory Commission (US) FPC Federal Power Commission (US) GL Gigalitres (equal to one thousand megalitres) GTE Government trading enterprise IBT Inclining block tariff ICEWaRM International Centre of Excellence in Water Resources Management ICRC Independent Competition and Regulatory Commission IPART Independent Pricing and Regulatory Tribunal IPE Independent procurement entity IWCM Integrated Water Cycle Management kL Kilolitres (equal to one thousand litres) LGAQ Local Government Association of Queensland LGSA NSW Local Government and Shires Associations of NSW LMWUA Lower Macquarie Water Utilities Alliance LRAC Long-run average cost LRMC Long-run marginal cost LWU Local Water Utilities ML Megalitres (Equal to one thousand kilolitres) MVRC Moonee Valley Racing Club MWST Ministerial Water and Sewerage Taskforce (Tas) NCC National Competition Council NCP National Competition Policy NEM National Electricity Market NHMRC National Health and Medical Research Council NPAT Net profit after tax

XII ABBREVIATIONS

NRETAS Department of Natural Resources, Environment, The Arts and Sport (NT) NTE Network transmission entity NWC National Water Commission NWI National Water Initiative OECD Organisation for Economic Co-operation and Development Ofwat The Water Services Regulation Authority (UK) OMA Operating, maintenance and administration costs OTTER Office of the Tasmanian Economic Regulator PC Productivity Commission PIAC Public Interest Advocacy Centre QCA Queensland Competition Authority QWC Queensland Water Commission RIS Regulatory impact statement SCA Sydney Catchment Authority SDP Sydney Desalination Plant Pty Ltd SEQ South-east Queensland SEQWGM South-east Queensland water grid manager SRMC Short-run marginal cost TasCOSS Tasmanian Council of Social Service VCEC Victorian Competition and Efficiency Commission VTS Victorian Transmission System WELS Water Efficiency Labelling Scheme WGM Water grid manager WICA Water Industry Competition Act 2006 (NSW) WICS Water Industry Commission for Scotland WIST Water Industry Skills Taskforce WSAA Water Services Association of Australia

ABBREVIATIONS XIII

OVERVIEW

Key points

• There is a public perception that water provision should be treated differently from other utility services (energy, telecommunications and mail) because water is ‘essential for life’.

• In recent times, the urban water sector has faced unexpected severe low water availability, growing populations and ageing assets.

• Governments have largely responded with prolonged use of severe water restrictions and large investments in desalination capacity.

• But the costs to consumers and the community have been high. – Nationally, evidence from a number of sources suggests that water restrictions are likely to have cost in excess of a billion dollars per year from the lost value of consumption alone. – Based on modelling for Melbourne and Perth, inefficient supply augmentation could cost consumers and the community of these two cities between $3.1 to $4.2 billion over 20 years, depending on modelling assumptions.

• There is a compelling case for reform, with conflicting objectives and unclear roles and responsibilities of institutions contributing to inefficient allocation of water resources, inefficient investment, undue reliance on water restrictions and costly water conservation programs.

• Gains are likely to come initially from improving the performance of institutions with respect to governance, regulation, and procurement of supply and pricing, rather than trying to create a competitive market as in the electricity sector.

• Some reforms should be adopted across all jurisdictions and regions as a priority, with other (structural) reforms assessed and implemented on a case-by-case basis.

• The universal (priority) reforms relate to: – clarifying that the overarching objective for policy in the sector is the provision of water, wastewater and stormwater services that maximise net benefits to the community – ensuring that procurement, pricing and regulatory frameworks are aligned with the overarching objective and assigned to the appropriate organisation – putting in place best practice arrangements for policy making and regulatory agencies, and water utilities – performance monitoring of utilities and monitoring progress on reform.

• The circumstances of each jurisdiction and region differ and there is not a ‘one size fits all’ solution to industry structure. In addition to the universal reforms, the Commission has set out: – four structural options for large metropolitan urban water systems – three structural options for small stand-alone regional systems.

• There is a role for COAG, but governments can proceed to implement reform.

XVI AUSTRALIA'S URBAN WATER SECTOR

Overview

Following the agreement of COAG, the Australian Government has asked the Productivity Commission to examine the case for microeconomic reform in the urban water sector and to identify pathways to achieving improved resource allocation and efficiency.

The urban water sector is taken to include:

• planning, procuring and supplying water of appropriate quality to households and commercial users

• collecting, treating and disposing or recycling of wastewater (sewage and tradewaste)

• managing drainage and stormwater for flood mitigation, environmental protection, disposal or recycling purposes.

The terms of reference involve three main tasks. First, a requirement to identify opportunities for efficiency gains through changes to structural, institutional, regulatory, and other arrangements in the Australian urban water and wastewater sector.

Second, provide options to achieve the identified efficiency gains, and quantitatively assess these options (to the extent possible) to identify their:

• economic, social and environmental impacts

• impacts on Australian governments, business and consumers

• propensity to facilitate supply and demand planning and decision-making in the medium and long term.

Third, propose a work program, including priority areas and implementation plans.

The origin of this inquiry can be traced to the COAG agreement of 2008 (box 1), with recent experiences in the sector (outlined below) creating further impetus for this inquiry.

OVERVIEW XVII

Box 1 History of urban water reform Water reform in Australia began in the early 1980s, notably with the appointment of John Paterson as President and Chief Executive of the Hunter Water Board. In 1982, the Board implemented a user-pays water tariff for residential customers. In 1992, the Hunter District Water Board became the first major urban water authority in Australia to be corporatised. Significant milestones for reform include the:

• Industry Commission (1992) inquiry into water resources and wastewater disposal

• COAG (1994) strategic framework for the efficient and sustainable reform of the Australian water industry, developed by the Working Group on Water Resource Policy

• COAG (1995) National Competition Policy and Related Reforms, which included payments to jurisdictions that effectively implemented the strategic framework for water reform in the 1994 agreement

• COAG (2004) National Water Initiative and the establishment of a National Water Commission to assist with, and to assess progress on the effective implementation of, the water related reforms in the 1995 agreement and to progress additional agreed reforms

• COAG (2008) enhanced national urban water reform framework to improve the security of supply for urban water.

Several organisations are concurrently undertaking projects that cover issues being examined in this inquiry, in particular the National Water Commission. The Productivity Commission is liaising with these organisations and is drawing upon their work as it becomes publicly available.

The urban water sector is diverse. The structural, institutional, governance and regulatory arrangements vary between jurisdictions as well as between metropolitan and regional areas. In 2008-09, there were 32 major urban, 51 non-major urban and 194 minor urban providers of water and wastewater services. Collectively, they had total revenue of about $10 billion. There has been reform to the structural arrangements of the sector in the past two decades. In metropolitan areas, there has been a move towards vertical separation of the supply chain, as well as corporatisation of utilities. In regional areas, most utilities are vertically integrated and in some jurisdictions, there has been aggregation of small utilities, with some corporatisation of these utilities.

XVIII AUSTRALIA'S URBAN WATER SECTOR

there is understandable community anxiety about the consequences of there not being enough water to meet basic human and industry needs. This can lead to a high degree of political involvement in water issues and pressure to adopt objectives, policies and institutional arrangements that are different from those applied in other utility sectors.

An urban water sector under stress

Although considerable reform has occurred over the past three decades, the urban water sector has been under stress in recent times. This has mainly arisen from a lengthy period of unexpected low rainfall and inflows to dams, rivers and aquifers, followed most recently by heavy rain and floods in eastern Australia. Pressures from growth in demand and reduced capacity to supply from existing rainfall dependent sources has led to:

• prolonged use of severe water restrictions and consumption targets

• use of mandated measures and/or subsidies to reduce the consumption of potable water from bulk sources of supply (including rainwater tanks, low flow shower heads and water recycling schemes for non-potable uses)

• large investments in rainfall-independent supply capacity, often after political intervention and/or consideration of a limited set of options.

In some regional areas deficient operational, maintenance and investment practices have led to inadequate water quality, with ‘boil water’ notices being issued and exemptions granted for compliance with standards for the discharge of treated wastewater.

Water restrictions and water conservation measures have been costly

Although generally very well tolerated by consumers, restricting water consumption is costly and the distributional consequences are not well understood (box 2). Water consumption is relatively unresponsive to changes in price, indicating that consumers generally place a high value on water consumption. Numerous studies indicate that the costs of water restrictions can be large. Nationally, water restrictions are likely to have cost in excess of a billion dollars per year from the lost value of consumption alone.

OVERVIEW XIX

Box 2 Consumer costs of water restrictions Some of the costs imposed on consumers from water restrictions include:

• loss of amenity from the deterioration of lawns and gardens

• purchasing and installing new watering systems as changes occur in allowed methods of watering, such as installing ‘greywater’ systems and rainwater tanks

• the need to adopt labour-intensive methods of watering when watering is permitted, a tax in kind on watering: – carrying ‘greywater’ in buckets from showers to outdoor plants – loss of sleep and/or leisure as a result of setting alarms to arise and water gardens in permitted time periods – having to water in the dark – cancelling or rearranging other activities in order to water gardens at permitted times

• inability of children to play under garden sprinklers and to use water toys

• the need to drive cars to a car wash and paying to clean them

• increased damage to buildings, other structures and pipes through cracking. The distributional consequences of these costs are not well understood, with some experiencing many of these costs and others only a few. However, it is difficult to conclude the distributional outcomes are progressive with respect to income. Water restrictions impact on people beyond their homes. They experience loss of amenity from unwatered council parks (or they pay through their rates for high-cost recycled water to keep them green). Community sporting facilities can also be adversely affected because of the state of water-deprived sports grounds. The Centre for International Economics estimated that the total cost of restrictions to the ACT community for stage 1 restrictions was $5.2 million per annum and $209 million for stage 4 restrictions. Grafton and Ward (2010) found that water restrictions in Sydney in 2004-05 resulted in aggregate welfare losses to consumers of about $275 million (2010 dollars) relative to a volumetric price that would have ensured the same level of demand and a lower fixed charge. Based on economic modelling undertaken by the Commission for this inquiry, the reduction in welfare to the community from stage 3a restrictions in Melbourne is estimated to be between $420 million and $1500 million over a 10 year period, depending on modelling assumptions. This welfare loss is an understatement of the actual costs of restrictions as it does not capture the differential effect of restrictions for individual households. For example, some households that are prepared to pay a high price for additional water might have to forego consumption due to restrictions.

XX AUSTRALIA'S URBAN WATER SECTOR

Further, demand side management and water conservation programs are imposing large costs on consumers per unit of water saved that far outweigh the cost of supplying them with water. For example, Crase and Dollery (2005) examined subsidies paid in Melbourne on water-saving investments for households. They found that the cost per megalitre of water saved ranged from $770 for AAA shower roses, to $9069 for rainwater tanks, to $33 395 for AAA dishwashers. This compares with a price for water of between $750 and $1300 per megalitre at the time of the study.

Costs of inefficient resource allocation and investment are large

There is sufficient evidence available to the inquiry to conclude that much of the recent investment in supply augmentation using desalination (table 1) could have been smaller in scale and from a source other than desalination, while maintaining security of supply. Lower cost sources of water supply, such as urban-rural trade and aquifers, have been available in several jurisdictions, but large investments in desalination have been preferred.

Table 1 Desalination plants

Initial Maximum Initial (and Initial Completion capacity expandable expandable) investment date capacity capacity as a percentage of annual consumption in 2007-08

Units GL/year GL/year % ($m) Sydney (Kurnell) 90 180 15 (30) 1 890 completed Melbourne (Wonthaggi) 150 200 41 (54) 3 500 2011 SE Queensland (Tugun) 49 24 1 200 completed Adelaide (Port Stanvac) 100 71 1 830 2012 Perth (Kwinana) 45 19 387 completed Perth (Binninyup) 50 100 21 (42) 955 2011 Total 484 674 27 (38) 9 762

Although it is difficult to estimate the costs of inefficient investment with precision, these costs appear to be large. For example, in 2006, a review of plans to augment Sydney’s water supply estimated that expected savings of around $1.1 billion were available from adopting a 30 per cent (dam storage) trigger for augmentation, relative to a decision to proceed with augmentation when dam levels were at 48 per cent. Subsequently, the government committed to proceeding when dam levels were 34 per cent and signed the contract to proceed at a time when storages

OVERVIEW XXI

were at 57 per cent, suggesting that even larger savings would have been possible from deferring the decision to invest.

Based on case-study modelling of Melbourne and Perth undertaken by the Commission, the costs to consumers and the community of proceeding with desalination plants ahead of lower cost alternatives could be of the order of $1.8 billion to $2.5 billion for these two cities combined over a 10 year period and $3.1 billion to $4.2 billion over a 20 year period, depending on modelling assumptions.

Evidence suggests that inefficient investment in supply augmentation has also occurred in other capital cities, such as Adelaide.

What are the impediments to performance?

Outcomes for the sector over time depend, in large part, on government policies and regulations designed to achieve objectives relating to provision of services, affordability, public health and the environment. Specific government policies and regulations relate to:

• price setting, security and reliability of supply, water quality standards, water use efficiency, and water conservation

• affordability of water for low-income households

• supply of water for amenity and environmental purposes within urban areas

• the use and procurement of various sources of bulk water supply, and disposal or recycling of wastewater and stormwater.

The outcomes also depend on how well elected representatives, government departments, regulators and utilities perform their roles. This, in turn, is dependent on how effective governance arrangements are at ensuring institutions are accountable and face the right incentives.

Conflicting and inappropriately assigned objectives

There is an absence of clarity and transparency about the way government objectives and policies relating to service delivery, environmental, public health and social matters, are being applied to the urban water sector. Governments are assigning multiple objectives to their agencies, utilities and regulators, with inadequate guidance on how to make trade-offs among them (box 3). This appears to be particularly true for retailer-distributor utilities and regulators.

XXII AUSTRALIA'S URBAN WATER SECTOR

Box 3 Multiple and conflicting objectives — one example Under its legislation, the Queensland Competition Authority has to have regard to the following matters when making a price determination:

• the need for efficient resource allocation

• the need to promote competition

• the protection of consumers from abuses of monopoly power

• decisions by the Ministers and Local Governments under part 3 about pricing practices of monopoly business activities involving the supply of water

• the legitimate business interests of the water supplier carrying on the monopoly water supply activity to which the determination relates

• in relation to the monopoly water supply activity – the cost of providing the activity in an efficient way, having regard to relevant interstate and international benchmarks – the actual cost of providing the activity – the quality of the activities constituting the water supply activity – the quality of the water being supplied

• the appropriate rate of return on water suppliers’ assets

• the effect of inflation

• the impact on the environment of prices charged by the water supplier

• considerations of demand management

• social welfare and equity considerations, including community service obligations, the availability of goods and services to consumers and the social impact of pricing practices

• the need for pricing practices not to discourage socially desirable investment or innovation by water suppliers

• legislation and government policies relating to ecologically sustainable development

• legislation and government policies relating to occupational health and safety and industrial relations

• economic and regional development issues, including employment and investment growth.

Moreover, some objectives are more appropriately assigned to public health and environmental regulators, or are matters most appropriately considered as part of other government policies and programs, rather than by the economic regulator or utility.

OVERVIEW XXIII

Policy making and regulation is being undertaken in a manner that is at odds with principles for best practice policy making and regulation (box 4).

Box 4 Principles for best practice regulation — Regulation Taskforce (2006)

• Governments should not act to address ‘problems’ until a case for action has been clearly established. This should include establishing the nature of the problem and why actions additional to existing measures are needed, recognising that not all ‘problems’ will justify (additional) government action.

• A range of feasible policy options — including self-regulatory and co-regulatory approaches — need to be identified and their benefits and costs, including compliance costs, assessed within an appropriate framework.

• Only the option that generates the greatest net benefit for the community, taking into account all the impacts, should be adopted.

• Effective guidance should be provided to relevant regulators and regulated parties in order to ensure that the policy intent of the regulation is clear, as well as the expected compliance requirements.

• Mechanisms are needed to ensure that regulation remains relevant and effective over time.

• There needs to be effective consultation with regulated parties at all stages of the regulatory cycle.

Lack of clarity about roles and responsibilities

Governments are also influencing or making decisions, often in a non-transparent way, that more appropriately belong to utilities. This can weaken the incentives, responsibilities, and accountability of utilities to deliver their services in an economically efficient manner. In addition, utilities are often required to make decisions, such as the level of environmental flows in waterways, that are more appropriately assigned to another agency.

Moreover, constraints are being imposed on the operation of utilities that are unnecessarily distorting the allocation of water resources and increasing the cost of supply. This is leading to higher consumer charges, which in many cases could persist for decades.

XXIV AUSTRALIA'S URBAN WATER SECTOR

Impediments to efficient water resource allocation and supply augmentation

Much of the recent investment in supply augmentation using desalination could have been smaller in scale and from a source other than desalination, without jeopardising security of supply. Lower cost sources of water supply, such as rural-urban trade and aquifers, have been available in several jurisdictions.

There are many instances in Australia and other regions (notably Europe) of wastewater being treated and discharged into a river system used to supply downstream communities with potable water. For example, most of the wastewater from the ACT is treated and discharged into the Molonglo River, which then flows into the Murrumbidgee and Murray Rivers. This water is used to supply many cities and towns, including Adelaide.

However, the planned indirect potable use of recycled water has so far been ruled out by governments in response to opposition by communities, even though the National Water Commission has stated there are no public health barriers, and it is used overseas (for example, in Singapore and the United States). In such circumstances, it is important that the community and decision makers are properly informed about the costs, benefits and risks to water consumers, so that the best choices can be made. Community consultation needs to be a component of any decisions on supply augmentation.

There is also evidence to suggest that a more rigorous adoption of the ‘real options’ or adaptive approach to planning and delivering augmentation of supply (box 5) would have reduced the cost of supply augmentation and lowered prices to consumers. For example, the Commission’s own modelling indicates that the difference between applying a real options approach and applying traditional approaches to investment could reduce the cost of supply for Melbourne and Perth collectively, by about $1.1 billion over a 10 year period. This gain can be achieved independently of whether or not consumer prices are flexible.

Subsidies provided by the Australian Government are further distorting investment decisions. For example, in Adelaide, part of the explanation for the large investment in desalination capacity relative to demand (table 1) was a grant of $328 million provided by the Australian Government.

OVERVIEW XXV

Box 5 ‘Real options’ or adaptive planning and investment Making supply augmentation decisions efficiently while maintaining security of supply requires a sophisticated approach to dealing with risk and uncertainty associated with demand and supply, principally arising from the large variation in rainfall and climate change. Real options, or adaptive planning, incorporates into the planning and water procurement processes:

• risk and the probabilities of different scenarios (such as rainfall and inflows)

• the value of flexibility to consumers and suppliers in managing the timing and selection of supply and investments from a portfolio, as rainfall scenarios evolve over time. The portfolio of options include: – supply augmentation – demand-side management, facilitated through an enhanced choice of service offerings available from water retailers. This planning approach can result in some costs being incurred ahead of time, such as getting portfolio projects ‘shovel ready’. However, these costs are more than offset by the flexibility to proceed when required (with a shorter lead time) or to defer the investment if it is not required (it rains). Under traditional planning approaches, a supply augmentation, such as investment in large desalination production capacity, occurs to cover all future supply risks. However, there is a risk that it will rain after the plant is commissioned and it might not be used for a substantial period of time. Santa Barbara, California, built a desalination plant during a 1991 drought; the drought ended before the plant was on-line, and the plant has been mothballed since construction.

A considerable number of regional water utilities fail to meet the water quality standards of the Australian Drinking Water Guidelines and/or issue ‘boil water’ alerts, whereas this is rare in larger metropolitan areas. Similar non-compliance issues exist with respect to wastewater discharge. Many utilities in regional New South Wales and Queensland service fewer than 10 000 connected properties, with some servicing fewer than 1000. A number of reports in recent years indicate that inadequate water quality and asset management are largely attributable to an absence of scale, and constraints on revenue and capital raising, of small utilities.

Too great a focus on water restrictions, water use efficiency and conservation for their own sakes

It is clear that mandatory water restrictions are costly to consumers (box 2) and their use should be limited to extreme circumstances. Similarly, mandatory water conservation measures entail the government ‘picking winners’ as to which water saving technology is used. If these measures are not justified based on rigorous

XXVI AUSTRALIA'S URBAN WATER SECTOR

cost–benefit analysis (of which there is little evidence), consumers can incur costs per unit of water saved that far outweigh the cost of supplying them with water.

Too great a focus on addressing affordability by distorting prices

Using inclining block tariffs that involve setting a low price for essential water is complicated by the link between non-discretionary use and household size. The best illustration of the difficultly and subjectivity of the task of estimating an appropriate entitlement to water at a low price is the large variation in the size of initial blocks chosen by policy makers. Current first tier (lowest price) blocks include 160 kilolitres (kL) in Melbourne, 150 kL in Perth, 255 kL in Brisbane, and 125 kL in Adelaide.

Furthermore, inclining block tariffs can actually result in inequitable outcomes. They disadvantage large households that have higher essential needs than smaller households.

As part of its inquiry, the Commission undertook its own research into consumption patterns and expenditure on water and wastewater services by consumer groups, utilising data from water utilities matched with ABS census data. It was found that in low-income areas of Sydney and Melbourne (those in the lowest quintile of median household income), average household expenditure on water and wastewater services averaged just over 1 per cent of income, and ranged between 0.3 per cent and 4.9 per cent of income in 2005-06, assuming all volumetric costs were borne by the household and before concessions were deducted.

The available evidence indicates that relatively few households experience payment difficulties for water and wastewater services, with more households experiencing difficulty paying for other services, particularly housing and electricity, which take up larger proportions of their expenditure (figure 1). It is likely that the costs created by interfering with water pricing, particularly the volumetric rate, outweigh any benefits low income households receive from them. Although access and affordability are important issues, distorting prices is not the best way to deal with these issues.

OVERVIEW XXVII

Figure 1 Household expenditure on water and sewerage, electricity and housing

Panel A: Household expenditure on water and wastewater services by quintile of household disposable income by state, 2007-08 3.5

2.5

1.5

0.5

0 Per cent of disposable income lowest lowest lowest lowest lowest lowest lowest lowest lowest middle middle middle middle middle middle middle middle middle highest highest highest highest highest highest highest highest highest NSW Vic Qld SA WA Tas NT ACT Aust

Panel B: Household expenditure on selected essential services, Australia

0 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 Per cent of total household expenditure household of total cent Per Water and sewerage Energy Housing

XXVIII AUSTRALIA'S URBAN WATER SECTOR

Summing up on performance

The prolonged and severe drought has posed significant challenges for policy making and service delivery. However, it is important that adaptation to such challenges is achieved in an efficient manner that minimises costs and maximises net benefits to the community.

Based on the evidence, there is a strong case for microeconomic reform in the urban water sector.

The fundamental impediment to improved performance is an absence of clarity about government objectives for guiding policy development and its implementation. Policies and decisions about pricing and supply have become too politicised. This is leading to inadequate transparency about which institutions of government are responsible for procuring supply, and inadequate analyses of some decisions. Deficiencies in the institutional and governance arrangements are leading to policies and water supply decisions that are costly to consumers of water, wastewater, and stormwater services.

Many of the costs associated with past decisions are now sunk and the community must live with the consequences for decades to come. Consequently, the gains from implementing reform can only be modest in the short term, but will increase over time as demand for water increases and new supplies are needed. In any event, it is opportune to implement reform while there are no concerns about supply security, for the foreseeable future in most areas.

Goals of reform and the role of governments

The goal of reform is to ensure that water, wastewater and stormwater services are provided in a manner to maximise net benefits to the community. This can be achieved by striving to allocate water resources efficiently across the water cycle (figure 2) based on costs of supply and value to users, subject to public health and environmental requirements.

OVERVIEW XXIX

Figure 2 Illustration of the integrated water cycle for urban water systems

XXX

It is the role of governments to create the incentives for institutions undertaking policy making, regulatory and service delivery functions to operate efficiently. Governments can do this by:

• setting a clear overarching objective for the development and implementation of policy in the sector

• ensuring that the policy frameworks and principles are consistent with the overarching objective in the following areas that significantly impact on services provision and resource allocation in the sector: – public health and environmental protection – service delivery of potable water, non-potable water, wastewater, drainage and stormwater services – water property rights across the water cycle

• putting in place best practice institutional, regulatory and governance arrangements in relation to: – economic, public health and environmental regulation – service delivery of potable water, non-potable water, wastewater and stormwater services.

Proposed program for reform — two streams

Some reforms being proposed should be adopted across all jurisdictions as a high priority, with other (structural) reforms applied on a case-by-case basis.

1 High priority, universally applicable reforms

Setting of objectives

Governments should set an overarching objective for utilities of delivering water, wastewater and stormwater services in an economically efficient manner (box 6) so as to maximise the net benefits to the community. The objective of economic efficiency should also be applied more broadly to guide policy development and regulation relating to public health and the environment (box 6). This should be facilitated by the more rigorous application of the principles of best practice regulation (box 4).

OVERVIEW XXXI

Box 6 Economic efficiency, broadly defined The concept of ‘economic efficiency’ encapsulates many of the more specific objectives that should be pursued in the urban water sector, including those related to water security, water quality, flood mitigation and the environment. It allows short-term and long-term environmental and social considerations to be integrated into decision making, as required by the principles of ecologically sustainable development. As such, it can also be used to guide the assessment of public health and environmental decisions based on rigorous cost–benefit analysis. For example, in assessing the benefits of water quality standards, especially in relation to non-health critical aspects, the opportunity cost of various standards in terms of the price of water to consumers should also be a relevant consideration in the analysis. In terms of the value of water consumed, consumers are usually best placed to make their own water use decisions. Water use that one person might regard as being of low value, might be of high value to another person. Although there are consumer and political sensitivities about water policy and the provision of water services, independent cost benefit analysis and other information should be provided to communities to inform their responses prior to decisions being made.

Procurement of supply and water resource allocation across the water cycle

Based on the evidence before the Commission, and insights from its modelling, the largest gains to the community are likely to arise from achieving water security at a lower expected cost. This can be achieved by governments removing ‘policy bans’ on supply augmentation from certain sources, such as rural-urban trade and potable reuse. Putting these options back on the table for consideration will not be easy. Negative community perceptions have become entrenched in the absence of good evidence about the costs and benefits of the choices available for supply augmentation.

As well, it is clear that a significant factor in the overinvestment in desalination capacity in recent years has been poor institutional arrangements for determining supply augmentation and, in particular, the inability of those arrangements to resist political involvement. It is, of course, entirely appropriate for government to seek to ensure their communities have adequate water security. However, a particular focus on desalination, to the exclusion of any options other than restrictions has come at significant cost to the community.

All options should be evaluated based on their respective economic merit, subject to public health and environmental requirements. To gather public support for reconsideration of these policies, reliable information on the costs and benefits of

XXXII AUSTRALIA'S URBAN WATER SECTOR

various supply augmentations should be publicly available so that the community is well informed about them and the tradeoffs well understood. Community consultation is essential to this.

In addition, governments should direct their water utilities (as part of a charter discussed below) to adopt real options/adaptive planning approaches to procurement (box 5), to manage risk about rainfall and inflows and minimise the cost of supply in this inherently risky decision-making environment.

Water restrictions, pricing, water efficiency and conservation

Though tolerated by the community when imposed, water restrictions are costly to consumers and should only be invoked in circumstances of ‘force majeure’. Water restrictions should be phased out and consumers provided with service/cost options that enable them to exercise their preferred choice.

Some mandated approaches to integrated water cycle management are inefficient, because it is assumed, without examining the full costs and benefits, that greater recycling, reuse and conservation are in the community’s interests. A better approach is to remove impediments to contestability, thereby creating incentives and opportunities for recycling, reuse and conservation technologies, where they are economically worthwhile and preferred by customers.

Although scarcity-based pricing at the retail level has potential to reduce the cost of supply in the long run, the directly attributable benefits from mandating this approach to pricing water for all consumers are likely to be small relative to other policy changes. The main reason is that on average, consumer demand is not particularly responsive to changes in price in the short-term.

However, the Commission sees merit in freeing up the pricing of water by retailers by encouraging them to have multiple service offerings (tariffs) subject to:

• providing a default ‘vanilla’ two-part tariff, with a single volumetric price and fixed service charge set for three to five years, and with guaranteed supply

• policy guidelines determined by governments

• normal application of competition and consumer protection laws.

Such tariffs would:

• give consumers choice to exercise their preferences rather than have an ‘essential’ level of demand prescribed for them

OVERVIEW XXXIII

• provide an opportunity for retailers to manage demands better as supply changes over time.

The default tariff would cater for consumers who prefer secure supply and stable prices.

Affordability

It is clearly important that all Australians have access to water services. Some low income households may struggle to make payments to water utilities even though water services account for a small part of their expenditure (figure 1).

Utilities accordingly have, and should continue to have, ‘hardship policies’ that apply to customers genuinely having difficulty paying their bills, such as by allowing some customers to pay their bill over time.

However, hardship policies do not directly address affordability. Further, the rising levels of financial hardship reported by community organisations are the result of price increases more generally (food, housing, petrol, other utility services) rather than increases in prices in the urban water sector, which represents only a small proportion of household income. Policies to achieve access and affordability objectives ideally should be designed to achieve these objectives at least cost.

Assistance measures, such as social security for low income families and income tax assistance for families, are generally available to individuals and families. These measures are preferred for addressing affordability because they treat individuals in similar circumstances equitably and they support individuals and families in need.

If water specific assistance is provided, it should be through a rebate (concession) on the fixed service charge, which is also clearly identified as a community service obligation and funded by government.

Public health, environmental protection and economic regulation

Regulation has an important role in setting the boundaries in which the urban water sector operates, particularly in ensuring that public health and the environment are protected. However, there are costs associated with regulation, particularly when multiple regulators with differing objectives are involved. Transparency in following good regulatory practice can minimise these costs.

XXXIV AUSTRALIA'S URBAN WATER SECTOR

Application of the six principles of good regulatory practice spelt out by the Regulation Taskforce in 2006 would provide a sound basis for formulating regulatory policies impacting on the urban water sector (box 4).

Institutional arrangements and governance

Notwithstanding progress, there is a need for greater clarity about the roles and responsibilities of institutions in the urban water sector. In particular, there is a need for clear delineation between decisions most appropriately made by elected representatives (those regarding ‘public interest’ and policy considerations), commercial decisions by water utilities regarding service delivery, those decisions most appropriately made by regulatory agencies, and those made by consumers.

Service delivery by utilities

There would be a significant payoff in clearly assigning the responsibility for service delivery (including procurement of new supplies) to Government Trading Enterprises (GTEs) or companies that undertake retail–distribution. The Commission sees merit in the procurement and security of supply responsibilities being assigned to a retailer–distributor because:

• it is best placed to understand consumer preferences

• it can facilitate contestability and competition for new water supplies and services from potential service providers

• commercial responsibility for efficient procurement strengthens commercial incentives and risk management about investment on an on-going basis.

These utilities might be owned by State and Territory Governments or one or more Local Governments. They would be responsible for providing their services in an economically efficient manner and meeting security-of-supply standards set by the government. It would not be the role of the utility to make judgments about health or environmental aspects. Rather, utilities should operate within these policy and regulatory settings.

Governments should ensure that their governance arrangements hold utilities accountable for performing their functions. The best practice governance arrangements are also relevant to local government service providers. Aspects of the governance arrangements should include:

• full corporatisation of the GTE

• an independent board (appointed on merit)

OVERVIEW XXXV

– incorporation under the Corporations Act 2001 (Cwlth) would strengthen the independence and accountability of the board

• a charter with the shareholder government (box 7)

• public reporting of utility performance against the charter

• independent periodic review of the performance of the utility against the charter.

The combination of government ownership, the charter between the government and its utility, the application of state GTE legislation or the Corporations Act, and public performance monitoring would minimise the risk of misuse of market power or excessive production costs. Consequently, the Commission does not see a role for price-setting by economic regulators. Utilities subject to price controls should be subject to price monitoring. After five years, a review would be undertaken to assess whether price monitoring could be abandoned and replaced by self reporting.

Box 7 Key elements of a charter between a government and its water utility

• obligation to serve (security of supply and obligation to procure)

• processes and procedures for choosing supply augmentation (transparent, tenders for supply, public consultation, and public reporting of the decision (which includes an audit of the decision by an independent body)

• principles for pricing and service offerings (including asset valuation and return on assets)

• process and procedures for setting prices that are transparent, involve public consultation, and public reporting of decisions (which include a periodic review by an independent body)

• borrowings and dividends policies

• customer service standard/hardship policies

• risk allocation (consumers, government shareholder, private suppliers)

• clearly specified and fully funded Community Service Obligations

In addition, the Commission sees some attractions in the possibility of using a consumer representative group as a way of improving information available to utilities about consumer preferences for a wide range of supply characteristics and their preparedness to pay for them. There are some precedents:

• consumer representative groups that participate in utility price determinations in some states and provinces in the United States and Canada (box 8)

XXXVI AUSTRALIA'S URBAN WATER SECTOR

• assistance provided to businesses and households to represent their interests in policy and regulatory decisions relating to the Australian National Energy Market.

Box 8 Harnessing consumer preferences in utility pricing and supply augmentation decisions In urban water, there is no competitive market-based mechanism to reveal the preferences of individual consumers regarding potential service offerings, such as the willingness of individual consumers to pay for different levels of reliability and security of supply. In these circumstances, a utility with an aversion to security of supply risk could overinvest in supply instead of using services offerings to match individual consumer willingness to pay with the marginal cost of supply of the service. One possible way to facilitate consumer revelation about preferences relating to services offerings, prices and supply augmentations, is through the use of representative consumer groups. Examples of using consumer representatives as participants in utility pricing in the United States and Canada include those overseen by the Federal Energy Regulatory Commission in the United States and the National Energy Board in Canada (both dealing with gas pipelines), and those facilitated by the Office of Public Counsel in Florida. The Office of Public Counsel is a consumer advocate created to provide representation for consumers in utility related matters. It participates in price setting proceedings before the Florida Public Service Commission and counties involving various utilities (including water and wastewater). The Consumer Advocacy Panel assists Australian businesses and households to represent their interests in policy and regulatory decisions relating to the National Energy Market by providing grants to eligible groups.

A consumer representative group could have a role in the development of service offerings, reliability standards and assessing supply augmentations. It could be funded out of utility charges to consumers, and buy in expert advice to assist it in its deliberations on complex pricing and procurement matters. The Commission is seeking views about the desirability of such a group and how it would be structured and operate.

The most common consumer protection matters relate to difficulty paying bills, and reduced service levels for non-payment of bills. There is a role for independent dispute resolution using either a state government ombudsman or a nationally consistent industry code.

OVERVIEW XXXVII

Regulatory institutions

In addition to governments better defining the roles of regulators and providing better guidance on the principles and frameworks regulators are to apply, it is also desirable to ensure that best practice institutional design, processes and procedures are adopted to make regulators responsible and accountable for their actions, such as:

• merit appointment of independent regulators

• ensuring transparent decision making using public consultation processes and public reporting

• appeals process (courts).

2 Structural reform — case-by-case

The economics of providing water services vary substantially across geographic regions (box 9). Water is heavy, and unlike other utility services, transport costs can escalate if pumping uphill and over long distances. Such factors have a significant bearing on the costs and benefits of different structural arrangements. For these reasons, the net benefits of structural reform should be considered on a case-by-case basis.

Box 9 Major factors impacting on the economics of supply and demand The economic drivers of the water system include:

• source, location, abundance, and cost of developing, extracting and transporting water resources

• the variability of rainfall, storage inflows, storage capacity, and uncertainty about trends and extremes arising from climate change

• the demands on stormwater management systems

• the size of, and distance between, the urban centres for demand

• the service requirements and expectations of individual communities.

The universal (high priority) reform package has been based on a vertically integrated utility (option 1 in table 2), but is generally applicable to institutions under different structural models. The Commission has identified a number of additional structural reforms that could be beneficial (table 2).

XXXVIII AUSTRALIA'S URBAN WATER SECTOR

Table 2 Optional structural reforms

Reform Detail

Metropolitan areas

Vertically integrated water utility Procurement of bulk water services using transparent (option 1) selection processes and procedures, with contracting out and public–private partnerships Contestability in bulk water supply Vertical separation of the bulk water supply function (option 2) Horizontal separation of bulk water service providers by type of supply source Procurement of bulk water services via bilateral contracts, using transparent and contestable processes and procedures Contestability in bulk water supply In addition to option 2 reforms: and wastewater treatment (option 3) • Vertical separation of the wastewater treatment function • Horizontal separation of wastewater treatment service providers • Wastewater treatment services also procured using bilateral contracts Contestability in bulk water supply In addition to option 3 reforms: and wastewater treatment, and • Horizontal separation of retail–distribution function into yardstick competition in regional geographic monopolies retail–distribution (option 4) • Shared transmission network services provider / grid manager • Transmission services also procured using bilateral contracts Decentralised competitive market Decentralised supply and demand decisions, coordinated (option 5) using market prices Futures market

Regional urban areas in NSW and Qld (outside of south-east Queensland) Aggregate small utilities to exploit Options include: economies of scale • County councils • Regional water corporations • Regional organisation of councils / alliances

Regional urban areas in SA, WA and NT Disaggregation of jurisdiction-wide Options include: utilities • Multiple regional water corporations • Retain jurisdiction-wide utility but price according to geographic boundaries

In metropolitan areas the structural reforms are aimed at strengthening the pressures for efficient water resource allocation and productivity by introducing (progressively more) contestability into elements of the integrated water cycle (figure 2).

OVERVIEW XXXIX

In regional-urban areas, there is less scope for contestability and so structural reforms are, in general, about achieving efficiency gains through more efficiently-scaled utilities.

Large metropolitan utilities

Vertical and horizontal separation of the bulk water supply function (option 2) facilitates competition and contestability for the supply of bulk water services (supply, treatment, transfer and storage). Bulk water of different classes and from various sources will compete on merit and the least-cost combination of water supply will be used to satisfy new and existing demand (efficient bulk water resource allocation).

Option 3 extends competition and contestability to the wastewater treatment and discharge function, and provides strong incentives for innovation by wastewater treatment service providers, including the production of recycled wastewater products.

Disaggregation of a single retailer-distributor into smaller geographic monopolies (option 4) would support yardstick competition between utilities, and further strengthen competition and contestability between bulk water and wastewater treatment service providers.

At this stage, the Commission sees particular merit in options 2 and 3. Competing investors for new supplies and facilities would have greater confidence in the knowledge that their competitors are not also their client.

There is insufficient evidence at this time to conclude that a competitive, decentralised urban water market (option 5) is feasible and would have net benefits. Any market based system must be able to meet security of supply standards expected by governments and consumers through investment in new sources of water. As yet there are no real world examples of such competitive urban water markets to observe and draw upon. Significant challenges remain to the creation of such markets.

Small regional utilities

The Commission is proposing several options for the creation of larger water utilities to exploit economies of scale as a way of improving performance in New South Wales and Queensland, where there are very small stand-alone utilities (table 2).

XL AUSTRALIA'S URBAN WATER SECTOR

The Commission is also suggesting that consideration be given to whether regional communities in South Australia and Western Australia could be better served by one or more regional utilities, separate from the main metropolitan water supply task, as compared with the current state-wide utility model.

Framework for implementation

Under the terms of reference for this inquiry, the Commission has been asked to give priority to areas where the greatest efficiency gains can be achieved and where early action is practicable.

Priorities for reform

Implementation of the universally applicable reforms should be the priority. These reforms to policy, governance and institutions present the greatest scope for efficiency gains, and are a prerequisite to pursuing effective structural reforms. They can also be accommodated within existing structural arrangements.

It is the Commission’s view that the optional structural reforms are of secondary importance. Once the universally applicable reforms have been introduced, however, there are likely to be further efficiency gains to be had from implementing structural reform in a number of jurisdictions.

The role of governments in implementing reform

A role for COAG

Agreement of all jurisdictions is not necessary for individual State and Territory Governments to pursue most of the reform program proposed by the Commission.

That said, effective arrangements for integrating and coordinating policy and its implementation are fundamental to achieving successful reform of the urban water sector. The COAG process can help to facilitate this, as well as ensure a nationally consistent approach to reform, particularly when supported by a standardised framework for monitoring progress.

COAG should put in place a new intergovernmental agreement on the reform program. The agreement would explicitly incorporate the universally applicable reforms, according to an agreed timetable. The Commission suggests that broad commitment to reviewing and implementing structural reform (according to a

OVERVIEW XLI

specified timeline) should also be incorporated into the agreement. It should specify the desired outcomes and priorities and, where appropriate, provide for interim targets and for adjustment to targets as new information emerges or where circumstances change.

Jurisdictions need flexibility to determine the most appropriate way forward in terms of structural reform. Determining the preferred option will require assessment on a case-by-case basis, negotiations between State and Local Governments, and consultation with the industry and consumers.

COAG should also monitor progress in implementation of the agreement against the agreed timetable. The National Water Commission could perform this role.

State and local government action

Governments should not delay reform until the new COAG agreement is put in place. Earlier reform will deliver the benefits to the community sooner. It is also currently an opportune time to implement reform while there are no immediate concerns about security of supply and pressures of major demand management or supply augmentations, in most areas.

Reviewing the reform package

The Commission’s reform package would improve the performance of Australia’s urban water sector for the benefit of water consumers and the community as a whole. The Commission acknowledges, however, that all outcomes cannot be known with certainty, and circumstances can change over time. Therefore, there should be an independent public review of the impact of the proposed new arrangements after five years, after the sector has had sufficient time to adjust to them.

XLII AUSTRALIA'S URBAN WATER SECTOR

Draft recommendations, findings and information requests

Chapter 3 — Objectives for the urban water sector

DRAFT RECOMMENDATION 3.1 The Australian, State and Territory Governments should articulate a common objective for the urban water sector in relevant policy documents along the following lines:

• The primary objective of the sector is to provide water, wastewater and stormwater services in an economically efficient manner so as to maximise net benefits to the community. Economic efficiency should be defined broadly to include environmental, health and other costs and benefits that might not be priced in markets.

Chapter 4 — The role of governments

DRAFT FINDING 4.1 It is the role of governments (elected representatives) to:

• set objectives for policy development for urban water and relevant objectives for each agency

• develop policy frameworks and principles in relation to public health, the environment and service delivery that are consistent with these objectives

• define property rights for water

• put in place institutional and governance arrangements for: -public health, environmental and economic regulation relating to water -service delivery of potable water, non-potable water, wastewater and stormwater services.

DRAFT XLIII RECOMMENDATIONS AND FINDINGS

Chapter 5 — Improving regulation of the urban water sector

DRAFT RECOMMENDATION 5.1 Urban water sector regulators should rigorously apply the six principles of good regulatory practice spelt out by the Regulation Taskforce in 2006.

DRAFT FINDING 5.1 Price regulation is not an appropriate mechanism to deal with affordability concerns or to ensure that urban water utilities fully recover costs.

Chapter 6 — Supply of water, wastewater and stormwater services

DRAFT RECOMMENDATION 6.1 State and Territory Governments should adopt policy settings that allow the costs and benefits of all supply augmentation options to be considered using a real options (or adaptive management) approach. Information on costs, risks and benefits to consumers of all augmentation options should be made publicly available and views of the community sought, especially regarding sensitive options like potable reuse. Bans on particular augmentation options (those explicitly stated and those that are implied by government decisions) should be removed, including those on:

• rural–urban trade (to allow water to be allocated to its highest value use)

• planned potable reuse (unplanned potable reuse occurs commonly without any apparent ill-effects).

DRAFT RECOMMENDATION 6.2 The Australian, State and Territory Governments should not provide subsidies for supply augmentations and other urban water infrastructure, except where:

• it directs a utility to invest to produce a particular environmental outcome unrelated to its service delivery responsibilities and the subsidy is commensurate with the costs attributable to achieving the outcome

• a formal process has identified that a particular community should be exempted from the requirement to fully recover costs through water charges (see draft recommendation 13.3).

XLIV AUSTRALIA'S URBAN WATER SECTOR

DRAFT FINDING 6.1 Integrated water cycle management initiatives are often driven by the assumption that increased water reuse and recycling, and decreased reliance on centralised water supply systems are always in the community’s interests. A better approach would be to seek to remove impediments to integration (such as the absence of appropriate property rights for wastewater and stormwater and deficiencies in the analyses, and community awareness, of costs and benefits), thereby allowing efficient recycling and reuse projects to be implemented.

Chapter 7 — Pricing of water and wastewater

DRAFT FINDING 7.1 By more closely reflecting the opportunity cost of supply, flexible (scarcity) pricing of bulk water helps to facilitate a more efficient allocation of water resources and more efficient supply augmentation decisions.

DRAFT FINDING 7.2 There appears to be scope for efficiency gains in ensuring that developer charges better reflect the costs of service provision in new developments. Upfront charges should be used where the incremental costs of development are well established and, in the case of urban infill, benefits do not accrue to incumbents. Where the benefits also accrue to incumbents, costs should be spread across all users through rates, taxes or the fixed part of a two-part tariff for water and wastewater.

INFORMATION REQUEST

The Commission is seeking further information on how developer charges are levied in each jurisdiction, for both greenfield and urban infill developments. Do these currently provide adequate signals on the costs of servicing new developments? To what extent should developer charges be set periodically on an ‘across utility’ basis, or be specific to the development in question? Would more development specific charges, especially in high cost areas, encourage greater innovation? Would it be better for developers to build the required infrastructure according to standards set by the utility? If so, what issues would need to be addressed to operationalise this? What are the main impediments to introducing more efficient developer charges?

DRAFT XLV RECOMMENDATIONS AND FINDINGS

DRAFT RECOMMENDATION 7.1 Metering technology should be introduced in all new single and multi-unit dwellings. The case for retro-fitting existing single and multi-unit dwellings with separate metering technology should be assessed by utilities.

DRAFT RECOMMENDATION 7.2 Utilities should charge tenants directly for all water charges, both fixed and volumetric, where water is separately metered. Where this does not already occur, State and Territory Governments might need to put in place transitional arrangements to ensure that savings to landlords are passed through to tenants.

DRAFT FINDING 7.3 The volumetric component of two-part tariffs is currently distorted by inclining block tariffs. Inclining block tariffs lead to inefficiencies and inequities. There are substantial efficiency gains to be achieved from moving to a flat volumetric retail pricing structure.

DRAFT FINDING 7.4 Charging the same price for water over large geographic areas irrespective of the different costs of servicing individual locations within those boundaries leads to inefficiencies and inequities. There is scope for efficiency gains in moving to more location-specific pricing, particularly where cost differences within ‘postage stamp’ areas (uniform pricing) are currently large and easy to quantify. In such cases, the benefits are more likely to outweigh the costs.

DRAFT RECOMMENDATION 7.3 More consumer choice in urban water tariff offerings should be available. This would:

• allow consumers to express their preferences on security of supply and price stability

• provide an opportunity for water utilities to manage demand better as water availability changes over time. Utilities would be required to provide default two-part tariffs with a single volumetric component.

XLVI AUSTRALIA'S URBAN WATER SECTOR

DRAFT FINDING 7.5 The National Water Initiative pricing principles are unclear and provide scope to implement pricing policies that are not necessarily in line with the principles of economically efficient pricing.

INFORMATION REQUEST

The Commission is seeking views about pricing principles. What should be included in these principles so that they provide sufficient guidance for utilities?

Chapter 8 — Non-price demand management

DRAFT FINDING 8.1 Although apparently reasonably well accepted by the community, water restrictions generate costs for households, businesses and the community. They do so by denying consumers the opportunity to choose how to use water in the ways that are most valuable to them. The evidence suggests that the costs of restrictions are significant and can amount to several hundred million dollars per jurisdiction per year where they have been in place.

DRAFT RECOMMENDATION 8.1 The use of water restrictions should be limited to times of emergency where a water shortage arises unexpectedly, or in regional urban areas where there are no viable new water sources available to augment supply and restrictions are needed to avoid running out of water. Consumers should instead be able to exercise choice in their water consumption behaviour through an efficient price mechanism.

DRAFT FINDING 8.2 The WELS scheme has been successful at providing the public with an objective set of information with which to make informed decisions, and should continue.

DRAFT RECOMMENDATION 8.2 Neither governments nor regulators should mandate water use efficiency and conservation activities, unless there is a market failure present and it is clearly established that the social benefits of intervention exceed the social costs.

DRAFT XLVII RECOMMENDATIONS AND FINDINGS

Government education and information campaigns should be refocused to provide more balanced information on the costs and benefits of water saving activities, as well as the relative merits of using prices, restrictions and water use efficiency and conservation measures to manage demand.

DRAFT FINDING 8.3 Although there has been community support for restrictions and water use efficiency and conservation activities, not all consumers share the same preferences for using less water. There is evidence to suggest that many consumers would be willing to pay a higher water bill to avoid being subject to restrictions on their water use.

Chapter 9 — Achieving affordability and consumer protection objectives

DRAFT FINDING 9.1 Water consumption per capita in Australia is well above generally agreed subsistence requirements. There is no need for an ‘essential’ volume of water to be determined by governments.

DRAFT FINDING 9.2 Expenditure on water and wastewater services generally represents a small proportion of income, including for low income groups. Price increases in water and wastewater services, although contributing to rising costs of living, are likely to have had less detrimental effect on consumers than price increases of other essential goods and services such as energy and housing, on which expenditure represents a greater share of incomes.

DRAFT FINDING 9.3 Current state and territory concession arrangements for water and wastewater services are inefficient and inequitable. Efficiency gains can be made by replacing or amending water and wastewater concessions with direct payments to targeted households or rebates on the fixed component of water and wastewater service bills.

DRAFT FINDING 9.4 The affordability of water and wastewater services for low income and disadvantaged households, in addition to the affordability of other essential goods and services, is most efficiently achieved through non-concession elements of Australia’s tax and transfer payments system.

XLVIII AUSTRALIA'S URBAN WATER SECTOR

DRAFT RECOMMENDATION 9.1 COAG should commission a review of concessions on utility services across all levels of government. The review should assess:

• the appropriateness of existing arrangements for providing concessions, including eligibility criteria

• the merit of and scope for abolishing concessions and providing relevant assistance to all low income households via other elements of the tax and transfer payments system.

DRAFT FINDING 9.5 Properly designed hardship policies that outline the obligations of water utilities when dealing with customers facing payment difficulties, including the availability of payment extensions or payment plans, are in the interests of consumers. Other measures to alleviate hardship for low income and disadvantaged consumers in exceptional circumstances, such as utility grant schemes, also have merit.

DRAFT RECOMMENDATION 9.2 COAG should develop a set of best practice consumer protection principles for water utilities. These could be included in any new intergovernmental water agreement. At a minimum, the principles should include:

• access to an independent dispute resolution process, preferably by a specialist utilities industry ombudsman

• the establishment of an industry code defining service standards and provisions to assist consumers facing hardship.

DRAFT RECOMMENDATION 9.3 COAG should progress implementation of measures to support consumer advocacy and research consistent with Recommendation 11.3 of the Commission’s 2008 Review of Australia’s Consumer Policy Framework.

Chapter 11 — Institution-centred reform

DRAFT FINDING 11.1 A key impediment to performance is the lack of clarity about roles and responsibilities for the procurement of new water supplies and services. The most appropriate organisations are the retail–distribution utilities. They:

• are best placed to understand the preferences of urban water consumers

DRAFT XLIX RECOMMENDATIONS AND FINDINGS

• are in a position to facilitate contestability and competition for new water supplies and services from potential service providers

• have the incentives to, and are best placed to, manage the commercial risks of procurement, particularly those associated with long-term supply and service contracts.

DRAFT RECOMMENDATION 11.1 Retail–distribution utilities should be assigned responsibility for meeting security of supply standards and procuring water supply and services.

DRAFT RECOMMENDATION 11.2 State and Territory Governments should draw up charters for urban water utilities incorporating best practice governance arrangements and governments’ requirements for the performance of utilities. The charter would set out details about:

• obligations to serve (security of supply and obligation to procure)

• transparent processes and procedures for choosing supply augmentations (public consultation, tenders for supply, public reporting of the decision, and monitoring by an independent body)

• principles for pricing and service offerings

• transparent processes and procedures for setting prices that involve public consultation, public reporting of decisions and periodic review by an independent body

• borrowing and dividend policies

• customer service standards/hardship policies

• risk allocation (between consumers, government shareholders and private suppliers)

• nature and funding of Community Service Obligations. There should be public consultation regarding the contents of the charter, and independent economic regulators in each jurisdiction would also be well placed to provide advice to the government. Independent economic regulators, or some other appropriate government agency in each jurisdiction, could oversee reporting against the charter.

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DRAFT FINDING 11.2

Government-owned water utilities are typically given a number of conflicting objectives by governments. Some objectives are inefficient (for example, utilities being required to reduce per capita consumption) and some are more appropriately assigned to other agencies. Often, little guidance about the relative importance of objectives is provided.

INFORMATION REQUEST

Are ministerial directions common for Government Trading Enterprises (GTEs) in the urban water sector? If so, are they given formally, and are they publicly reported? Are informal directions seen as a problem? Are there similar issues with instructions from councillors in those cases where utilities are council owned? Would independence, responsibility and accountability be improved by constituting utilities under the Corporations Act 2001 (Cwlth), rather than state water industry or general GTE legislation?

DRAFT RECOMMENDATION 11.3 Governments should further improve governance arrangements for publicly-owned urban water utilities. Areas for improvement include:

• governments setting overall water security and reliability objectives, and requirements for wastewater, stormwater and flood mitigation

• further separation between Ministerial and board governance

• greater definition and alignment of objectives and assignment to appropriate agencies

• implementing procedures to ensure independence of boards

• regular reviews of Community Service Obligation payments

• regular reviews of board performance

• greater flexibility regarding dividend payments to ensure they are consistent with investment intentions. Initial recommendations on payments should be made by boards.

DRAFT LI RECOMMENDATIONS AND FINDINGS

DRAFT FINDING 11.3 Establishing good governance procedures would render much of the current price regulation of government-owned water utilities unnecessary, and would be likely to provide greater net public benefits when compared to price regulation.

DRAFT RECOMMENDATION 11.4 State and Territory Governments should move away from regulatory price setting to a price monitoring regime (where some form of prices oversight is considered necessary). Within five years of moving to a price monitoring regime, all State and Territory Governments should initiate independent reviews (not by regulatory agencies) to determine:

• whether water utilities are abusing their market power and, if they are, what action should be taken to deal with this

• whether ongoing price monitoring would likely produce net benefits to the community and, therefore, whether it would still be required. If such benefits cannot be demonstrated, all price regulation should be abolished and replaced by a self-reporting regime to be overseen by an appropriate government agency in the relevant jurisdiction. Rather than proceeding to implement a price setting regime, Queensland should continue with its interim price monitoring arrangements until it undertakes a review of whether price regulation produces net benefits to the community. The National Water Initiative pricing principles should be amended to remove any reference to independent regulatory price setting, except where it can be demonstrated that a more light handed approach as described above would be unlikely to prevent an abuse of market power.

DRAFT FINDING 11.4 In urban water, there is no competitive market-based mechanism to reveal the preferences of individual consumers regarding potential service offerings, such as the willingness of individual consumers to pay for different levels of reliability and security of supply. One possible way to facilitate the revelation of such consumer preferences is through the use of representative consumer groups.

LII AUSTRALIA'S URBAN WATER SECTOR

INFORMATION REQUEST

The Commission seeks views on the desirability of establishing a consumer representative body, and on the appropriate scope, funding and governance model for such a body.

DRAFT RECOMMENDATION 11.5 The Australian Government should proceed with the scheduled independent review of the National Access Regime. This review should commence no later than 31 December 2012. The terms of reference should include an examination of all state-based access regimes, including those for the urban water sector.

INFORMATION REQUEST

The Commission seeks views on the most appropriate appeal mechanisms for regulatory decisions. In the case of economic regulation, is the Australian Competition Tribunal the most appropriate appeal body? If not, why not? What are the most appropriate appeal mechanisms for environmental and health regulators?

DRAFT RECOMMENDATION 11.6 Environmental and health regulators should be more transparent and accountable in their decision making. Except in matters where urgent public or environmental safety issues are involved regulators should also publish draft decisions and seek public comment on these. They should publish the reasons for their decisions in a similar manner to economic regulators and governments should consider the development of appropriate decision review mechanisms.

INFORMATION REQUEST

The Commission seeks feedback on whether there are regulatory inconsistencies between jurisdictions that are creating unnecessary burdens for urban water sector participants. How significant are these burdens?

DRAFT RECOMMENDATION 11.7 All remaining impediments to rural–urban trade, particularly volumetric restrictions and excessive termination fees, should be removed as soon as possible.

DRAFT LIII RECOMMENDATIONS AND FINDINGS

DRAFT RECOMMENDATION 11.8 Any bans (legislated or otherwise) preventing trade between regional water utilities should be independently reviewed and, if it cannot be shown the bans provide net public benefits, they should be removed.

Chapter 12 — Structural reform options for large urban cities

DRAFT FINDING 12.1 Available evidence on economies of scale in the water and wastewater industry suggests:

• water supply and wastewater utilities are characterised by constant or increasing returns to scale (economies of scale) for a wide range of output levels

• horizontally aggregating small utilities is expected to generate gains from economies of scale. This is particularly likely if utilities are located in relatively close proximity to each other, and there is scope to increase scale without a significant increase in network costs

• horizontally disaggregating very large utilities is unlikely to lead to economies of scale losses, that is, produce utilities that thereafter operate below minimum efficient scale. However, scale impacts are location (and context) specific, and should be assessed on a case-by-case basis. Some utilities may be approaching diseconomies of scale, such that there are efficiency gains from horizontal disaggregation, all else equal.

INFORMATION REQUEST

Can you provide the Commission with any further information or analyses on scale and scope economies in the urban water sector?

DRAFT FINDING 12.2 There is a range of structural options for urban water supply in Australia’s large urban cities, including:

• Option 1: a vertically-integrated utility

• Option 2: vertical separation of the bulk water supply function from other elements of the supply chain, and horizontal separation of the bulk water supply function

• Option 3: vertical and horizontal separation of the wastewater treatment function (in addition to option 2)

LIV AUSTRALIA'S URBAN WATER SECTOR

• Option 4: horizontal separation of the retail–distribution function (in addition to option 3)

The potential benefits of options 2, 3 and 4 are much more compelling. State and Territory Governments should undertake a detailed assessment of the full costs and benefits of undertaking structural reform in large urban cities.

INFORMATION REQUEST

Are any or all of these options feasible and cost effective for delivery of urban water supply, wastewater and stormwater services in Australia’s large urban cities? If so, where? If not, why not? How could these options be improved?

Chapter 13 — Reform in regional areas

INFORMATION REQUEST

Is the economic real rate of return an appropriate measure to assess full cost recovery? Are there any risks in using this measure, especially in considering whether utilities are properly providing for returns on capital invested to date, and on future capital expenditure? Is there merit in adopting a measure, or at least a benchmark, that reflects full economic cost?

DRAFT FINDING 13.1 In many areas of regional Australia, water utilities recover their costs and are financially sound. However, a significant number of regional water utilities are earning negative or very low real rates of return. It is not clear that these utilities are achieving genuine cost recovery (that is, recovering all costs — including asset maintenance and renewal costs — over the capital cycle). This could have serious implications for water system infrastructure over the longer term, particularly if negative or low returns are sustained over a number of years.

DRAFT LV RECOMMENDATIONS AND FINDINGS

INFORMATION REQUEST

Do local government financing policies, including restrictions on rate increases, directly or indirectly influence the price setting or investment behaviour of council-owned utilities, and if so how?

INFORMATION REQUEST

As with the major metropolitan utilities, the Commission is interested in views as to whether regional water corporations should be structured as Government Trading Enterprises or corporations under the Corporations Act 2001 (Cwlth). Further, what are the ways that community views could be reflected in the utilities’ activities without undermining the principle of board appointment by merit?

DRAFT RECOMMENDATION 13.1 There is a strong case for undertaking aggregation of small water and wastewater utilities in regional areas of New South Wales and Queensland. The precise approach — including identification of affected councils and the preferred grouping of councils — should be assessed and determined by relevant State Governments, in consultation with Local Governments and affected communities. This process should consider the relative merits of alternative organisational structures, including:

• county council

• regional water corporation

• regional alliance (or regional organisation of councils).

DRAFT FINDING 13.2 The Productivity Commission endorses the majority of the findings and recommendations of the Armstrong and Gellatly inquiry into urban water supply and sewerage services for non-metropolitan New South Wales. The Commission does not endorse recommendation 1 (that utilities should necessarily be grouped into 32 regional aggregations) or recommendation 4 (independent price regulation).

DRAFT RECOMMENDATION 13.2 The New South Wales Government should provide a formal response to the recommendations of the Armstrong and Gellatly inquiry as a matter of priority.

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The Queensland Government should commence a similar process, in consultation with Local Governments and communities, to consider the costs and benefits of different structural reform options for the urban water sector in regional Queensland (outside of south-east Queensland).

DRAFT RECOMMENDATION 13.3 Jurisdictions should identify those regional utilities that are unable to provide safe and secure water and wastewater services for economic reasons. In doing so, the relative merits of alternative supply options (including moving to a system of self-supply) should be considered. State and Territory Governments should subsidise the provision of water supply and wastewater services in regional areas where it is uneconomic for the utility to provide these services safely and efficiently. This funding should be granted via an explicit Community Service Obligation, and subject to periodic review. The case for providing subsidy funding for capital works, financial incentives for reform and assistance for affected local councils should be determined by State and Territory Governments.

DRAFT RECOMMENDATION 13.4 State and Territory Governments should undertake regular, public reviews of water and wastewater outcomes in Indigenous communities. Water and wastewater services should be assessed against the same metrics that are used to measure service quality in non-Indigenous communities.

DRAFT RECOMMENDATION 13.5 Compliance with the health critical elements of the Australian Drinking Water Guidelines should be mandatory, and implemented via legislation. Utility performance against all elements of the Australian Drinking Water Guidelines should be publicly reviewed and reported on annually by State and Territory Governments. Sanctions should apply if water utilities do not comply with the mandatory elements of the guidelines, and directors or other accountable persons such as councillors should be personally liable for the risks associated with non-compliance. Utilities that do not comply with the non-health critical elements of the guidelines must develop and implement a risk management plan (approved by the relevant health department) that will move the utility toward full compliance with all elements of the guidelines.

DRAFT LVII RECOMMENDATIONS AND FINDINGS

DRAFT RECOMMENDATION 13.6 The Governments of Western Australia, South Australia and the Northern Territory should consider the costs and benefits of replacing the single, jurisdiction-wide public corporation model with a regional water corporation approach (horizontal disaggregation). In undertaking this analysis, relevant State and Territory Governments should consider factors other than scale, including opportunities for yardstick competition, the proximity of utilities to the customers they serve, opportunities for more location-specific pricing arrangements and the effectiveness of water resource management and water system planning.

INFORMATION REQUEST

What are the likely sources of costs and benefits of undertaking structural reform of the urban water sectors in Western Australia, South Australia and the Northern Territory?

DRAFT FINDING 13.3 There may be scale and scope benefits for water supply and wastewater services to be provided by a single utility in regional areas. This should be considered by jurisdictions as part of the reform process.

INFORMATION REQUEST

Is there a case for reintegrating water supply and wastewater services in regional areas where they are currently provided separately? In which regions? What are the principle costs and benefits of separate, as compared to integrated, water supply and wastewater service provision?

Chapter 14 — Implementing reform and monitoring progress

DRAFT RECOMMENDATION 14.1 Governments should implement the universally applicable reforms to policy, governance and institutions identified by the Commission. These should be the highest priority for reform of the urban water sector as they present the greatest scope for efficiency gains, and are an essential precursor to pursuing structural reform. These universally applicable reforms centre on:

LVIII AUSTRALIA'S URBAN WATER SECTOR

• setting an overarching objective for government policy in the sector for the provision of water, wastewater and stormwater services in an economically efficient manner to maximise the net benefits to the community

• developing appropriate policies and principles that align with this objective

• putting in place best practice institutional, regulatory and governance arrangements.

DRAFT FINDING 14.1 An intergovernmental agreement could be formulated by the end of 2012 through the COAG process that commits each jurisdiction to implementing the universally applicable reforms identified by the Commission, and to implementing structural reform, with agreed deadlines for progress. The universally applicable reforms could be in place by the end of 2013. Where a case in favour of structural reform is identified, the reform process could begin by the end of 2014.

INFORMATION REQUEST

The Commission is seeking feedback on its suggested timetable for reform.

DRAFT RECOMMENDATION 14.2 Agreement across all jurisdictions is not necessary for the State and Territory Governments to pursue the recommendations made by the Commission as most relate to implementation of best practice. The State and Territory Governments should immediately commence enacting reforms unilaterally.

DRAFT FINDING 14.2 The social security and taxation systems, together with generally available adjustment measures, are likely to be the most appropriate ways of providing transitional assistance to those significantly disadvantaged by urban water reform. However, in some cases there might be a need for additional specific transitional assistance from State and Territory Governments. General principles for the provision of such assistance should be spelt out at the beginning of the reform process.

INFORMATION REQUEST

The Commission is seeking feedback on what the major transitional issues might be if the urban water sector were reformed in line with the recommendations

DRAFT LIX RECOMMENDATIONS AND FINDINGS

contained in this draft report, particularly for low income households and regional urban areas.

DRAFT FINDING 14.3 State, Territory and Local Governments will be the major beneficiaries of the Commission’s proposed reforms to the urban water sector. While some costs will be incurred, these are expected to be outweighed by the benefits from more widespread cost recovery and increased dividend payments. Therefore, there is no case for Australian Government funding to promote urban water reforms.

DRAFT RECOMMENDATION 14.3 Progress against COAG agreed water reforms should be subject to monitoring. The National Water Commission would be the most logical body to undertake such monitoring.

DRAFT RECOMMENDATION 14.4 An independent public review of the reform package should take place after five years.

LX AUSTRALIA'S URBAN WATER SECTOR

1 Introduction

The Australian Government has asked the Commission to examine the case for microeconomic reform, and to identify pathways to achieving improved resource allocation and efficiency, in the urban water sector.

1.1 Background to this inquiry

Water reform began in the early 1980s, notably with the appointment of Mr John Paterson as President and Chief Executive of the Hunter Water Board. In 1982, the Board implemented water pricing reform, starting with a user-pays water tariff for residential customers. In 1992, the Hunter District Water Board became the first major urban water authority in Australia to be corporatised.

Other significant milestones for reform include the:

• Industry Commission (1992) inquiry into water resources and wastewater disposal

• COAG (1994) strategic framework for the efficient and sustainable reform of the Australian water industry, developed by the Working Group on Water Resource Policy

• COAG (1995) National Competition Policy and Related Reforms (NCP), which included payments to jurisdictions that effectively implemented the strategic framework for water reform in the 1994 agreement

• COAG (2004) National Water Initiative (NWI) and the establishment of a National Water Commission (NWC) to assist with, and to assess progress on the effective implementation of, the water related reforms in the 1995 agreement and to progress additional agreed reforms

• COAG (2008) enhanced national urban water reform framework to improve the security of supply for urban water.

The origin of this inquiry can be traced back to the COAG agreement in 2008 (bold dot point in box 1.1). The purpose of the inquiry is to assist COAG to advance urban water reform by identifying pathways to achieve improved resource efficiency through reform of arrangements that govern the urban water sector.

INTRODUCTION 1

Box 1.1 Enhanced national urban water reform framework In 2008, COAG agreed to the following:

• adopt national urban water planning principles

• establish and publish the levels of service for metropolitan water supplies

• publish guidance to facilitate best practice scenario planning for climate variability

• finalise and adopt National Water Initiative pricing principles

• review consumer protection arrangements for services provided by water utilities

• investigate possible enhancements to pricing reform, including scarcity value of water and the valuation and recovery of environmental externalities

• explore the issue of establishing entitlements for recycling, stormwater and managed aquifer recharge

• promote the use of competition through an examination of barriers to third party access and the costs and benefits of establishing a nationally consistent regime

• examine the case for a microeconomic reform agenda in the urban water sector

• examine the role of improved urban water metering and billing practices in the allocation, use and management of water

• finalise a review of water restrictions in Australia

• investigate the establishment of a national clearing house for best practice urban water management

• investigate the development of a national system for reporting urban water consumption

• establish centres of excellence for recycling and desalination

• develop a strategy to improve water supply and wastewater services in remote communities.

Source: COAG (2008).

Although considerable reform has occurred over the past three decades, the urban water sector has been under stress in recent times. This has mainly arisen from a lengthy period of unexpected low rainfall and inflows to dams, rivers and aquifers, followed most recently by heavy rain and floods in eastern Australia. Pressures from growth in demand, ageing assets and reduced capacity to supply from existing rainfall dependent sources has led to:

• prolonged use of severe water restrictions and consumption targets

2 AUSTRALIA'S URBAN WATER SECTOR

• use of mandated measures or subsidies to reduce the consumption of potable water from bulk sources of supply (rainwater tanks, low flow shower heads, water recycling schemes for non potable uses)

• large investments in rain independent supply augmentation (primarily desalination plants).

Water quality problems have also occurred in some regional areas (health quality of potable water and the environmental quality of discharged wastewater). In some regional areas, water quality issues have led to ‘boil water’ notices being issued and exemptions granted for compliance with standards for the discharge of treated wastewater.

The recent experiences in the sector have created further impetus for this inquiry.

1.2 What has the Commission been asked to do?

Under the terms of reference, the Commission has been asked to:

• identify the opportunities for efficiency gains, which might be achieved through changes to structural, institutional, regulatory, and other arrangements in the Australian urban water and wastewater sector

• provide options to achieve the identified efficiency gains, and quantitatively assess these options (to the fullest extent possible) to identify their: – economic, social and environmental impacts – impacts on Australian governments, business and consumers – propensity to facilitate supply and demand planning and decision-making in the medium and long term

• propose a work program including implementation plans for the options, identifying – practical actions that the Australian, State and Territory Governments and Local Governments can undertake to implement options for reforms, including any transitional arrangements – priority areas where the greatest efficiency gains are evident and where early action is practicable – quantitative and qualitative indicators that can be used to monitor changes in efficiency in the urban water and wastewater sectors.

INTRODUCTION 3

1.3 Scope of the Inquiry

Australia’s urban water sector is responsible for providing three services to households, commercial and industrial businesses:

• potable water (bulk water harvesting and manufacturing, storage, treatment, distribution, and retail)

• wastewater (receipt and transport of sewage and trade-waste, treatment, recycling and disposal)

• stormwater (receipt and transport, treatment, recycling and disposal).

For the purpose of this inquiry, the scope of services is limited to cities, towns and settlements that are serviced using reticulated systems.

Historically, urban water services have been provided by government-owned businesses (State or Local Government), which have often been vertically integrated regional monopolies (sometimes statewide monopolies).

Water utilities are also required to comply with government policies regarding environmental protection, water conservation, public health and economic regulation of government businesses, including:

• the supply of water of appropriate quality for environmental purposes, such as maintaining ecologically healthy wetlands and waterways (including in urban areas)

• water conservation and water use efficiency

• flood mitigation and possibly power generation

• the quality of recycled or disposed wastewater and stormwater

• the quality of potable and non-potable classes of water

• the operation of government-owned trading enterprises

• consumer prices

• social policies (discounts or subsidies to specific groups of consumers).

1.4 The Commission’s approach

The Commission is taking the following approach to the inquiry:

• identifying and clarifying the policy objectives for the urban water sector

4 AUSTRALIA'S URBAN WATER SECTOR

• identifying the policy, institutional, structural and other impediments to achieving the objectives and assessing the potential benefits from overcoming them

• examining the changes to policies, institutions, and industry structure that governments could implement to unlock the benefits

• developing priorities for reform

• developing a monitoring framework to assess progress on implementing reform.

Water is often perceived to be different from other utility services (electricity, gas, telecommunications and mail) because water is ‘essential for life’ and/or it exhibits common property characteristics. Further, as a consequence of prolonged droughts, there is understandable community anxiety about the consequences of there not being enough water to meet basic human and industry needs. This can lead to a high degree of political involvement in water issues and pressure to adopt objectives, policies and institutional arrangements that are different from those applied in other utility sectors. The Commission considers that, in adopting the same approach as it would when considering other utilities that also provide ‘essential services’, it will arrive at policy advice that deals with the challenges and legitimate concerns of the community in both country and metropolitan areas.

On 28 July 2010, the United Nations adopted a resolution recognising access to clean water and sanitation as a human right although Australia abstained in this vote. The resolution is principally aimed at improving access to water and wastewater services in developing nations. In the context of this inquiry, it is expected that the reforms being proposed would comply with the human rights obligation. It is a role of government to decide on the most appropriate mix of policies that achieve its objectives for the urban water sector and provide the community with access to water and wastewater services.

The circumstances of the urban water sector vary across regions in terms of:

• source, location, abundance, and cost of developing, extracting and transporting water resources

• the variability of rainfall, storage inflows and demands on stormwater management systems and uncertainty about trends and extremes arising from climate change

• the size of, and distance between, the urban centres for demand

• the service requirements and expectations of individual communities

• the capacity of consumers to pay

• the historical starting point in terms of industry structure.

INTRODUCTION 5

In recognition of different circumstances across regions, the Commission has categorised its priorities for reform into:

• those that can be universally applied across all jurisdictions and regions

• those that are likely to depend on the specific circumstances of the jurisdiction or region.

There are several other organisations (the National Water Commission, the Committee for Economic Development of Australia, and Infrastructure Australia) concurrently undertaking projects that cover some of the issues being deliberated on in this inquiry. The Commission is liaising with these organisations and is drawing upon their publically available information as it becomes available.

The Commission is undertaking modelling to assist it in evaluating the case for microeconomic reform and to identify priorities for reform. In accordance with the general policy guidelines of the Productivity Commission Act 1998 (Cwlth), the Commission has appointed Professor Alan Woodland (University of New South Wales) and Professor John Freebairn (University of Melbourne) to a reference panel for the purpose of reporting on the modelling.

The Commission’s modelling approach, together with some preliminary applications to Melbourne and Perth, were discussed at a modelling workshop on 1 February 2011. Participants included the two referees and representatives from academia, expert consultants that work in the sector, government officials and water utilities.

The modelling results included in this draft report are preliminary and will continue to be revised during the course of this inquiry. The technical details of the modelling will be placed on the inquiry website about two weeks after the release of this draft report.

1.5 Conduct of the inquiry

The terms of reference for this inquiry were received from the Assistant Treasurer on 22 July 2010.

The Commission has consulted widely with stakeholders, drawing on input from participants through consultations, roundtable discussions, a modelling workshop, written submissions and public hearings.

The inquiry was advertised nationally, as well as in metropolitan areas (table 1.1), and the Commission promoted the inquiry on its website.

6 AUSTRALIA'S URBAN WATER SECTOR

Table 1.1 Print advertising for the new inquiry and public hearings

State/Territory Publication The Australian Australian Financial Review New South Wales The Sydney Morning Herald Victoria The Age Queensland The Courier-Mail South Australia Adelaide Advertiser Western Australia The West Australian Australian Capital Territory Canberra Times

The Commissioners and team undertook initial industry visits and released an issues paper prior to inviting submissions to this inquiry. The issues paper and a circular announcing public hearings were sent to interested parties.

The hearings and roundtables were held in various locations (table 1.2).

Table 1.2 Schedule of public hearings and roundtables

Location Date

Public hearings Sydney Tuesday, 9 November 2010 Canberra Monday, 29 November 2010 Melbourne Tuesday, 30 November 2010 Adelaide Tuesday, 7 December 2010 Perth Wednesday, 8 December 2010 Hobart Monday, 13 December 2010 Roundtables Perth Monday, 18 October 2010 Melbourne Wednesday, 27 October 2010 Sydney Wednesday, 20 October Sydney (regional) Thursday, 2 December 2010

In conducting its inquiry, the Commission consulted widely, including through discussions with interested parties including relevant government departments (appendix A).

Eighty-eight submissions have been received in preparation of this draft report. The purpose of the due dates for submissions is to encourage participants to make submissions prior to public hearings. However, the usual practice of the Commission is to accept submissions for the duration of the inquiry, with the caveat that the later they are received, the less scope the Commission has to consider them in preparing the draft report.

INTRODUCTION 7

The Commission thanks all inquiry participants for meeting with Commissioners and staff, facilitating visits, participating in roundtables and hearings, making submissions to the inquiry, and providing information and data to enable the Commission to undertake its modelling.

1.6 Guide to the report

Chapter 2 of this report provides an overview of the industry, putting the modern history of reform, current government policies, governance arrangements and industry structure into context.

Without a clear idea of the policy objectives for the urban water sector, the case for reform cannot be assessed or reform options designed. Chapter 3 examines the overarching objective for the sector. In Chapter 4, the roles of government and the principles that could guide the design of these roles are considered.

In chapter 5, the role of regulation and ways of improving its application to the sector are examined.

The scope for efficiency gains in the supply of water, wastewater and stormwater services is examined in chapter 6. The scope for efficiency gains through pricing and demand side management is considered in chapters 7 and 8. More effective and efficient ways of achieving the distributional and consumer protection objectives are considered in chapter 9.

The Commission’s overarching framework for reform of the urban water sector is outlined in chapter 10. The proposed universal reforms of policies and institutions are set out in chapter 11. Options for structural reform for metropolitan utilities are discussed in chapter 12, and structural reform options for some smaller regional utilities are discussed in chapter 13.

Finally, the proposed reform priorities are summarised in chapter 14, along with a suggested timetable and framework for monitoring progress on the implementation of reform.

Appendix A lists the participants that made submissions to the inquiry and the consultations conducted by the Commission, including public hearings and roundtables. Appendix B provides further detail on the nature of the urban water sector and current arrangements governing the sector. Lessons from reform in other water sectors are summarised in appendix C and lessons from reform in other utility sectors are summarised in appendix D.

8 AUSTRALIA'S URBAN WATER SECTOR

2 About Australia's urban water sector

Key points

• Australia’s urban water sector comprises three sub-sectors, potable and non-potable water, wastewater and stormwater (including drainage and flood mitigation).

• The industry is very capital intensive with high fixed costs. Generally, the largest component of costs is in the transportation of water and wastewater.

• There has been a heavy reliance on climate dependent sources of water, such as dams, rivers and aquifers. Water storages and inflows into dams, rivers and aquifers diminished in many jurisdictions over the past decade due to decreased rainfall arising from drought and climate change.

• As a result, in most metropolitan areas there has been investment in large climate independent supply augmentation projects in recent years. It is expected that further major supply augmentations will not be required until the 2020s in some areas.

• Many jurisdictions have also used non-price demand management measures such as water restrictions and water efficiency and conservation measures (often utilising moral suasion) to deal with water shortages. This has reinforced a longer-term trend of decreasing total and per capita water consumption.

• More recently, heavy rains have led to increased inflows in most parts of the country, with the notable exception of south-west Western Australia.

• The challenges brought about by the drought conditions faced over recent years, have affected the financial and economic performance of the sector. Performance differs by utility size, among other things.

• The structural, institutional, governance and regulatory arrangements vary not only between jurisdictions, but also within jurisdictions, especially between metropolitan and regional urban areas.

• There has been reform to the structural arrangements of the sector in the past two decades. In metropolitan areas, there has been a move towards vertical separation of the supply chain, as well as corporatisation of utilities. In regional urban areas of some jurisdictions, the move has been towards aggregation of utilities, with some corporatisation of utilities.

• There has been a move towards more independence in the economic regulatory oversight of the urban water sector, as opposed to ministerial control. However this is not the case in all jurisdictions.

ABOUT AUSTRALIA'S 9 URBAN WATER SECTOR

In this inquiry, Australia’s urban water sector comprises three sub-sectors, potable water, wastewater and stormwater. It includes both the entities that supply these services to households and businesses, as well as the institutions that govern and regulate the sector. Australia’s urban water sector is diverse, and the picture is different not only across states and territories, but also within them.

This chapter gives an overview of Australia’s urban water sector. The structure of supply of the urban water industry is discussed in section 2.1, including the supply chain through which services are provided and its cost structure, as well as the various sources of water and their characteristics. Section 2.2 focuses on the demand for water, including how much water is consumed by urban users and how consumption has changed over time. Increasing uncertainty around supply and demand due to climate change has led to concerns about the security of water supply. In response, most jurisdictions have undertaken supply augmentation and demand management initiatives (section 2.3).

There has been ongoing reform in the urban water sector since the early 1990s (driven by interjurisdictional agreements such as National Competition Policy and the National Water Initiative (NWI) — discussed in section 2.5) which, together with the challenges brought about by the drought conditions faced over recent years, has affected the financial and economic performance of the sector (section 2.4) and led to changes in the structural, institutional, governance and regulatory arrangements (section 2.5).

More detail on some of the information presented in this chapter can be found in appendix B.

2.1 Water supply

This section includes a discussion of the supply chain for the provision of water services, the costs of providing those services, as well as the variability in water supply due to rainfall and inflow variability.

Supply chain and cost structure

Supply chain

The supply chain for the water, wastewater and stormwater industries is set out in figure 2.1. The potable water industry harvests and manufactures bulk water, stores water, treats water to a standard fit for human consumption, and transports water

10 AUSTRALIA'S URBAN WATER SECTOR

through transmission networks and then on to distribution networks for delivery to end users through a retailer. The wastewater industry transports sewage and tradewaste from customers to where it is treated, and then either disposes of it or recycles it. The stormwater industry collects stormwater run-off, and transports it to where it is disposed of or recycled. The urban water industry also plays a role in flood mitigation through it being one of the primary providers of stormwater infrastructure and services. Some dams have also been built with a purpose of mitigating floods, in addition to providing water — in some cases flood mitigation has been the primary purpose.

Figure 2.1 Supply chain for water, wastewater and stormwatera, b

Bulk water source (surface water, Indirect potable water desalination, rural-urban trade) reuse

Recycled wastewater treatment Water treatment

Recycled water distribution Water transmission (third pipe system) (trunk mains)

Non-potable recycled water retail Water distribution (reticulation)

Micro supply Water and wastewater retail (rainwater tanks, bores)

Wastewater distribution (reticulation)

Wastewater transmission (main sewers) Stormwater distribution (collection and transport)

Wastewater treatment

Stormwater Recycled stormwater transmission treatment Wastewater discharge and (and discharge) residuals management

a Stormwater includes all drainage services. b Non-potable recycled water is discharged from households via the standard wastewater distribution network.

The different types and classes of water and wastewater are summarised in box 2.1.

ABOUT AUSTRALIA'S 11 URBAN WATER SECTOR

Box 2.1 Elements of the water cycle Water can be treated to different levels suitable for different purposes. Types of water can be classed under two main headings, potable and non-potable. There are also different levels of treatment for wastewater.

Potable water Potable water is water that is treated to a level that is suitable for human consumption. It is the water supplied through the main reticulated water system in Australia. The National Health and Medical Research Council and the Natural Resource Management Ministerial Council developed the Australian Drinking Water Guidelines, which provide guidance to the water industry on what constitutes good quality drinking water. The guidelines cover issues such as identifying acceptable water quality, the health risk posed by different substances and guidance on monitoring programs and assessing performance of water supply systems.

Non-potable water Non-potable water can include either untreated water, or water that is treated to a lower standard than potable water. Recycled water is increasingly being used for both residential and industrial non-potable uses. It is supplied to homes through a third pipe system.

Recycled water Recycled water is water taken from any waste stream — usually sewage or stormwater — and treated to a higher standard so it can be used for a new activity. It can be treated to a number of classes, with higher classes having a wider range of possible uses. Although there is some variation in the activities that different classes of water can be used for across jurisdictions, they are broadly similar. As an example, Victoria’s classes and urban uses are:

• Class A: Uses a tertiary treatment process (discussed below) combined with pathogen removal. Uses include residential garden watering, toilet flushing and irrigation of municipal parks and sportsgrounds.

• Class B: Uses a secondary treatment process (discussed below), combined with some pathogen reduction. Urban uses are confined to those with restricted public access and closed industrial systems.

• Class C: Uses a secondary treatment process combined with minor pathogen reduction. Urban uses are confined to those with restricted public access, and industrial systems with no potential work exposure.

• Class D: Uses a secondary treatment process. Only agricultural uses.

(Continued next page)

12 AUSTRALIA'S URBAN WATER SECTOR

Box 2.1 (continued) The Environment Protection and Heritage Council of Australia and New Zealand, the National Resource Management Ministerial Council and the National Health and Medical Research Council have developed a number of guidelines on the use of recycled water, covering topics such as augmentation of drinking water supply, stormwater harvesting and reuse, and managing aquifer recharge.

Wastewater treatment Wastewater can be treated to a primary, secondary or tertiary standard, with tertiary treatment being the highest standard. Wastewater is required to be treated to different standards depending on where it will be discharged and how it might potentially be reused.

• Primary treatment: This treatment consists of sedimentation (sometimes preceded by screening and grit removal) to remove gross and settleable solids. The remaining settled solids, referred to as sludge, are removed and treated separately.

• Secondary treatment: This treatment removes 85 per cent of biochemical oxygen demand and suspended solids via biological or chemical treatment processes.

• Tertiary treatment: This normally implies the removal of a high percentage of suspended solids and/or nutrients, followed by disinfection. It might include processes such as coagulation, flocculation and filtration.

Sources: Engineers Australia (2010h); EPA Victoria (2003); EPHC (2011); Melbourne Water (ndb); NHMRC (2010).

The recycling of wastewater and stormwater is increasing (section 2.3). Notwithstanding the river-based disposal of treated wastewater and reuse downstream (box 2.2), in Australia recycled wastewater and stormwater has been kept separate from the potable water supply, and instead has been used for non-potable purposes or discharged to the environment. (For a period of time in Orange recycled water was introduced into one of the town’s dam (Orange City Council 2009b).) This however, is not the case in other countries. For example, Singapore recycles treated wastewater for potable and non-potable uses. Recycled water meets 30 per cent of Singapore’s water demand (PUB 2010; 2011).

ABOUT AUSTRALIA'S 13 URBAN WATER SECTOR

Box 2.2 Potable consumption of treated wastewater and stormwater in Australia Although planned indirect recycled water consumption has occurred very little in Australia (it has occurred in Orange), there are places where there is unplanned potable consumption of untreated stormwater and treated wastewater. For example, wastewater from upstream towns and cities that has been treated to a secondary or tertiary treatment level and undergoes natural treatment as it heads downstream. In many towns, stormwater enters the river system through drains. Unplanned indirect potable reuse of treated wastewater has occurred in cities and towns that source drinking water from the Murrumbidgee and Murray Rivers. Adelaide has long taken drinking water from the Murray River. In recent years Canberra has sourced drinking water from the Murrumbidgee River and is in fact using its own stormwater.

Sources: ActewAGL (2011b); Alexander (2007); Costello (2006).

Cost structure of the water and wastewater industries

The costs of providing water and wastewater services vary along the supply chain. As an example, table 2.1 provides a breakdown of the share of a typical $1000 water and wastewater bill in Sydney.

Table 2.1 Breakdown of water and wastewater supply chain costs attributable to a typical $1000 Sydney household bill

Activity Share of bill (%)

Bulk water supplya 20 Water treatment 7 Water transport and distribution 23 Water and wastewater retailing 3 Wastewater transport 14 Wastewater treatment and disposal 33 a Half of this relates to dam water and the other half to desalination. Source: Sydney Water Corporation (sub. 21).

However, it is important to note the breakdown of costs along the supply chain will vary between locations and utilities due to a number of factors:

• Nature of primary sources — this will affect the costs of extracting water.

• Geography and topography — this will influence transportation costs. Pumping water longer distances or up hills will increase costs.

14 AUSTRALIA'S URBAN WATER SECTOR

• Health and environmental standards — more stringent standards might result in higher treatment costs.

• Degree of treatment — treatment to a higher standard will be more expensive.

• Number of connections/growth in connections — a higher number of connections will generally increase costs. This is typically the largest driver of wastewater capital expenditure.

• Asset life cycles — more recently constructed assets such as distribution systems might be cheaper to maintain than older assets.

Transport of water and wastewater accounts for the highest proportion of costs in Sydney (37 per cent). This is in contrast to other utilities such as gas and electricity where transport costs are relatively low (Schott, Wilson and Walkom 2008).

Wastewater treatment and disposal is also a major cost. It accounts for about a third of costs in Sydney. The Water Services Association of Australia (WSAA) (sub. 29) note wastewater services overall account for more than half of the urban water sector’s cost base. However, the cost of providing water services is expected to increase by a greater amount than wastewater services in many places, in part due to the large investment in supply augmentation (for example, ESC 2009b).

Bulk water supply and treatment together account for just under 30 per cent of water and wastewater supply costs in Sydney. In Melbourne, however, bulk water supply and treatment costs are reported to be significantly higher, at 56 per cent of an average residential water bill for Yarra Valley Water customers (Yarra Valley Water, sub. 19). This difference could be due to a number of factors, including ones listed above such as geography and topography and degree of treatment.

Retail accounts for only a small proportion of costs relative to other activities. For Sydney this is 3 per cent and it is a similar level in other places, such as Perth (less than 5 per cent of total costs) and Melbourne (about 6 per cent of City West Water’s operating costs) (VCEC 2008).

Capital and operating costs

The water and wastewater industries are generally capital intensive, and have a high proportion of fixed costs. For example, in Western Australia, about two-thirds of the cost of urban water supply relates to the upfront capital cost, with the remaining 30 per cent being the cost of operating and maintaining assets (Department of Water (WA), sub. 38).

ABOUT AUSTRALIA'S 15 URBAN WATER SECTOR

Bulk water supply requires large, lumpy investments in infrastructure such as pipelines, dams and desalinations plants. Bulk water operating costs are relatively small and include the costs of extracting (or, in the case of desalination, manufacturing) water and pumping it to treatment plants, which tend to be located in close proximity to the supply source. As an example, of the total cost of bulk water purchased by Sydney Water Corporation from Sydney Catchment Authority, over 80 per cent is fixed. Fixed and variable costs do not necessarily equate to capital and operating expenditure, but can provide a proxy for these costs. The operating costs of bulk water supply could be expected to rise in coming years. This is due to new supply augmentation options, such as desalination, having relatively high operating costs, compared with traditional supply sources such as dams (Australian Academy of Technological Sciences and Engineering, sub. 34).

Treatment of water and wastewater also includes high capital costs, and typically involves higher operating costs relative to other parts of the supply chain. These costs increase according to the level of treatment employed (particularly with respect to energy, discussed below). For Sydney Water, of the cost of treated water that is purchased, 70 per cent relates to fixed costs (Sydney Water Corporation, sub. 21).

Transportation of water, wastewater and stormwater through large transmission and distribution networks has very high capital costs relative to operating costs and, as a result, is often described as a natural monopoly. The main operating cost associated with transport is pumping.

Retail is likely to have a relatively higher proportion of operating costs relative to other activities in the supply chain, and low capital costs. The main driver of retail costs is the number of connections, and includes the cost of billing, meter reading and dealing with customer complaints.

Energy costs

One of the largest operating costs for urban water utilities is energy. Energy is mainly used for the pumping and treatment of water. Pumping water from locations a significant distance away can significantly contribute to energy use. Moreover, moving from primary to secondary, or secondary to tertiary levels of treatment can double the energy intensity of the process (Kenway et al. 2008).

The proportion of energy used in different activities along the supply chain varies between cities (figure 2.2). In Adelaide, the majority of energy is used in the pumping of water, representing over 70 per cent of total energy used. Sydney also uses a high proportion of energy for pumping, at over 55 per cent. In contrast, water

16 AUSTRALIA'S URBAN WATER SECTOR

pumping in Brisbane only accounts for about 6 per cent of energy used, with treatment being the most energy intensive activity at just under 50 per cent. The reasons for these differences are likely explained by some of the cost drivers discussed earlier, especially the availability of sites to provide storage at higher altitudes than the point of consumption. In Melbourne and the Gold Coast wastewater treatment is the higher user of energy at about 50 per cent.

Figure 2.2 Share of energy used by different activities by city, 2006-07

100

40 Per cent Per

0 Sydney Melbourne Perth Brisbane Gold Coast Adelaide

Water pumping Water treatment Wastewater pumping Wastewater treatment Other

Source: Kenway et al. (2008).

The water sector’s energy costs are likely to rise in the future, due to a combination of increasing energy prices and desalination plants coming online, which are relatively energy intensive compared to other supply sources (Australian Academy of Technological Sciences and Engineering, sub. 34).

Water supply

Sources of supply used by the urban water sector and variability in these sources of supply are discussed below.

Sources of supply

Australia has a high dependence on surfacewater for its water supply (table 2.2). In 2008-09 surfacewater accounted for just under three quarters of total water supplied by utilities. For New South Wales, Victoria, South Australia, Tasmania and the

ABOUT AUSTRALIA'S 17 URBAN WATER SECTOR

ACT surfacewater accounted for over 80 per cent of water supplied. Dams were the primary source of surfacewater in all of these areas except for metropolitan Tasmania, which sources its water from the Derwent River, and Adelaide, which sources a significant proportion of its surfacewater from the Murray River (and dams in the same water system) (NWC and WSAA 2010a; PC 2008d).

Of those areas that sourced a significant proportion of their water from non-surfacewater sources in 2008-09:

• the Northern Territory sourced a significant proportion from groundwater (28 per cent)

• Western Australia sourced a significant proportion from groundwater (mainly through aquifers) (50 per cent) and desalination (11 per cent)

• South Australia sourced a high proportion of its water from recycled water (15 per cent)

• regional urban New South Wales sourced a significant proportion from groundwater (10 per cent) (NWC and WSAA 2010a).

Table 2.2 Sources of water by jurisdiction, 2008-09 Per cent of total water sourced

Area Total water Surfacewater Groundwater Desalination Recycled Bulk sourced water watera

GL % % % % % NSW – metro 574.8 97.1 1.0 - 1.9 0 NSW – regional 193.9 71.4 10.0 - 3.5 15.1 urban Vic 632.4 86.9 4.0 - 4.1 5.0 Qld 304.2 35.4 0.6 - 5.2 58.8 SA 176.9 83.2 2.0 - 14.6 0.1 WA 309.5 33.2 50.4 10.7 1.9 3.8 Tas – metro 43.6 100.0 - - - - NT 54.1 69.9 28.0 - 2.1 - ACT 49.2 91.4 - - 8.6 - Total 2338.2 74.0 9.7 1.4 4.2 10.8 a The total volume of water (including recycled water) purchased from another utility or entity outside the utility’s geographic area of responsibility. Water subsequently exported has been removed. Source: adapted from NWC and WSAA (2010a).

Water utilities in Queensland and regional New South Wales sourced a significant proportion of their water (59 and 15 per cent, respectively) from other utilities outside their geographic area of responsibility.

18 AUSTRALIA'S URBAN WATER SECTOR

It should be noted the data presented are for 2008-09. Since then, desalination plants have come online in south-east Queensland and Sydney, and there has been increasing use of recycled water (section 2.3). As a result, the proportions sourced since this data period would likely reflect increased diversification in sources of supply in many areas.

It should also be noted that the data presented here come from the National Performance Report, prepared each year by the National Water Commission and WSAA. Not all water utilities in Australia appear in this report — many smaller ones in regional urban areas are not included. As a result, the data might not give a complete picture of water supply in regional urban areas in states such as Queensland, South Australia, Western Australia and Tasmania. In these areas, supply sources and water supply issues might be different from that in the capital cities of these states. This could be due to a number of factors, such as geography and size of communities limiting the supply sources available. For example, desalination is unlikely to be an option for many areas due to the high cost of transporting water inland from coastal areas. As a result, inland urban areas are unlikely to have the same diversification in supply that coastal areas can achieve.

As Australia experiences high variability in rainfall and inflows, and has a heavy reliance on surfacewater, its dam storage capacity is large by international standards (ABS 2010d), and it also varies by jurisdiction (table 2.3). Dam storage capacity is lower in cities such as Adelaide, Hobart and Perth, where alternative sources of supply have been historically available — river water in the case of Adelaide and Hobart, and groundwater in Perth. Given the recent investment in new sources of supply, dams are not as good an indicator of total supply capacity and the actual capacity to supply water would be higher in many places.

Variability in rainfall and inflows

Australia’s rainfall is highly variable and, hence inflows into storages both over time and space, are also highly variable. For example, long-term average annual rainfall varies from 225mm in South Australia to 1390mm in Tasmania (BOM 2010). Australia’s rainfall variability is also high by international standards, with it experiencing greater variability than any other continental region (Smith 1998, cited in ABS 2010e).

ABOUT AUSTRALIA'S 19 URBAN WATER SECTOR

Table 2.3 Storage capacity of dams supplying capital cities

Capital city Storage capacity (as at Total water supplied No. of years supply December 2010) 2008-09 when full (based on water supplied in 2008-09

GL GL Adelaide 197.4 139.1 1.4 Brisbane & south-east 2 070.5 190.8a 10.9 Queensland Canberra 205.5 41.8 4.9 Darwin 235.0 37.5 6.3 Hobart 3.6 43.2b 0.1 Melbourne 1 812.2 360.4 5.0 Perth 580.8 249.8 2.3 Sydney 2 581.9 492.0 5.2 a Figure includes water supplied to Brisbane, Gold Coast, Ipswich and Logan. b Hobart figure is total water sourced, not supplied. Sources: BOM (2011); NWC and WSAA (2010a).

Not only does Australia have highly variable rainfall, but in recent years many places have experienced significantly below average rainfall sustained over a number of years, reflecting both drought and climate change. This led to disproportionately reduced inflows and low dam storage levels in many places. The relationship between rainfalls and inflows is not linear, with a reduction in rainfall usually translating into an even greater reduction in inflows due to evaporation, retention of water in soil, and the extent and nature of ground cover (ABS 2008).

However, in the past year or two, rainfall, inflows and storages have increased again in many parts of Australia, with one of the main exceptions being south-west Western Australia. The example of rainfall and inflows in Melbourne is discussed below. Discussion of a number of other examples, Perth, south-east Queensland and Sydney, are included in appendix B. Again, as with sources of supply, rainfall and inflows in regional urban areas might be different from the rainfall and inflows of coastal capital cities, varying the water supply issues these places might face.

Melbourne

Melbourne has experienced severe water shortages in recent years. Since about 1997 both rainfall and inflows in Melbourne have decreased (figure 2.3). The average annual inflow into four of Melbourne’s large dams has decreased from 615 GL for the period 1913 to 1996 to 389 GL for the period 1997 to 2010. Dam storages hit a record low of 25 per cent in June 2009. Rainfall and inflows improved

20 AUSTRALIA'S URBAN WATER SECTOR

in 2010, and storages were about 53 per cent at the end of 2010 (Melbourne Water 2011b).

Apparent changes in weather conditions have led to concerns about increased uncertainty in rainfall and inflows, increasing difficulty in predicting future supply. As a result many jurisdictions have invested heavily in supply augmentation, particularly ‘climate independent’ sources of supply such as desalination and recycling (section 2.3).

Figure 2.3 Annual inflows at Melbourne’s major harvesting reservoirsa

1600

1200 Average Average (1913–1996) (1997–2010) 615 GL 389 GL 800 GL

400

0 1913 1918 1923 1928 1933 1938 1943 1948 1953 1958 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008

a Thompson, Upper Yarra, O’Shannassy and Maroondah Reservoirs. Source: Melbourne Water (2011d).

2.2 Water consumption

This section first focuses on total water consumption, and then provides more detail on water consumption by households.

Total water consumption

Total Australian water consumption, including non-urban/rural consumption, has decreased in recent years. In 2008-09 total water consumption was 14 101 GL, down 35 per cent from 2000-01. The main driver of this decrease was a 50 per cent

ABOUT AUSTRALIA'S 21 URBAN WATER SECTOR

reduction in consumption by agricultural activities (ABS 2010e). Nonetheless, agriculture still accounts for the majority of total Australian water consumption, at just over 50 per cent (figure 2.4).

Figure 2.4 Share of total water consumption in Australia by users, 2008-09

a Water supply industry 17%

Commercial & Agriculture industrial 54% 16%

Households 13%

a Includes sewerage and drainage services and water losses; excludes the supply of water to other users. Source: ABS (2010e).

Households, on the other hand, account for 13 per cent of total water consumption, a little less than commercial and industrial users (17 per cent). The remainder of total water consumption is accounted for by the water supply industry itself (17 per cent). This includes water consumed in the process of supplying water and sewage and drainage services, as well as water losses. Losses in distribution are the largest factor in the water supply industry’s consumption (ABS 2010e). The key drivers of demand are outlined in box 2.3.

Although volume of total water consumption might appear large, it is only a small proportion of the total volume of water extracted from the environment. Although total water consumption was 14 101 GL, total water extracted from the environment was 59 839 GL in 2008-09. Much of this water extracted is returned to the environment as regulated discharge from hydro-electricity power generation (ABS 2010e).

22 AUSTRALIA'S URBAN WATER SECTOR

Box 2.3 The nature of demand for water Demand for urban water can take the form of a final good, where water is desired in its own right, or an intermediate good, where water is used as an input into the production of another good or service. Households purchase water as a final good, and demand is determined by the preferences of those households for water and other goods and services. There are two components of household demand — essential (non-discretionary) and non-essential (discretionary) uses. There is no definition of what constitutes essential water demand. One very rough categorisation is that, in a developed country like Australia, essential use is approximated by indoor usage, while non-essential consumption is approximated by all outdoor uses. However, if essential is considered to be that which is necessary to sustain life, only a small percentage of average indoor household consumption would be considered essential. On the other hand, essential could be considered to cover some outdoor usage. This is discussed in chapter 9. Econometric analysis conducted by the Productivity Commission indicates that household size and income are the most influential determinants of household water consumption. Other factors that might also contribute to household water consumption include the climate, household composition, housing tenure status, educational attainment, occupation and skill levels. In contrast to household demand, commercial and industrial users purchase water as an intermediate good. This demand is ‘derived’ from the demand for other goods and services which are produced using water, and is influenced by the technologies used in producing that commodity. The largest commercial and industrial users of urban water are the mining, electricity and gas, and food and beverage manufacturing industries (ABS 2010e). Using water to maintain public areas such as parks, gardens and recreational ovals can also be considered as intermediate uses toward the final public good of public amenity. The demand for wastewater is linked to the volume of water consumed. The demand for household sewerage services is related to the amount of indoor water usage in bathrooms, laundries and kitchens. Demand for industrial tradewaste services is influenced by the nature of industrial production processes, which determine the quantity and quality of tradewaste and, in turn, the level of treatment required.

Sources: Baumann, Boland and Hanemann (1998); PC (2011b).

Household consumption

Despite steady growth in the population of Australia, household consumption has decreased in recent years. Between 2000-01 and 2008-09 it decreased by 22 per cent. This appears to be an even longer-term trend. For example, in Sydney total water supplied decreased by about 24 per cent between 1990-91 and 2009-10, and

ABOUT AUSTRALIA'S 23 URBAN WATER SECTOR

per capita water consumption appears to have been trending downwards since about the 1980s (Sydney Water 2010b).

According to the ABS Water Account, per capita household consumption Australia-wide was 221L per day in 2008-09. This is down from 329L per day in 2000-01. Most jurisdictions have seen similar declines except for Tasmania and the Northern Territory, where per capita consumption was higher in 2008-09 than in 2000-01 (figure 2.5). Tasmania and the Northern Territory are also the highest per capita users of water along with Western Australia (ABS 2010e). The reasons for this relatively higher per capita use are likely to vary between these jurisdictions. In Tasmania and the Northern Territory, it is likely to be because water supply security is not seen as an issue by consumers due to high rainfall in these places. WSAA (2010a) notes that Perth’s high level of residential water consumption reflects its hot summers, less stringent water restrictions and sandy soils.

Figure 2.5 Per capita household consumption by jurisdiction 2000-01, 2004-05 and 2008-09

2000-01 2004-05 2008-09

600

500

400

300

200 Litres per day per Litres 100

0 Aus NSW Vic Qld SA WA Tas NT ACT

Sources: adapted from ABS (2006; 2010e).

A relatively high proportion of household water is used outdoors. For example, just under 30 per cent of water used by Sydney households is used for outdoor activities, such as lawn and garden watering, pools and car washing. Lawn and garden watering itself is the highest use activity overall. Showering is the next highest use of water at about 24 per cent, followed by washing machine use at about 18 per cent (Schott, Wilson and Walkom 2008).

In Perth in 2008-09, the proportion of water used outdoors was higher than the proportion used in Sydney at 44 per cent. Irrigation (excluding hand watering) was

24 AUSTRALIA'S URBAN WATER SECTOR

the highest use activity at 39 per cent. Of indoor uses, showering and bathing was the highest use activity at 25 per cent (Water Corporation 2010).

Households expenditure on water and wastewater services is a relatively small proportion of overall household expenditure. In 2009-10, expenditure on water and wastewater made up about 1.0 per cent of total expenditure. This compares with about 2.3 per cent for energy services (ABS 2010a). As prices of water and wastewater services rise (section 2.3) the proportion of household expenditure spent on water and sewerage could be expected to rise. More information on water and expenditure can be found in chapter 9.

International comparisons

Australia’s per capita water consumption is quite high by international standards. In 2008, Australian per capita water consumption was amongst the highest of OECD countries (OECD 2011b). In contrast, the price that Australian’s pay for water is in the mid-range of OECD countries (OECD 2010). Given the recent declines in per capita water consumption, and the recent and future increases in water prices (section 2.3), it could be expected that Australia’s position, relative to the OECD average, might change.

Future demand

Recent research suggests that demand for water might increase in the long term. WSAA (2010a) found that despite the fact that water consumption has been decreasing in recent years, and many jurisdictions are raising water prices and investing in water efficiency and conservation (section 2.3), demand for water in the long term is likely to increase. Demand for water is influenced by a number of factors such as population growth, climate change, city design, economic growth, housing type and density and the cost of water. WSAA has estimated that water consumption in the large capital cities could increase by 600 GL by 2026, and 1000 GL by 2056, based on current population trends.

2.3 Recent supply augmentation and demand management initiatives

As mentioned above, in response to climate change and drought, many jurisdictions have invested in supply augmentation to manage the uncertainty associated with rainfall. They have also used demand management tools to bring demand in line with the reduced supply of recent years.

ABOUT AUSTRALIA'S 25 URBAN WATER SECTOR

Supply augmentation

There has been large investment in supply augmentation in recent years, ranging from households installing rainwater tanks and greywater systems to the construction of large desalination plants. The combined capital expenditure program of 30 of Australia’s largest water utilities is approximately $30 billion over the period 2005-06 to 2011-12 (WSAA 2009). This section outlines some of the larger supply augmentation projects initiated by both government and water utilities themselves that have been completed in recent years, are currently underway, or will begin (or could begin) in coming years.

Desalination plants

Many jurisdictions have invested heavily in desalination plants in recent years. Desalination is a climate independent source of water, making it a more certain supply source than surfacewater and groundwater alternatives. Large desalination plants have been, or are being, built to service capital cities, and many desalination plants have been built to service private users, often in mining operations.

Desalination plants have been built, or are currently being built, to service Sydney, Melbourne, south-east Queensland, Perth and Adelaide (table 2.4). The capacity and cost of the desalination plants vary greatly, with Perth and south-east Queensland constructing smaller desalination plants, between 45 and 50 GL, and costing between $387 million and $1.2 billion respectively, compared with Melbourne’s desalination plant which has a capacity of 150 GL and the construction will cost an estimated $3.5 billion. It has been reported that the Melbourne plant is the largest desalination plant in the Southern Hemisphere (Miller and Schneiders 2010). The Adelaide desalination plant was originally designed to have a 50 GL capacity but will now be built to provide 100 GL of water. This plant was funded jointly by the Australian and South Australian Governments (Office for Water Security 2009; WSAA 2010b).

Dams

Augmenting supply through building new dams has become more difficult in recent years for a number of reasons, including:

• there are fewer options available with the best sites already used

• the opportunity cost of the land has increased

• dams are dependent on rainfall

26 AUSTRALIA'S URBAN WATER SECTOR

• the community has changed its view on environmental impacts of dam construction, such as the impact on native fauna and flora, and significant environmental ecosystems and processes.

Table 2.4 Large desalination plants

Location Project Estimated cost Capacity Ability to increase Completion date of constructiona capacity

$m GL/annum GL/annum Sydney Kurnell 1 890 90 180 2010 Melbourne Wonthaggi 3 500 150 Up to 200 2011 South-east Tugun 1 200 49 2009 Queensland Perth Kwinana 387 45 2006 Binningup 955 50 100 2011 Adelaide Port Stanvac 1 830 100 2011 a Costs were incurred in different years, making them not directly comparable. Sources: Costa (2010); Gallop (2005); Hinchliffe (2010); Partnerships Victoria (2010); SA Water (2011c); Sydney Water Corporation (sub. 21); Water Corporation (ndb); WSAA (2010b).

These issues are demonstrated by a number of new dam proposals that have not gone ahead in recent years. Those that made it to the formal proposal stage include the Traveston Dam (on the Mary River in Queensland), which was vetoed by the Australian Government Environment Minister based on environmental concerns (ABS News 2009), and the Tillegra Dam (near Dungog), which was refused by the New South Wales Government due to uncertainty of environmental impacts, potential impacts on licensed water users and insufficient justification for the dam (NSW Government 2010a).

Nevertheless, there are a number of dam-related projects currently underway. Significant projects include the upgrading of the Hinze Dam, which serves south-east Queensland, which will almost double its storage capacity from 161 GL to 310 GL (table 2.5). This upgrade is due to be completed in December 2010. An enlargement of Canberra’s Cotter Dam is also underway, which will increase its capacity from 4 GL to 78 GL (WSAA 2010b). The project is expected to be completed in late 2011 (ACTEW 2010a).

Water recycling

Water recycling has been increasingly used in the past few years. In 1999-00 the volume of water recycled by urban water utilities was 60 GL (WSAA 2006). In 2008-09 the total volume had increased to 227 GL (NWC and WSAA 2010a).

ABOUT AUSTRALIA'S 27 URBAN WATER SECTOR

Table 2.5 Large dam projects

Location Project Estimated costa Capacity Completed

$m GL Canberra Expansion of 363 78b 2011 Cotter Dam South-east Upgrade of Hinze 395 310c 2011 Queensland Dam Wyaralong Dam 348 103 2011 Melbourne Tarago Reservoir 97d 37.5 2009 reconnection and upgrade a Costs were incurred in different years, making them not directly comparable. b Expansion from initial capacity of 4 GL. c Expansion from initial capacity of 161 GL. d Cost of the water treatment plant needed to reconnect the reservoir. Sources: ACTEW (2010a); Melbourne Water (nda); QWI (nd); Seqwater (2009); WSAA (2010b).

Water recycling usually involves the recycling of wastewater or stormwater. As mentioned above, recycled water is currently used in Australia primarily for non-potable activities. Recycled water is provided for industrial purposes (with some industrial users having on-site reuse) and for watering green public spaces such as parks and sporting fields. Recycled water is also delivered to households in new residential developments by water utilities for non-potable uses via a third pipe system.

Although recycled wastewater is not generally used to augment potable supplies, the stormwater recycling scheme in Orange has been used to indirectly augment potable supplies (discussed below).

Wastewater recycling

Australia’s largest wastewater recycling project is the Western Corridor Recycled Water Scheme located in south-east Queensland. It comprises three advanced water treatment plants that treat wastewater to supply power stations and industry. It is expected to supply about 36 GL per year (table 2.6). Recycled water might also be used to replenish Wivenhoe Dam for indirect potable reuse when south-east Queensland’s water storages fall below 40 per cent (increasing this trigger point would increase operating costs and the likelihood of dam spilling) (QWC 2010b).

One of Australia’s largest residential water recycling schemes is the Rouse Hill Water Recycling Scheme in Sydney’s north-west. Treated wastewater is distributed via a third pipe for toilet flushing, laundry washing and outdoor uses. Currently 19 000 homes are involved and eventually it will service 36 000 homes. The plant will treat about 4.7 GL of wastewater each year for use (Sydney Water 2010a).

28 AUSTRALIA'S URBAN WATER SECTOR

Table 2.6 Large water recycling projects

Location Project Estimated Supply/ Completion costa Capacity

$m GL Sydney St Mary’s Replacement Flows Project 250 18 2010 Rouse Hill Water Recycling Scheme 60b 4.7 2008 Rosehill-Camellia Recycled Water 100 4c 2011 Scheme Wollongong Wollongong Water Recycling Plant 25 >7.3 2006 Melbourne Eastern Treatment Plant – Tertiary 380 2012 Upgrade West Werribee Recycled Water 114 2013 South-east Western Corridor Recycled Water 2 600 36d Completed Queensland Project Murrumba Downs Sewage Treatment 197 11e 2010 Plant Perth Kwinana Recycled Water Scheme 28 6 2004 Adelaide Glenelg to Adelaide Park Lands 76 5.5 2010 Recycled Water Project a Costs were incurred in different years, making them not directly comparable. b Cost of the upgrade only. c Can be expanded to 7 GL. d Expected supply for urban water use. Total capacity is expected to be greater. e Based on 4 ML per day. Sources: GHD (2009); Glenelg to Adelaide Parklands Recycled Water Project (nd); QWC (2010b); Sydney Water (2006; 2009; 2010c; ndc; ndd); Unity Water (nd); Water Corporation (nda; 2008); WSAA (2008; 2009; 2010b).

Stormwater

One of Australia’s earliest stormwater harvesting projects is the City of Salisbury’s stormwater harvesting project. It involves treating stormwater through a series of wetlands. The treated stormwater can be distributed to households for use via a third pipe system, used for irrigation and industrial uses, or stored in aquifers. Currently the system can provide 8 GL a year of non-potable water (table 2.7) (City of Salisbury, sub. 10; trans., p. 246).

Stormwater harvesting is also occurring in Orange in New South Wales through the Blackmans Swamp Creek Stormwater Harvesting Scheme, and the Ploughmans Creek Stormwater Harvesting Scheme which is currently under construction. The Blackmans Swamp Creek scheme is capable of supplying up to 40 per cent of Orange’s water needs alone. It has been used to augment the city’s water supply when dam levels have been low. Currently, for reasons that are not clear to the Commission, the scheme can only be used when Orange’s combined water supply is below 50 per cent (Nicholson 2011; Orange City Council 2009a; 2009b; 2010).

ABOUT AUSTRALIA'S 29 URBAN WATER SECTOR

Table 2.7 Large stormwater harvesting projects

Location Project Estimated costa Supply/Capacity Completion

$m GL Adelaide City of Salisbury’s 43.5b 8 Initial project stormwater completed harvesting project City of 30 2.2 Unknown Onkaparinga’s Water Proofing the South Stage 2 City of Charles 58.6 2.4 Unknown Sturts’ Water Proofing the West Stage 1 Playford 9.6 1.3 Unknown Stormwater and Reuse Project Orangec Orange Stormwater 5 2.1 Completed Harvesting Scheme a Costs were incurred in different years, making them not directly comparable. b Includes Australian Government funding of $6.5 million and Local Government expenditure of $37 million. Not the full cost of the project. c The Orange scheme includes the Blackmans Swamp Creek Scheme and the Ploughmans Creek Scheme, which is not yet completed. Numbers are for the Blackmans Swamp Creek Scheme. Sources: City of Onkaparinga (2010); City of Salisbury (trans., p. 246); Department for Water (2011b); DSEWPC (2010b); Orange City Council (2009a); Wong (2008); Wong, Rann and Maywald (2009).

Rural–urban transfers

Transfers of water from rural to urban areas have been increasingly undertaken in recent years. Transfers can be categorised as being either:

• Trades — water providers purchase water, usually by purchasing allocations or entitlements, from other water providers or users.

• Non-price transfers — these can include administratively reallocating water among different users, indirect purchases, such as funding infrastructure upgrades in exchange for water, and borrowing water held in storage and paying it back later (PC 2008d).

A relatively small amount of water for agricultural use can often represent a relatively large amount of water for urban users. However, there are barriers to rural–urban trade, including policy bans and other institutional barriers (chapter 6), and the fact that many urban water systems are not geographically connected to rural systems.

30 AUSTRALIA'S URBAN WATER SECTOR

SA Water has been an active purchaser of water. In 2008-09, SA Water purchased 106 GL of temporary water for critical human needs, and 60 GL was purchased in 2009-10 (Maywald, 2009; Caica 2010).

Although most rural–urban water trades involve urban water utilities, a pilot scheme in northern Victoria allowed urban water users to trade directly with rural water providers. Regional urban water utilities in northern Victoria, such as Coliban Water, allowed urban water users to buy temporary water (allocations, not entitlements) on the open market and the regional urban utility delivered it through its infrastructure (Coliban 2009).

One of the most substantial non-price transfers of water involves the Sugarloaf Pipeline. Completed in 2010, and costing $750 million, this pipeline connects the Goulburn River to Sugarloaf Reservoir, and is expected to supply 75 GL of water to Melbourne each year, depending on it’s share of savings achieved under stage 1 of the Northern Victoria Irrigation Renewal Project (Victorian Government 2010a). Currently, the pipeline is not in operation, and will only be used in the case of critical human need (Melbourne Water 2011c).

Although not necessarily used to facilitate rural–urban trade, many pipelines have been built in recent years, increasing the interconnectedness of water systems, including capital cities’ water systems along eastern Australia (along with rivers). This is illustrated well by the construction of the south-east Queensland water grid. South-east Queensland’s water system was previously made up of eight largely distinct water supply zones. As a result of the lack of connectedness, there were some instances of some parts of south-east Queensland being in drought while dams in other areas were overflowing (QWC 2010b). The construction of the water grid involved building a number of pipelines to connect the separate water systems. The total length of the water grid is over 450km (WaterSecure nd).

Rainwater tanks and greywater recycling by households

The number of households with a rainwater tank has increased over time. The ABS (2010c) survey Environmental Issues: Water Use and Conservation found that 32 per cent of Australian households surveyed in March 2010 that were suitable for a rainwater tank (for example, had ample space) had one, compared with 24 per cent in 2007. This varied greatly between states from 57 per cent in South Australia to 16 per cent in Western Australia. The greatest increase in the proportion of households with a rainwater tank was in Victoria, increasing from 21 per cent in 2007 to 36 per cent in 2010. Households having a rainwater tank were more common in regional urban and rural areas than in capital cities. For many in non- metropolitan areas, rainwater tanks might be their only source of supply.

ABOUT AUSTRALIA'S 31 URBAN WATER SECTOR

Reasons for the increased installation of rainwater tanks in recent years have included government incentives, rebates and mandatory requirements, as well as water restrictions and conservation campaigns (discussed below). For example, of the households in Queensland that have installed a rainwater tank, 20 per cent report a government rebate or incentive was the reason, the highest of any state in Australia (ABS 2010c).

Like rainwater tanks, greywater recycling is a popular source of water for Australian households with 28 per cent of households reporting using it as a source of water in March 2010 (ABS 2010c). This varies between jurisdictions, with 43 per cent of Victorian households using greywater, compared with just 8 per cent in the Northern Territory.

Given the large investment in supply augmentation, as well as the increased rainfall in many areas in the past couple of years, many areas are no longer facing a water scarcity challenge and will not need another large supply augmentation for many years. For example, scenario analysis has been used in south-east Queensland to predict that the next supply augmentation would not be needed until about the mid-2020s, given different population growth and climate change scenarios, and consumption being maintained below 200 litres per person per day (QWC 2010b). In addition, modelling done for Sydney suggests that supply will not exceed demand until 2028 (O’Dea and Cooper 2008). The challenge that is now facing some places, particularly large urban areas, is how to efficiently manage and fund their varied and diversified sources of supply (chapter 6).

Demand management

Along with investment in supply augmentation, many places around Australia have also undertaken demand management. Demand management refers to the modification of the level and timing of water usage through various methods. Demand management can take two main forms — price and non-price.

Pricing

Water is priced differently across Australia. A summary of how prices are set in each jurisdiction is presented later in this chapter (section 2.5). This section focuses on the way that pricing has been adjusted as a means of managing demand.

Although prices have been used in only a limited sense to manage demand, there have been some major changes to pricing.

32 AUSTRALIA'S URBAN WATER SECTOR

Firstly, there has been a movement towards metering of water consumption. In the past, water was charged as a fixed rate per property — charges did not vary with the amount of water consumed. With the introduction of metering, most jurisdictions have now moved to consumption-based pricing, through a two-part tariff. These changes have been driven by COAG agreements, such as National Competition Policy and the NWI. A two-part tariff involves a fixed charge and one or more per unit volumetric prices.

In addition, in many areas the volumetric component of the tariff has been increasing relative to the fixed component (table 2.8). The main exception is in Melbourne, where the fixed component is already low, at about 40 per cent. Darwin is another notable exception, where the fixed bill component has risen and accounts for about 75 per cent.

Table 2.8 Fixed water and sewerage charges as a share of total water bill in capital citiesa

Capital city 30 June 2001 30 June 2009

Adelaide 60.8 57.0 Brisbane 70.0 64.3 Canberra 85.3 58.8 Darwin 70.5 75.9 Melbourne – City West Water 39.6 40.9 Melbourne – South East Water 37.0 39.0 Melbourne – Yarra Valley Water 39.8 39.7 Perth 56.2 53.9 Sydney 67.3 63.3 a Based of consumption of 200kL. Source: Engineers Australia (sub. 4).

Secondly, most jurisdictions have adopted inclining blocks tariffs for the structure of the volumetric component of prices (table 2.9). With inclining blocks tariffs, the volumetric component of water prices increases with increased blocks of usage — as more water is used and the threshold or tier is reached, the price per unit of water increases as the user moves to the higher tier of prices. Inclining blocks tariffs were introduced partly to encourage less discretionary water usage by charging more for higher volumes of usage.

While most jurisdictions currently have inclining block tariffs, some places are moving away from them. Sydney has recently removed its inclining block tariffs in favour of a single volumetric price, and Perth has reduced the number of blocks from five to three (ERA 2009).

ABOUT AUSTRALIA'S 33 URBAN WATER SECTOR

Table 2.9 Residential pricing structure and price path in capital cities and select large regional urban areas

Urban area Tariff structure Price setting period Real average annual bill increase over price setting period (%)

Adelaide Two-part tariff, with 2008-09 to 2010-11 2008-09: 12.7 three inclining blocks 2009-10:17.9 2010-11: 21.7 Brisbane Two-part tariff with 2008-09 to 2011-12 12.3 three inclining blocks Gold Coast Two-part tariff with 2008-09 to 2011-12 10.7 three inclining blocks Bunbury Two-part tariff with five 2009-10 to 2012-13 17.0a (nominal) inclining blocks Canberra Two-part tariff with two 2009-10 to 2012-13 Water: 1.0 tier inclining blocks Sewerage: 4.0 Darwin Two-part tariff with 2009-10 to 2011-12 20 (nominal) single usage charge Geelong Two-part tariff with 2008-09 to 2012-13 9.5 single usage charge Hobart Single usage charge 2009-10 to 2011-12 Capped at 5.0 (nominal) Launceston Two-part tariff with 2009-20 to 2011-12 Capped at 5.0 (nominal) single usage charge (where metered) Melbourne Two-part tariff with 2009-10 to 2012-13 City West Water: 10.9 three inclining blocks South East Water: 12.1 Yarra Valley Water: 13.2 Perth Two-part tariff with 2009-10 to 2012-13 Water: 10.0a three inclining blocks Sewerage: 2.0a Sydney Two-part tariff with 2008-09 to 2011-12 7.7 single usage charge Newcastle Two-part tariff with 2009-10 to 2012-13 6.9 single usage charge a Economic Regulation Authority’s recommendation. Sources: Barwon Water (2011); Ben Lomond Water (2010); ERA (2009); IPART (2009b); PWC (2010); WSAA (2010b; sub. 29); NWC and WSAA (2010a).

Thirdly, the level of water prices has increased in recent years (table 2.8), due to a number of factors including the need to pay off large supply augmentation projects, the move to full cost recovery (chapter 7), replacing ageing assets, maintenance catch up, and general inflationary pressures. The price increases have been relatively large in some places and this is likely to continue in coming years. Prices are set to increase by as much as 20 per cent per year (table 2.9).

34 AUSTRALIA'S URBAN WATER SECTOR

Non-price demand management

Non-price measures are the most commonly used demand management tool. Non-price demand management in water can generally be categorised as water restrictions, and water conservation and efficiency measures. These measures can be mandatory, or encouraged on a voluntary basis.

Water restrictions

Water restrictions have been used extensively in both metropolitan and regional urban areas in recent years. Water restrictions were relied on during the drought quite heavily, generally increasing in severity as the water supply situation worsened. For example:

• In Sydney, voluntary low level restrictions were introduced in November 2002 when dam levels were about 70 per cent. By June 2005 when dam levels were about 40 per cent, Sydney was on mandatory level three restrictions, limiting when and how hoses could be used (Sydney Water Corporation, sub. 21).

• In south-east Queensland, level 1 restrictions were put in place in May 2005, and by July 2008 High Level Restrictions had been implemented, limiting, among other things, garden watering, car washing, and filling of swimming pools and spas (QWC 2011; nd).

Restrictions have also been used extensively in regional urban areas. For example, 61 per cent of local water utilities in New South Wales have imposed water restrictions as a result of severe drought conditions (Local Government and Shires Associations of NSW, sub. 63).

As the result of recent rain, the level of restrictions has been downgraded in many areas, and some have removed them altogether. However, many places have replaced these with the introduction of permanent low level restrictions, such as:

• Brisbane’s permanent water conservation measures that limit the time of day that hoses can be used and limit the amount of time that sprinklers can be used.

• Sydney’s Water Wise rules that limit the time of day that hoses can be used and encourage cars to be washed on lawns (WSAA 2010b).

Water efficiency and water conservation measures

Along with the use of water restrictions, governments have used water efficiency and water conservation measures extensively in recent years to manage demand. Water efficiency measures generally aim to reduce water consumption, while

ABOUT AUSTRALIA'S 35 URBAN WATER SECTOR

maintaining the level of output or outcome delivered. Water conservation measures also aim for a reduction in water consumption, but might also reduce the level of output or outcome delivered (chapter 8).

Measures aimed at households

There have been a range of different types of water efficiency and water conservation initiatives aimed at households, such as:

• voluntary targets for individual and household water consumption

• education and information campaigns

• mandatory and non-mandatory guidelines for water efficiency in new homes

• rebates and other incentives.

Many initiatives will be a combination of different strategies. Some of the larger schemes are discussed below.

Voluntary water consumption targets have been used in many places including Melbourne and Perth. Up until recently, Melbourne had the Target 155 campaign, which encouraged individuals to limit their water consumption to 155 litres per day. It was also an education campaign, providing advice on how people can reduce their water usage around the home (Victorian Government 2011). From December 2010 to 31 March 2011, Perth had the Target 60 campaign which encouraged people to reduce their water consumption by 60 litres per day. Like the 155 campaign it includes information on how to reduce water consumption (Water Corporation 2011b). South-east Queensland also had a number of target programs including Target 140, Target 170 and Target 200 (QWC 2010b).

One of the biggest information campaigns is the Water Efficiency Labelling and Standards Scheme (WELS). WELS started in 2005 and involves labelling a range of appliances that use water with ratings on their water efficiency, in the hope that households will be encouraged to buy more water efficient products (Australian Government 2010b). Another education campaign is Sydney’s Every Drop Counts in schools, which provided educational material to schools promote responsible water use and water efficiency, including installation of water monitoring and alarm systems in high use schools, and materials to help schools identify leaks (Sydney Water 2010b).

Mandatory guidelines encouraging water efficiency exist in many places, including New South Wales and Queensland. New South Wales’ Building Sustainability Index or BASIX is a mandatory scheme that aims to make new homes more efficient by reducing the amount of water and energy used. It was introduced in

36 AUSTRALIA'S URBAN WATER SECTOR

2004 and as of 2007 it applied to all residential developments (including renovations) worth $50 000 or more (BASIX nda). The Queensland Development Code contains mandatory guidelines for commercial, industrial and residential buildings. New homes are required to meet mandatory water saving targets and must contain water efficient showerheads and toilets and water pressure limiting devices. Most new commercial and industrial buildings are required to have alternative water sources such as rainwater tanks or treated greywater (QWC 2010b).

Most jurisdictions have rebate schemes. One example is South Australia’s H2OME rebate scheme, which provides a range of rebates for products installed in and outside the home, including indoor products such as showerheads and washing machines with high WELS ratings, and outside products such as tap timers and rainwater tanks (Office for Water Security 2011).

These measures are likely to have been effective in reducing household consumption. The Environmental Issues: Water Use and Conservation Survey (ABS 2010c) found that, over the 12 month period to March 2010, 80 per cent of households had taken at least one step to save water. The most common way to save water was to decrease the amount used in the garden (61.7 per cent of households) and in the bathroom (59 per cent).

Measures aimed at industry

There are also a range of water efficiency and conservation measures aimed at industry. Two of the most common types of initiatives are mandatory water plans, and water utilities working with businesses to save water.

Many states, including Victoria, South Australia, Western Australia and Queensland require businesses that consume above a certain amount of water to develop mandatory water plans. For example, in Victoria, all non-household customers that consume more than 10 ML of water a year are required to develop a water management action plan (waterMAP), demonstrating how they will use water more efficiently in the future (Office of Water 2010a).

A number of utilities, including Sydney Water and SA Water, work with large no-household customers to help reduce their water use. Sydney Water, through its Every Drop Counts Business program, works with businesses to help them reduce their water usage and business costs. In particular, businesses that consume more than 80 000 litres are day are offered ‘one on one partnerships’ under the program, that include water efficiency audits and implementation of improvement plans (Sydney Water nda). SA Water, through its Business Water Saver Program, assists

ABOUT AUSTRALIA'S 37 URBAN WATER SECTOR

non-household customers that consume over 50 ML of water a year to reduce water consumption and minimise wastewater production (SA Water 2011b).

According to the Energy, Water and Environment Management, 2008-09 survey (ABS 2010b), about 22 per cent of Australian businesses reported having undertaken some type of water management practice. Of business employing over 200 people, about 60 per cent reported undertaking at least one water management activity.

2.4 Performance of the urban water sector

This section includes information on the financial and economic performance of the urban water sector, and information on employment in the urban water sector.

Financial performance

In this section, some information on indicators of financial performance, including expenditure, income, profit, dividends and rates of return over the period 2005-06 to 2008-09 is presented. This information is sourced from the 2008-09 National Performance Report (NWC and WSAA 2010a). More information on financial and other types of performance can be found in this publication.

In its reports on the Financial Performance of Government Trading Enterprises, the Commission assessed the financial performance of large urban water utilities that are Government Trading Enterprises (GTEs). Over the period 2000-01 to 2006-07, the performance of the major urban water GTEs combined, as measured by operating profit before tax, improved overall. In addition, dividends paid to government also increased. However, the combined utilities return on assets decreased over this period, from about 5.8 per cent in 2000-01 to 4.9 per cent in 2006-07 (PC 2006a; 2008b).

Operating expenditure

Operating expenditure on water and wastewater has been increasing in recent years (table 2.10). Between 2005-06 and 2008-09, the operating cost per property of the utilities that reported in each of these years increased on average by 6.5 per cent per year. Factors contributing to this increase include higher input costs, such as labour costs, the costs of operating new capital equipment and increased expenditure on water conservation programs (NWC and WSAA 2010a).

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Table 2.10 Average water and sewerage operating expenditure per property by utility size $

Utility size by number of 2005-06 2006-07 2007-08 2008-09 connected properties

100 000+ 448 467 496 541 50 000 to 100 000 575 614 614 649 20 000 to 50 000 664 667 682 669 10 000 to 20 000 778 787 754 781 Source: adapted from NWC and WSAA (2010a).

Average operating costs per property of smaller utilities is higher than that of larger utilities. This is likely due to smaller utilities not having the same economies of scale (NWC and WSAA 2010a). This scale might come from larger utilities being able to spread operating costs over a larger number of customers, and larger utilities might have higher operating efficiency (due to a greater capacity to attract and retain skilled staff, undertake asset management and meet health and environmental regulations).

Operating expenditure per property has increased by a relatively greater amount in major utilities compared to non-major utilities. Between 2005-06 and 2008-09 the average operating cost per property for major utilities with 100 000 plus connections increased by about 21 per cent. This compares with about 13 per cent for utilities with between 50 000 and 100 000 connections, and relatively stable average operating costs per property for utilities with less than 50 000 connections. The strong growth in costs experienced by major utilities is likely to be due to growth in the costs of operating the large capital projects undertaken by major utilities (NWC and WSAA 2010a).

The proportion of operating expenditure per property spent on water verses wastewater has remained similar over the past few years. For larger utilities, water has generally made up a higher proportion of operating expenditure than wastewater, although the reverse is true for smaller utilities (NWC and WSAA 2010a). This difference could be due to a number of factors including the level of integration across the supply chain and supply augmentation in major areas.

Capital expenditure

Capital expenditure has increased over the past few years. Total capital expenditure for utilities with more than 100 000 connections — and bulk water utilities — has more than tripled over the period 2005-06 to 2008-09 (table 2.11). Much of this increase was between 2007-08 and 2008-09, where total capital expenditure

ABOUT AUSTRALIA'S 39 URBAN WATER SECTOR

increased from $4.5 billion to $8.1 billion, an increase of about 80 per cent. The large increase in capital expenditure was driven by the major investments in supply augmentation undertaken by many jurisdictions (NWC and WSAA 2010a) (as outlined in section 2.3).

Table 2.11 Total water and sewerage capital expenditure by utility size $million

Utility size by number of 2005-06 2006-07 2007-08 2008-09 connected properties

100 000+ 1 866.8 2 076.9 2 894.3 4 112.4 50 000 to 100 000 189.8 368.5 418.9 481.9 20 000 to 50 000 250.4 355.7 534.2 551.6 10 000 to 20 000 214.3 320.0 341.0 330.1 Bulk water utilitiesa 163.5 197.9 356.0 2567.1 Total 2 684.9 3 314.9 4 544.3 8 133.1 a The bulk water utilities are Goldenfields Water (Bulk), Rous Water, Sydney Catchment Authority, Seqwater, Hobart Water and Melbourne Water. Source: NWC and WSAA (2010a).

The proportion of capital expenditure spent on water and wastewater for major utilities changed over the period 2003-04 to 2008-09, with 31 per cent of capital expenditure being spent on water in 2003-04, increasing to 65 per cent in 2008-09 (NWC and WSAA 2010a). Again, this likely reflects the increased investment in water supply augmentation, which currently makes up a large proportion of total capital expenditure. For example, of Melbourne Water’s capital expenditure for 2009-10 to 2012-13, about 65 per cent is expected to relate to large capital projects (Melbourne Water 2008).

As much of the planned large supply augmentations have been, or soon will be, completed, capital expenditure might decrease in coming years. For example, total capital expenditure for Melbourne Water and the three retailer–distributors in metropolitan Melbourne is expected to decrease over the period 2009-10 to 2012-2013 from $1.59 billion to $540.5 million, with a large proportion of this decrease being attributed to reduced capital expenditure because of the completion of supply augmentation-related projects such as the Sugarloaf Pipeline and the tertiary upgrade of the Eastern Treatment Plant (ESC 2009c; Melbourne Water 2008).

Income

The income of utilities has increased in recent years. Income per property has increased over the period 2005-06 to 2008-09 (table 2.12). Income per property is

40 AUSTRALIA'S URBAN WATER SECTOR

generally greater for smaller utilities than for larger utilities (NWC and WSAA 2010a). This could reflect higher costs due to a lack of scale economies, which is partially offset by lower levels of cost recovery by smaller utilities (discussed in chapter 13).

Table 2.12 Average income per property by utility size $

Utility size by number of 2005-06 2006-07 2007-08 2008-09 connected properties

100 000+ 1 049 1 053 1 033 1 150 50 000 to 100 000 1 150 1 133 1 188 1 148 20 000 to 50 000 1 142 1 126 1 205 1 218 10 000 to 20 000 1 319 1 353 1 342 1 342 Source: NWC and WSAA (2010a).

Net profit after tax

The net profit after tax (NPAT) of water utilities has decreased significantly over the past few years. Overall, for the utilities that report in all three years between 2006-07 and 2008-09, profitability fell by about one third. Non-major utilities’ fall in profitability was significantly greater than that of the major utilities, with utilities between 20 000 and 50 000 connections reporting a loss in 2008-09 (on average) (table 2.13). According to the National Performance Report, this result is driven by a combination of the decrease in revenue associated with lower water usage and higher capital and operating costs (NWC and WSAA 2010a).

Table 2.13 NPAT and NPAT ratio by utility size

NPAT NPAT ratio Utility size by 2006-07 2007-08 2008-09 Change 2006-07 2007-08 2008-09 number of connected (2006-07 to properties 2008-09)

$million $million $million % % % % 100 000+ 1 421.8 1 134.5 1 107.4 -22 20 16 16 50 000 to 100 000 53.1 36.4 -0.2 -100 9 6 -5 20 000 to 50 000 76.9 17.5 -15.1 -120 8 5 -4 10 000 to 20 000 80.8 51.3 30.8 -62 21 11 6 Total 1 632.7 1 239.6 1 092.2 -33 Source: NWC and WSAA (2010a).

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The average NPAT ratio (calculated by dividing NPAT by income) has also decreased between 2006-07 and 2008-09, which is to be expected given the general increase in income combined with reduced profit.

Dividends

The change in the level of dividends payable and the dividend payout ratio (dividends payable divided by NPAT) over 2006-07 to 2008-09 was mixed. For major utilities, total dividends payable decreased slightly over the period. However the dividend payout ratio increased (table 2.14). This implies that the fall in NPAT outweighed the fall in dividends. On the other hand, for non-major utilities total dividends payable increased over the period, along with the dividend payout ratio (NWC and WSAA 2010a). However, the number of non-major utilities paying dividends is low in comparison. Although all but one of the major utilities had dividends payable in all three years, most of the small utilities did not pay dividends, and this number increases as the utility size gets smaller.

Table 2.14 Total dividends and average dividend payout ratio by utility size

Utility size by number Total dividends ($000) Dividend payout ratio (%) of connected properties

2006-07 2007-08 2008-09 2006-07 2007-08 2008-09

100 000+ 1 014 196 1 018 597 988 663 61.8 73.5 68.7 50 000 to 100 000 15 052 16 173 25 774 26.8 70.3 53.2 20 000 to 50 000 8 529 2 276 9 802 15.8 11.1 -20.6a 10 000 to 20 000 2 064 1 327 1 051 8.5 17.4 0.3 a This number is negative due to Shoalhaven’s dividend payout ratio being negative, which is a consequence of its dividend policy. The sewerage side of the business recorded a profit and paid a dividend, while the water side recorded a net loss. Therefore the sewerage dividend, divided by the combined net profit has resulted in a large negative dividend payout ratio. Source: adapted from NWC and WSAA (2010a).

Of the 35 utilities with under 50 000 connections that reported on dividends, only four reported paying a dividend in 2008-09. Dividend policy is generally set by government, and dividends payable will reflect profitability, cost recovery levels, financing capacity, accounting practices and future cash requirements. Utilities might not be paying a dividend for a number of reasons, including they are not sufficiently profitable or are conserving cash for future investment. Utilities in regional urban New South Wales cannot pay a dividend if they do not meet the Best-Practice Management of Water Supply and Sewerage Guidelines (Department of Water and Energy 2007).

42 AUSTRALIA'S URBAN WATER SECTOR

Economic real rate of return

The median economic real rate of return1 has decreased over the period 2005-06 to 2008-09 (table 2.15). Overall, larger utilities have a higher median rate of return than smaller utilities, and all the major utilities have earned a positive rate of return. This is not the case for smaller utilities, with the range indicating that some utilities with less that 50 000 connections have been experiencing negative real rates of return. Generally, for utilities to be considered commercially viable, they should be earning in excess of the risk-free rate of return. The average 10-year Australian Government bond rate — widely used as the risk free rate of return benchmark — in 2008-09 was about 5 per cent (RBA 2011). It is common for water utilities to earn a return lower than this benchmark. Economic real rates of return for utilities with less than 10 000 connections are not presented in the National Performance Report.

Information on the rate of return, as it relates to cost recovery is presented in chapter 13.

Table 2.15 Median and range of economic real rate of return by utility size Per cent

Utility size by number of 2005-06 2006-07 2007-08 2008-09 connected properties

100 000+ 4.7 3.3 3.1 2.4 (2.7–6.4) (1.2–5.8) (0.7–6.2) (1.2–9.9) 50 000 to 100 000 1.35 1.7 0.45 0.9 (-2.0–4.7) (-1.0–4.8) (-2.3–10.9) (-1.0–6.8) 20 000 to 50 000 2.3 1.55 1.1 0.85 (-1.1–10.7) (-0.1–6.5) (-0.4–8.8) (-2.3–5.7) 10 000 to 20 000 1.1 1.15 1.1 0.9 (-2.3–6.6) (-1.9–8.7) (-1.3–8.4) (-2.3–5.9) Source: adapted from NWC and WSAA (2010a).

Economic performance

Financial indicators only give an indication of one facet of urban water utilities’ performance. This sections looks at trends in productivity and employment.

1 In the National Performance Report, the economic real rate of return is calculated as revenue minus operating expenses (operation, maintenance and administrative expenses plus the current cost of depreciation) divided by the written down replacement cost of operational assets (NWC and WSAA 2009).

ABOUT AUSTRALIA'S 43 URBAN WATER SECTOR

Productivity literature

There have been some attempts to measure the overall relative productivity of Australian urban water utilities. Four papers that have been published have attempted to do this: Woodbury and Dollery (2004), Coelli and Walding (2005), Byrnes et al. (2009) and Byrnes et al (2010). These are summarised below.

Woodbury and Dollery (2004) attempted to measure the relative efficiency of regional urban water utilities in New South Wales for 1999 and 2000 using data envelopment analysis. This is a quantitative technique that combines all the input and output information of the organisation into a single measure of productive efficiency (Woodbury and Dollery 2004). They found that, generally, there was scope for improvement in performance of New South Wales regional urban water utilities. In 1999 and 2000, water utilities generally had scope to improve their relative efficiency by about 26 per cent. It was also found that total factor productivity over the period 1997-98 to 1999-00 increased only slightly.

Coelli and Walding (2005) attempted to measure the relative efficiency of the largest 18 water utilities in Australia over the period 1995-96 to 2003-04 using data envelopment analysis. They found that the average business could have reduced inputs used by 9.6 per cent without reducing output. Total factor productivity growth was found to have declined over the period, with an average annual decline of 1.2 per cent. However, they emphasised that their results were sensitive to the measures used, and that better quality data was needed.

Byrnes et al. (2009) examined the relative efficiency of regional urban water utilities and their wastewater services in New South Wales and Victoria over the period July 2000 to June 2004 using data envelopment analysis. The authors found significant differences in the relative technical efficiency of utilities in New South Wales and Victoria, with Victorian utilities of a similar size to New South Wales utilities being more technically efficient.

Byrnes et al. (2010) again examined the relative efficiency of regional urban water utilities in New South Wales and Victoria over the period July 2000 to June 2004 using data envelopment analysis. This paper focused on water service provision rather than wastewater service provision. They found that Victorian water utilities were 13 per cent more efficient than similarly sized New South Wales utilities. In addition, they found that the larger Victorian utilities had relatively better managerial efficiency and that water restrictions are likely to reduce relative efficiency.

44 AUSTRALIA'S URBAN WATER SECTOR

Employment

The number of people employed in the water industry appears to have increased in recent years, after a large decline over the previous two decades (figure 2.6).

Figure 2.6 Number of person employed full time in water supply, sewerage and drainage services

40 30 20

0 No. of employed (000s) persons Nov-84 Nov-86 Nov-88 Nov-90 Nov-92 Nov-94 Nov-96 Nov-98 Nov-00 Nov-02 Nov-04 Nov-06 Nov-08 Nov-10

Source: ABS (2011).

The decrease in employees between the mid 1980s and early 2000s could be due to a number of factors, including efficiency improvements such as elimination of excess staffing and rationalising non-core business activities (Sydney Water Corporation, sub. 21).

The increase in employees in the sector in recent years could be the result of the increased investment in supply augmentation, which would have resulted in an increase in workers needed to deliver the large capital projects. Much of the employment in the water industry in recent years is in the private sector, because of increased use of outsourcing. Outsourcing appears to be used extensively by the urban water sector with a high proportion of both capital and operating expenditure being outsourced. For example, the three Melbourne retailer–distributors outsource close to 100 per cent of their capital expenditure (WSAA, sub. 29).

There is currently a skills shortage in the urban water industry, which is expected to worsen over the coming years (for example, WSAA 2008 cited in Armstrong and Gellatly 2008). More information on this can be found in chapter 13.

ABOUT AUSTRALIA'S 45 URBAN WATER SECTOR

2.5 Structure, institutions, governance and regulatory arrangements

The administrative arrangements surrounding the provision of urban water vary by jurisdiction and within jurisdictions, particularly between metropolitan and regional urban areas. An overview of the structural, institutional, governance and regulatory arrangements of Australia’s urban water sector are discussed in this section. Appendix B provides a more detailed discussion on the arrangements for each jurisdiction.

Ownership and structure of the supply chain

Table 2.16 provides an overview of the entities responsible for each part of the supply chain. Traditionally, urban water and wastewater services have been supplied by vertically-integrated government-owned monopolies. This remains the case in Adelaide, Perth, Canberra and Darwin, and in most regional urban areas around Australia.

The structure of the urban water industry varies between states, and between metropolitan and regional urban areas. South Australia, Western Australia2, the ACT and the Northern Territory have jurisdiction-wide utilities, whereas New South Wales, Victoria, Queensland and Tasmania have multiple water utilities, servicing different areas (the structure of the water sector in these four states in discussed below).

There is increasing involvement of the private sector in urban water supply. For example, in 1996, the supply of water and wastewater services to Adelaide was contracted out to United Water, a private company. Whilst this contract expires in June 2011, water and wastewater services will continue to be provided by the private sector (chapter 12) (Emmerson 2010; United Water 2009). In Sydney, among other places, many treatment plants are owned and operated by private companies (New South Wales Government, sub. 65), whilst many of the large desalination plants around Australia are built and managed by private businesses in partnership with government.

In regional urban areas, the government ownership of water utilities varies, with regional urban utilities in Queensland, New South Wales and Tasmania being

2 Except for the areas Bunbury, Busselton, Dampier, Paraburdoo and Tom Price, and some other small local government areas.

46 AUSTRALIA'S URBAN WATER SECTOR

mostly Local Government-owned, and regional urban utilities in Victoria being State Government-owned.

Significant structural reform has taken place in recent years in some jurisdictions, which has changed the urban water supply structure in many places. Since the 1990s, there has also been a move to corporatisation of utilities, with most metropolitan utilities being corporatised, and a move towards this model in regional urban areas in Victoria and Tasmania.

Reform in metropolitan areas

Melbourne has moved from having a sole vertically-integrated utility to vertical separation of the bulk supply and retail functions. Melbourne Water is the bulk water service provider, and it also owns the transmission network. Melbourne has three retailer–distributors, City West Water, South East Water and Yarra Valley Water, that supply different areas of Melbourne, and share the entitlements to the bulk water produced by Melbourne Water (Office of Water 2010b; PWC 2010). The operation of the desalination plant has been contracted out to a private company (Office of Water 2011).

Sydney has also separated its bulk supply and retail functions. The Sydney Catchment Authority is responsible for bulk water supply and treatment. Many of the treatment plants are privately-owned and operated (New South Wales Government, sub. 65). Sydney Water undertakes the distribution and retail functions for water and wastewater. A subsidiary of Sydney Water, Sydney Desalination Pty Ltd owns the desalination plant (Sydney Water Corporation, sub. 21).

South-east Queensland has moved away from local councils being the water service providers, to a situation where three retailer–distributors, Allconnex Water, Queensland Urban Utilities and Unitywater, serve different areas of south-east Queensland. South-east Queensland currently has two bulk water suppliers:

• Seqwater, which owns all the dams, groundwater infrastructure and water treatment plants.

• WaterSecure, which owns the desalination plant and Western Corridor Recycled Water Scheme (QWC 2010b).

ABOUT AUSTRALIA'S 47 URBAN WATER SECTOR

Table 2.16 Urban water supply and service arrangements

Jurisdiction Bulk supply Water retail Wastewater retail Stormwater

New South Wales Sydney Catchment Authority Sydney Water Corporation Sydney Water Corporation Sydney Water Corporation Sydney Desalination Pty Ltd (subsidiary Hunter Water Corporation Hunter Water Corporation Hunter Water Corporation of Sydney Water) Gosford Wyong Joint Water Authority Gosford Wyong Joint Water Gosford Wyong Joint Water State Water Corporation 105 local water utilities Authority Authority 105 Local water utilities Local Governments Victoria Melbourne Water Yarra Valley Water Yarra Valley Water Melbourne Water 13 regional urban water utilities South East Water South East Water Local Governments City West Water City West Water 13 regional urban water businesses 13 regional urban water businesses Queensland Seqwater Queensland Water Utilities Queensland Water Utilities Local Governments WaterSecure Allconnex Water Allconnex Water Sun Water Unitywater Unitywater Local Government-owned providers 71 local water utilities 71 local water utilities South Australia SA Water SA Water SA Water Local Governments Small Local Government providers Small Local Government Natural Resource Management providers Boards Western Australia Water Corporation Water Corporation Water Corporation Water Corporation Local Government providers Busselton Water Hamersley Iron Pty Ltd Local Governments Aqwest Water (Bunbury) Some Local Government Hamersley Iron Pty Ltda providers Tasmania Southern Water Southern Water Southern Water 8 Local Government – Drainage Ben Lomond Water Ben Lomond Water Ben Lomond Water Trusts Cradle Mountain Water Cradle Mountain Water Cradle Mountain Water Northern Territory Power and Water Corporation Power and Water Corporation Power and Water Department of Lands and Planning Corporation Local Governments ACT ACTEW ACTEW ACTEW Roads ACT a Hamersley Iron Pty Ltd is a private company that provides water and wastewater services to the towns it operates in — Dampier, Paraburdoo and Tom Price. Sources: NWC (2009b); PWC (2010); QWC (2010b); Sydney Water Corporation (sub. 21).

Another Government-owned entity, Linkwater, owns all the major pipelines. It has been announced that Seqwater and WaterSecure will merge on 1 July 2011, to achieve a more streamlined, cost-efficient operation (Fraser and Robertson 2010). The establishment of the south-east Queensland water grid (section 2.3) has resulted in the establishment of the South East Queensland Water Grid Manager which owns the water entitlements and manages the strategic operations of the water grid by selling treated water bought from the bulk water service providers to retailers and other customers (SEQ Water Grid Manager 2011).

Reform in regional urban areas

Recent reforms to Tasmania’s urban water sector have resulted in a move away from local councils providing water beyond the bulk supply point to three Local Government-owned vertically-integrated water utilities, Southern Water, Ben Lomond Water and Cradle Mountain Water. These utilities provide water and wastewater services to both metropolitan and regional urban areas of Tasmania. A common service provider owned by the three water utilities, Onstream, provides services such as IT, finance and billing to the utilities (Onstream 2010).

Victoria’s regional urban water sector underwent significant reform in the 1990s, when, as part of wider local government reforms, over 140 Local Government-operated utilities were amalgamated into 15 catchment-based State Government-owned vertically-integrated utilities. Catchment Management Authorities were also established to coordinate the management of catchments in their region (DSE 2011a). A few years later, some of these water utilities were further amalgamated, bring down the number of regional urban water utilities to 13 (Armstrong and Gellatly 2008).

Regional urban Queensland underwent reform in 2008 when the number of local councils was reduced through amalgamations from 157 to 73. As a result, the number of regional urban water utilities was reduced to 71 (Department of Environment and Resource Management (Qld), sub. 60). In addition to Local Governments supplying water, there is two commercialised water boards — the Gladstone Area Water Board and the Mount Isa Water Board — and the Local Government-owned Wide Bay Water Corporation (Local Government Association of Queensland, sub. 20).

There have been calls for reform to the regional urban New South Wales water sector (for example, Armstrong and Gellatly 2008). Currently there are 106 (including Gosford-Wyong) local water utilities providing water and wastewater services. The vast majority of these are Local Government council utilities, and a

ABOUT AUSTRALIA'S 49 URBAN WATER SECTOR

number are county council utilities or water supply authorities (more information on these arrangements can be found in appendix B and Armstrong and Gellatly 2008).

There is now quite a large difference in the number and type of utilities servicing regional urban areas. For example, although the Northern Territory has only one metropolitan and regional urban utility (Power and Water Corporation), New South Wales has over 100 regional urban utilities, most of these being Local Government-owned and operated. Queensland also has over 70 regional urban utilities, again, most being Local Government-owned and operated (table 2.16).

Institutions and governance

There are a number of different institutions that are involved in the water sector at a state and territory level, and Australia-wide. Apart from the providers of water, such as State and Local Government-owned utilities (discussed above), there are many institutions that govern and oversee the sector. These include Australian Government institutions, which have a role in driving policy development and reform; State and Territory Governments, which oversee the water industry in their respective jurisdictions and are responsible for policy, planning and sometimes regulatory functions; and regulators (discussed below).

An overview of the institutional and governance arrangements is given below. More information on each jurisdiction is given in appendix B.

Council of Australian Governments

The Council of Australian Governments (COAG) has been the driving force for water reform over the past couple of decades, through a number of agreements, including the 1994 COAG water reform framework, 1995 National Competition Policy, the 2004 NWI, and the 2008 enhanced urban water reform framework. The NWI and the 2008 enhanced urban water reform framework are discussed in more detail below.

National Water Initiative

In 2004, COAG agreed to the NWI. The NWI builds on the 1994 agreement and National Competition Policy, and is intended to ‘extend the reform agenda to more fully realise the benefits intended by COAG in 1994’ (COAG 2004, p. 1). It has actions and outcomes for reforming both the urban and rural water sector. The NWC was established to drive reform under the NWI (discussed above). The outcomes related to urban water reform are outlined in box 2.4.

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Box 2.4 National Water Initiative — urban water reform outcomes 90. The Parties agree that the outcome for urban water reform is to: i) provide healthy, safe and reliable water supplies ii) increase water use efficiency in domestic and commercial settings iii) encourage the re-use and recycling of wastewater where cost effective iv) facilitate water trading between and within the urban and rural sectors v) encourage innovation in water supply sourcing, treatment, storage and discharge vi) achieve improved pricing for metropolitan water [consistent with earlier paragraphs].

Source: COAG (2004, p. 19).

2008 COAG enhanced urban water reform framework

Slow progress and the NWI not being seen to include enough on urban water reform led to COAG agreeing to an enhanced urban water reform framework to improve the security of urban water in 2008. Agreed actions to progress urban water reforms are set out in box 2.5.

Australian Government

The Australian Government plays a role in overseeing and encouraging reform of the urban water sector. The Australian Government takes the lead on many policy initiatives, including Water for the Future, where the Government is investing $12.9 billion over ten years to address four priority areas:

• taking action on climate change

• using water wisely

• securing water supplies

• supporting healthy rivers and waterways (NWC 2009b).

The Australian Government also funds and coordinates other programs such as WELS (discussed in section 2.3), and has helped to fund some large infrastructure projects, such as the Adelaide desalination plant, through subsidy programs such as the National Urban Water and Desalination Plan and the National Water Security Program for Cities and Towns (DSEWPC 2010c). The Australian Government Department of Sustainability, Environment, Water, Population and Communities is responsible for coordinating most of the Australian Government’s water initiatives. In addition, a number of other water-related projects, such as small stormwater

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harvesting projects, have been funded out of more general grants programs such as the Regional and Local Community Infrastructure Program (Australian Government 2009a).

Box 2.5 Actions to progress urban water reforms under the COAG enhanced urban water reform framework

• Adopt national urban water planning principles.

• Establish and publish the levels of service for metropolitan water supplies.

• Publish guidance to facilitate best practice scenario planning for climate variability.

• Finalise and adopt NWI pricing principles.

• Review consumer protection arrangements in relation to services provided by water utilities.

• Investigate possible enhancements to pricing reform, including scarcity value of water and the valuation and recovery of environmental externalities.

• Explore the issue of establishing entitlements for recycling, stormwater and managed aquifer recharge.

• Promote the use of competition through an examination of barriers to third party access and the costs and benefits of establishing a nationally consistent regime.

• Examine the case for a micro-economic reform agenda in the urban water sector.

• Examine the role of improved urban water metering and billing practices in the allocation, use and management of water.

• Finalise a review of water restrictions in Australia.

• Investigate the establishment of a national clearing house for best practice urban water management.

• Investigate the development of a national system for reporting urban water consumption.

• Establish centres of excellence for Recycling and Desalination.

• Develop a strategy to improve water supply and wastewater services in remote communities.

Source: COAG (2008).

Australian Government agencies are also responsible for the Australian Drinking Water Guidelines and guidelines on the use of recycled water (box 2.1). The Australian Government also administers the Environment Protection and Biodiversity Conservation Act 1999 (Cwlth) (EPBC Act).

52 AUSTRALIA'S URBAN WATER SECTOR

National Water Commission

The NWC is an Australian Government body that was established in 2004 to be responsible for driving reform under the NWI (discussed above). The NWC is responsible for advising COAG and the Australian Government on national water issues and progress under the NWI. It undertakes biennial assessments of progress made under the NWI and publishes position statements on water reform issues (NWC 2011a).

State and Territory Governments

The overall governance of the water sector in each jurisdiction is usually undertaken by State and Territory Government departments. Table 2.17 lists the key government departments in each jurisdiction. These departments are generally responsible for the policy, planning and management, and sometimes regulation, of the water sector in their respective jurisdiction. Their responsibilities vary slightly from jurisdiction to jurisdiction, but overall are quite similar. For example, the urban water planning and management activities undertaken by the NSW Office of Water are representative of many of the functions undertaken by the equivalent departments in other state and territories:

• coordinating the development of urban water policy, planning and implementation of large infrastructure projects

• surfacewater and groundwater management

• water licensing and compliance

• research, such as modelling and evaluation

• regulation of regional urban water utilities

• providing water-related legal advice to government (NSW Office of Water 2010b).

Other entities are often involved in water planning and management, including water utilities and economic regulators (discussed below). Usually more than one state or territory department is involved in the urban water sector in each jurisdiction. Examples of other departments and agencies that could be involved include:

• health departments, which will usually be in charge of drinking water management and regulation

• environmental protection authorities, which will often be involved with environmental regulation related to water

ABOUT AUSTRALIA'S 53 URBAN WATER SECTOR

• treasury departments, which will often be involved with budgets, community service obligations, borrowing controls and dividend policy

• the ministers themselves, which are responsible for setting water prices and other key decisions in some places.

Table 2.17 Key State and Territory Government departments involved in metropolitan water planning and management

Jurisdiction Department Examples of key plans and policy documents

New South Wales Department of Environment, Climate Metropolitan Water Plan Change and Water (NSW Office of Water) Victoria Department of Sustainability and Our Water Our Future 2004 Environment Next stage of the plan 2007 Queensland Department of Environment and Resource South East Queensland Water Management Strategy 2010 South Australia Department for Water (Office for Water Water for Good 2009 Security) Western Australia Department of Water Tasmania Department of Primary Industries, Parks, Water and Environment Northern Territory Department of Natural Resources, Environment, The Arts and Sport ACT Department of Territory and Municipal Think Water, Act Water – a Services (Office of Sustainability: Water strategy for sustainable water Policy Unit) resource management Source: NWC (2009b).

Regulatory arrangements

The regulatory arrangements of the urban water sector vary quite considerably by jurisdiction. This section summarises the main economic regulations Australia-wide, including price regulation, third party access arrangements and licensing arrangements. It also includes some brief information on public health and water quality regulation, and environmental regulation. More detail on regulation by jurisdiction is presented in appendix B.

Economic regulation

Economic regulation of the water sector generally refers to three main areas: pricing, third party access and licensing.

54 AUSTRALIA'S URBAN WATER SECTOR

Pricing

Pricing is one of the main water regulatory functions. Approaches to water pricing vary greatly by jurisdiction, including who sets prices (box 2.6), how prices are set, how widely they are applied and how long they are applied for.

Box 2.6 Who sets water prices? New South Wales — the Independent Pricing and Regulatory Tribunal sets urban water prices in Sydney, the Hunter, Gosford, Wyong and Broken Hill. Non-metropolitan urban water prices are set by local water utilities. Victoria — the Essential Services Commission sets water prices Victoria-wide Queensland — in south-east Queensland, the State Government sets bulk water prices and the three retailer-distributors set retail prices. From 2013, it is expected that the Queensland Competition Authority will be responsible for making price determinations in south-east Queensland. In regional urban areas, the local water utilities set prices. South Australia — the South Australian Cabinet currently sets urban water prices. From July 2012, the Essential Services Commission of South Australia will be responsible for setting prices. Western Australia — the Western Australia Cabinet sets urban water prices after having received advice from the Economic Regulation Authority. Tasmania — the three Local Government-owned water corporations set urban retail water prices. The Office of the Tasmanian Economic Regulator will be responsible for pricing from July 2012. Northern Territory — the Treasurer sets prices Northern Territory-wide. ACT — the Independent Competition and Regulatory Commission set water prices.

Sources: South Australian Government (sub. 52); NWC (2009b); OTTER (2010b); QCA (2010b); QWC (2010a).

Prices are generally set by independent economic regulators (in metropolitan New South Wales, Victoria and the ACT), or State or Local Governments. Where prices are set by either the State Government or independent regulators, prices are generally set for a period of about 3-4 years (table 2.9). The independent economic regulators set prices through a transparent process, which can include calling for submissions, draft price determinations, and final price determinations. Independent economic regulators set prices to recover costs, including a return on capital. In recent price determinations, a rate of return of about 5 to 7.5 per cent has been set (PWC 2010).

Where governments set prices, the economic regulator still plays some role in price setting. For example, in South Australia, the Essential Services Commission of

ABOUT AUSTRALIA'S 55 URBAN WATER SECTOR

South Australia reviews price setting policies, and in Western Australia, the Economic Regulation Authority makes price recommendations to the Western Australian Government.

In regional urban areas of New South Wales and Queensland, prices are set by the water utilities themselves, in accordance with guidelines issued by the NSW Office of Water and the Queensland Competition Authority (NSW Office of Water 2010b; QCA 2009). More information on pricing is presented in chapter 7.

Third party access arrangements

Third party access involves a party other than the incumbent service provider being able to access natural monopoly-type infrastructure to provide services to others. Given the increasing diversification of supply options, and newer supply options such as recycling being increasingly used, third party access to water infrastructure might be increasingly sought in the future.

Arrangements exist under the National Access Regime in Part IIIA of the Competition and Consumer Act 2010 (Cwlth) (formerly the Trade Practices Act) to enable access to be obtained when the owner of the infrastructure will not provide it on acceptable terms and conditions. Access to water infrastructure can be sought through this regime. However, to gain access through the Competition and Consumer Act, one of the requirements is that, for a service to be declared, the service needs to be nationally significant, which could make it difficult for the private sector to get access to infrastructure in smaller areas (National Competition Council, sub. 12).

There have been two applications for the declaration of water services under the National Access Regime, both in New South Wales, one of which was successful. The declaration in this case was sought by Services Sydney Pty Ltd. This is described in box 2.7.

Some states have implemented, or are considering, state-based third party access regimes for water. New South Wales has introduced its own third party access regime through the Water Industry Competition Act 2006. This regime allows the private sector to access publicly-owned infrastructure in the areas of operation of the Sydney Water Corporation and Hunter Water Corporation (IPART 2008b).

Queensland has a third party access regime that applies to water, as well as other utilities and transport infrastructure, under the Queensland Competition Authority Act 1997. Third party access arrangements for water are also being considered in

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other places such as Victoria and South Australia (Department for Water (SA), sub. 79; ESC 2009a).

Box 2.7 Services Sydney case In March 2004, Services Sydney Pty Ltd applied to the National Competition Council for a recommendation of declaration of some services provided Sydney Water’s sewerage distribution network in metropolitan Sydney. Services Sydney intended to provide sewage collection services using Sydney Water’s network to help transport the sewage, then recycle the wastewater and supply the recycled water for non-potable uses. In December 2004, the National Competition Council recommended to the Premier of New South Wales that six sewage interconnection and transportation services provided by Sydney Water be declared for a period of 50 years. The Premier was deemed to have decided not to declare the services, as after 60 days of receiving the National Competition Council’s recommendation, the Premier had not published a decision. Services Sydney sought review of the Premier’s deemed decision by the Australia Competition Tribunal, and in December 2005 the tribunal handed down its decision to set aside the Premier’s deemed decision and to declare the services for a period of 50 years.

Source: National Competition Council (sub. 12)

Licensing

Most water and wastewater service providers are required to hold a license. This includes water utilities in most jurisdictions, and in some places, such as metropolitan Sydney, private providers of stand-alone systems (such as new residential developments with a third pipe system) are also required to be licensed. Licenses generally set out the conditions under which the service provider can operate in the market, and the requirements that they must meet. Requirements can include standards of service, including an obligation to serve a certain area, ways of dealing with customer complaints and reporting requirements, including information to be used for benchmarking and performance monitoring.

In most jurisdictions the economic regulator has a role in licensing, including administering licenses, and monitoring the performance of license holders to make sure they meet the requirements of the license.

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Environment and health regulation

Environment and health regulation, including regulation of drinking water and recycled water quality, is usually undertaken by State and Territory Governments, including government health departments (which often regulate drinking water and recycled water quality) and environmental protection authorities and/or environment departments (which often regulate environmental health). Environment and health regulation will often include setting minimum standards that utilities must meet, and monitoring compliance with these minimum standards, including publishing testing results. In some jurisdictions, utilities require specific licences from these government bodies. Often standards, particularly recycled water standards, will vary between jurisdictions.

As mentioned earlier, the Australian Government also plays a role in environment and health regulation through setting health guidelines and administering the EPBC Act. The Australian Drinking Water Guidelines, developed by the National Health and Medical Research Council and the Natural Resource Management Ministerial Council, are used to form the basis for drinking water quality standards in most metropolitan and regional urban areas.

In addition, Australian Government entities, the Environment Protection and Heritage Council of Australia and New Zealand, the Natural Resource Management Ministerial Council and the National Health and Medical Research Council have developed the Australian Guidelines for water recycling. This set of guidelines includes information on topics such as augmenting drinking water supply, stormwater harvesting and reuse and managing aquifer recharge (EPHC 2011).

The Australian Government Department of Sustainability, Environment, Water, Population and Communities administers the EPBC Act. The Act provides a legal framework for protecting and managing matters of national environmental significance, including important flora, fauna, ecological communities and heritage places.

58 AUSTRALIA'S URBAN WATER SECTOR

3 Objectives for the urban water sector

Key points

• Without clear objectives for the urban water sector the case for reform cannot be assessed or reform options designed.

• Governments should set an overarching objective for the sector of delivering water, wastewater and stormwater services in an economically efficient manner so as to maximise net benefits to the community.

• The concept of ‘economic efficiency’ encapsulates many of the more specific objectives that should be pursued in the urban water sector, including those related to water security, water quality, flood mitigation and the environment. It can also be used, through the application of a number of quantitative and qualitative techniques, to guide the tradeoffs that need to be made between these objectives, as required by ecologically sustainable development principles.

• Universal and affordable access to water and wastewater services should be a government objective for both efficiency and equity reasons. In general, ensuring access to affordable water services for low income households is best addressed through measures that are outside the urban water sector, such as the social security and taxation systems.

• In many cases, the role of the urban water sector should be to respond effectively and efficiently to environmental policies rather than to independently pursue environmental objectives. In relation to environmental aspects of stormwater management and wastewater discharge, the sector should assume primary responsibility for delivering the mitigation outcomes governments determine as being reflective of community values.

• Consumers are usually best placed to make their own water use decisions. A water use that one person might regard as being of low value, might be of high value to someone else.

• Increasing water use efficiency and water conservation are not appropriate objectives in their own right because in some circumstances this reduces overall benefits to the community.

Without clear objectives for the urban water sector the case for reform cannot be assessed or reform options designed. Ultimately, the purpose of reform is to deliver benefits to the community by more fully meeting objectives. This chapter examines

OBJECTIVES 59

possible objectives for the sector and reaches conclusions about their merits and about how tradeoffs between objectives should be made.

The urban water sector is taken to include the delivery of the following services for urban areas:

• planning, procuring and supplying water of appropriate quality to households, firms and other consumers (for example, hospitals)

• supplying water for amenity and environmental purposes within urban areas

• collecting, treating and disposing of wastewater

• managing stormwater for flood mitigation and other purposes.

The sector also includes sector-specific regulation (including of prices, supply reliability standards and water quality standards) and urban water policy (for example, programs that promote water use efficiency).

Outcomes for the sector also depend on a range of outside influences. For example:

• affordability of water for low-income households depends not only on water prices, but on the social security and taxation systems, and the general level of prices in the economy

• the ability of the sector to supply water and to dispose of wastewater and stormwater is affected by general environment policy.

An important aspect of this chapter, therefore, is to consider what objectives are best met by decisions taken within the urban water sector and what objectives should be left to other spheres of policy.

3.1 What objectives?

A range of possible objectives for the urban water sector put forward by inquiry participants and other commentators is considered below.

Water security and reliability

Water security can be defined as ensuring that water users have continual access to supplies of suitable quality water. High variability in rainfall and inflows to rivers has long been a major challenge to managing water security in Australia. This has been exacerbated by a decade or more of dry conditions in parts of Australia, and the prospect that climate change may reduce river and dam inflows into the future. Recent dam-replenishing rain across much of eastern Australia has served as a

60 AUSTRALIA'S URBAN WATER SECTOR

reminder of the great uncertainty inherent in the water security challenge in this country.

There are three main types of actions that can be taken to increase water security. These are:

• investing in supply augmentations that add to available water supplies (for example, building wastewater recycling plants, desalination plants or dams)

• developing options that allow extra water to be made available at short notice if needed (for example, planning and obtaining regulatory approvals for an investment in water supply infrastructure, or entering into options contracts to buy irrigation water)

• reducing water consumption through demand management activities so that more water is available to meet future needs (for example, increasing prices when water is relatively scarce, water restrictions or campaigns appealing to the community to conserve water).

Complete failure in maintaining water security could result in there being no water for the reticulated water supply system. If this eventuated in a small community the situation might be able to be managed by bringing in water by road or rail transport. These options, however, would be profoundly difficult for larger towns and cities and so such a situation should be avoided at virtually any cost. Less catastrophic failure to properly manage water security involves the community incurring costs that are higher than necessary to have continual access to reticulated water.

Achieving water security at least expected cost should be an objective for the urban water sector. This does not imply that any particular mix of the above types of actions should be used, as each has its own costs and benefits. For example, demand management activities often do not require large capital investments (a relative benefit) but they do entail people forgoing using water in ways that may have benefited them (a cost). The approach taken, therefore, should be governed by the assessment of costs and benefits of different options. Consumers’ willingness to pay for water, and their attitude to risk, should play a central role in this assessment (box 3.1).

This way of understanding water security is different from the ‘supply-focused’ perspective that is sometimes taken. Under a supply-focused approach it is predominately supply augmentations (sometimes in concert with water efficiency/conservation measures) that are seen as increasing water security, with water restrictions used as a ‘backstop’ measure when augmentations have failed to achieve the required level of supply.

OBJECTIVES 61

Box 3.1 Achieving water security at least expected cost with and without risk aversion Strictly speaking, achieving water security at least cost would involve making decisions about supply augmentation and demand management that perfectly match subsequent patterns of rainfall and inflows. So for example, not building a desalination plant if subsequent years are going to be wet. Achieving this with certainty is clearly infeasible as it requires knowledge of the future that is unobtainable (at least with present weather forecasting technology). Setting the objective of achieving water security at least expected cost is done in recognition of the inherent uncertainty surrounding decision making. The following stylised example illustrates the concept of achieving water security at least expected cost. Suppose a decision must be made about whether to proceed with a supply augmentation and there is uncertainty about future rainfall. Assume that:

• there are five possible future rainfall scenarios; the three central ones each have a probability of just below one-third and the two extreme scenarios each have probabilities of only 2 per cent

• regardless of the augmentation decision or the rainfall scenario, water security will be maintained — in the drier scenarios this will be achieved by progressively increasing water prices

• there will be a positive payoff for the community from proceeding with the investment under the drier scenarios and a negative payoff for the others below.

Scenario Probability Augmentation payoff

Extreme wet 2% -$120 million Wet 32% -$70 million Average 32% -$10 million Dry 32% +$50 million Extreme dry 2% +$100 million Expected payoff -$10 million

Taking the probability of each scenario into account, the expected payoff of the augmentation is negative (the expected payoff is calculated by summing the probability times the payoff for each scenario). Accordingly, if a least expected cost approach to water security is taken, and there is no risk aversion, a decision would be made not to proceed with the augmentation. If there is risk aversion, however, this could change the decision. Suppose for example, that the water users were presented with the above information and they each had strong concerns about the high water prices that would result if the augmentation were not built and the ‘extreme dry’ scenario eventuated. It might be that in aggregate they would be prepared to pay say $12 million to avoid this risk and be assured of more stable water prices. Taking this risk aversion into account, a least expected cost approach to water security would require a decision to proceed with the augmentation.

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A distinction is sometimes made between water security and service reliability. Where this is done, the former relates to having enough water, while the latter is about being able to deliver water services to customers. As such, a reliability objective focuses attention on the infrastructure and operations needed to deliver services to customers. Reliability is important for both water and wastewater services.

Controlling costs

Ensuring that the cost of supplying water, wastewater and stormwater services is not higher than necessary is an important objective for the urban water sector. Achieving this requires that:

• whatever level of service that is provided is supplied at the lowest possible expected cost (for example, using low cost sources of water in preference to higher cost sources, other things being equal)

• the level of service provided is not higher than can be justified by the value consumers place on the service (for example, treatment processes to improve the appearance or taste of water should be undertaken only where the benefits to customers (as measured by their willingness to pay for improvements) exceed the costs).

Universal and affordable access

Water provision and wastewater removal are essential services and are important for public health. Because of this, a number of inquiry participants argued that universal and affordable access to these services should be an important government objective. For example, the Public Interest Advocacy Centre canvassed Australia’s human rights obligations to ensure that everyone has access to water and concluded that: In practical terms, [Australia’s obligations to protect, promote and fulfil human rights] … means that the Australian Government must ensure that all households are able to afford to purchase an appropriate quantity and quality of water. (sub. 61, p. 3)

The Commission agrees that universal and affordable access to water and wastewater services should be a government objective. This does not mean, however, that the government should always take responsibility for providing these services. For example, where someone chooses to build a house in a location that would be most efficiently served by distributed systems, such as a rainwater tank and a septic system, they should generally provide these themselves. Whether this is

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affordable for them is something they would take into account when deciding whether to build.

One way that the urban water sector can pursue this objective is through controlling costs, as discussed above. This has the potential to keep cost down for the entire community, including low-income and disadvantaged groups. A variety of other possible means focus more on achieving what some might consider to be a more equitable distribution of costs across different groups. These include:

• using a pricing structure that includes an initial allocation of water at a low volumetric price, possibly zero

• uniform or postage stamp pricing across regions

• using water restrictions and other non-price demand management measures in lieu of higher prices during times of high water scarcity.

Governments also seek to assist particular groups, such as the unemployed and others on low-incomes, through means outside the urban water sector. These means include: progressive rates of income tax; social security payments; providing concessions on some goods and services (including water); and consumer protection laws.

There is a question, therefore, about what is the best mix of means for pursuing the objective of universal and affordable access to water and wastewater services. It is certainly the case that governments should ensure that the cost of supplying water and wastewater services is not higher than necessary for the community as a whole. Beyond this, there would seem to be advantages in using methods that are outside the urban water sector, rather than distorting water prices away from their efficient level.

For example, providing financial assistances, such as social security payments, allows people to spend this money in the way that they consider will benefit them most. As such, they are a more flexible form of assistance than can be provided through water pricing.

In certain circumstances, however, there may be arguments in favour of using pricing and other arrangements in the urban water sector to influence affordability and access (for example, for remote communities, including Indigenous communities). Chapter 9 considers these arguments.

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Public health

Access to clean water for drinking and washing, and reliable wastewater services are vital for public health. Indeed, the history of government involvement in urban water supply systems is very much tied up with public health concerns. Improvements in the standard of urban water and wastewater systems during the nineteenth and the first half of the twentieth century played a major role in reducing the prevalence of diseases such as typhoid and cholera in various countries (Barzilay, Weinberg and Eley 1999).

While gains in public health made in the distant past are often taken for granted in developed countries such as Australia, contributing to good public health outcomes remains an important objective for the urban water sector. Achieving this objective involves managing risks to public health, for example, the risk that people will get sick from ingesting water that contains microbial and chemical hazards. There is evidence that this risk is not always well managed in some regional areas (chapter 6).

Managing such risks efficiently does not usually involve eliminating all risks entirely. Consider a situation where there are large benefits available from developing a fit-for-purpose recycled water product for garden watering, toilet flushing and other uses. A risk eliminating approach might specify that the quality of such water needs to be comparable to that of potable water on the grounds that a small number of people may drink it. Such a requirement might make the project uneconomic, meaning that a large benefit is lost in order to eliminate what may have been a very small risk.

Environmental protection, sustainability and amenity

A range of environmental issues relate to urban water and the question of objectives needs to be considered for each.

Allocating water between urban and environmental uses

Water can either be allocated for consumptive use (in agricultural production or urban areas) or environmental use. Irrigators and urban water users benefit from the use of water and can express this in their willingness to pay for it. By contrast, the benefits that occur from environmental use, such as maintenance of the health of water-dependent ecosystems, often accrue to the community as a whole (that is, they are said to be ‘public goods’). While some individuals put money towards environmental watering (for example, through donations to organisations such as

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Healthy Rivers Australia and the Australian Conservation Foundation), such private provision is likely to understate the value people put on environmental outcomes, given this public good aspect.

Because of this, governments have a role in allocating water to the environment in a way that reflects judgments about the value of water for environmental use relative to consumptive use. The National Water Initiative recognises this role and stipulates that it be pursued through water planning (box 3.2). This water planning function is part of broader water policy, rather than being strictly an urban water policy function. Accordingly, environmental water allocations should be largely determined outside the urban water sector. Therefore, striking the right balance between consumptive and environmental uses of water is not an objective that should be set for the urban water sector. The urban water sector’s role in this process should be to:

• provide information on the value of water for urban use to the planning process that determines this balance

• operate effectively and efficiently within the constraints imposed by the environmental water allocations that are set.

Box 3.2 National Water Initiative: allocating water between consumptive and environmental uses The National Water Initiative includes the following paragraphs relating to the allocation of water between consumptive and environmental uses. 36. Recognising that settling the trade-offs between competing outcomes for water systems will involve judgements informed by best available science, socio-economic analysis and community input, statutory water plans will be prepared for surface water and groundwater management units in which entitlements are issued … . Water planning is an important mechanism to assist governments and the community to determine water management and allocation decisions to meet productive, environmental and social objectives. 37. Broadly, water planning by States and Territories will provide for: i) secure ecological outcomes by describing the environmental and other public benefit outcomes for water systems and defining the appropriate water management arrangements to achieve those outcomes; and ii) resource security outcomes by determining the shares in the consumptive pool and the rules to allocate water during the life of the plan.

Source: COAG 2004.

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Environmental services and amenity from water in the urban landscape

Water contributes to people’s enjoyment of urban landscapes in many ways. Green gardens (public and private), parks, playing fields, and urban waterways and wetlands can contribute significantly to urban amenity. The Centre for Water Sensitive Cities (sub. 75) reported that green spaces can reduce the heat island effect, which can have health as well as amenity benefits. The urban water sector can influence these types of outcomes through management of the water supply and wastewater systems, and through management of stormwater. For example, by implementing stormwater reuse projects that supply water to irrigate public parks or using urban wetlands to help filter stormwater.

In the Commission’s view, the urban water sector has an important role to play in finding innovative ways to deliver water services that enhance environmental services and amenity in urban landscapes. It does not, however, regard the sector as always being in the best position to determine what outcomes should be pursued. Maintaining environmentally healthy urban waterways is a legitimate objective for stormwater management. When it comes to land-based outcomes, however, whoever is responsible for managing the land in question will normally be best placed to take responsibility. Depending on the circumstance, this could be Local Governments, park managers, State Government environment departments or residential gardeners. Accordingly, the role for the urban water sector is to be an efficient, cooperative and innovative supplier of fit-for-purpose water products to meet these outdoor watering demands.

Environmental impacts associated with water supply options

Different water supply options can have different environmental impacts, both negative and positive. For example:

• dam construction can result in the loss of valued ecosystems and impairment of ecological processes

• desalination plants use electricity that may be sourced from generators that emit greenhouse gases

• stormwater recycling may reduce the level of pollutants reaching creeks and rivers.

It is important that these differences are taken into account in supply augmentation decisions. The option that is least cost from a financial point of view may not be least cost when environmental values are factored in.

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In general, environmental policy should determine the weight that should be given to particular environmental impacts associated with water supply options and possibly what economic value should be placed on these (such as establishing a price for greenhouse gas emissions). This is because the same or similar environmental impacts arise in other contexts and it is desirable that they are dealt with consistently across all sectors. For example, there are benefits in taking a consistent approach to reducing greenhouse gas emissions, as outlined in box 3.3. The role of the urban water sector should be to respond effectively and efficiently to the regulations and incentives provided through environmental policy.

Box 3.3 Advantages of taking an economywide approach to reducing greenhouse gas emissions Human-induced climate change is a global problem that can only be effectively mitigated by many countries reducing their greenhouse gas emissions. The Australian Government has set a target of reducing emissions by 5 per cent by 2020 (relative to the year 2000) and has agreed to make bigger cuts, conditional on the commitments made by other countries. There is a wide range of policy instruments that could be used to achieve Australia’s national target. The Commission, and many other researchers, have concluded that putting a price on emissions, either through an emissions trading scheme or a tax, is the optimal policy response because it is likely to achieve the target at the lowest cost to the community (PC 2008e). There are also advantages in the trading scheme or tax covering the widest range of sources of emissions, and sectors of the economy, as is feasible. Putting a price on emissions across the economy achieves the target at least cost by creating an incentive for all abatement opportunities that cost less then the emissions price to be implemented. By contrast, having a patchwork of different policy instruments that apply to some sectors but not others tends to result in some high cost abatement opportunities being taken up, while some low cost opportunities are not. In the urban water sector, considerable attention has been given to the greenhouse gas emissions associated with the energy used by desalination plants. In some cases, it has been decided that renewable (and low emission) sources of energy will be developed to offset the energy use of the plant. This is an example of a sector-specific policy that may result in unnecessarily high abatement costs. An economywide price on emissions has the potential to influence the supply augmentation options that are chosen in the urban water sector. This is because it tends to make energy prices higher than they would otherwise be (the environmental cost of emissions become ‘internalised’ in energy prices). This in turn makes energy-intensive augmentation options, like desalination, less attractive than they would otherwise be.

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Water catchments that are used for urban supply are somewhat of a special case in that their management can influence water yield and quality, as well as biodiversity conservation, agricultural production and wood production. How catchments are managed can have large consequences for water supply systems, as illustrated by the example of catchments that supply New York City (box 3.4).

Box 3.4 Management of catchments supplying New York City Historically, the Catskills’ catchments have supplied New York City with high quality water with little contamination due to the natural filtration processes of the ecosystems on the banks of streams, rivers, lakes, and reservoirs. However, increasing housing developments and pollution from vehicles and agriculture threatened water quality in the region. By 1996, New York City faced a choice: either it could build water filtration systems to clean its water supply or the city could protect the Catskills’ catchments to ensure high-quality drinking water. A decision was taken to protect the Catskills’ catchments and this decision is supported by cost–benefit analysis. It has been estimated that the total cost of building and operating the filtration system was in the range of US$6 to $8 billion. In comparison, the total cost for protecting the water provision service of the Catskills through land purchases and regulations to control development and land use in the catchments has been estimated at US$1 to $1.5 billion.

Source: Barbier and Heal (2006).

The overall government objective should be that catchments are managed in a way that maximises the net benefits to the community, taking into account all of the values that they can provide. The role that the urban water sector should play in this, however, is less clear. At one extreme the sector could own and have sole responsibility for managing catchments — in which case the sector would need to be assigned the overall government objective. At the other, catchments could be entirely owned and managed by government land management agencies and/or private interests — in which case the sector’s role would be confined to seeking to influence management to improve water-related outcomes.

Environmental impacts associated with wastewater treatment and disposal

The environmental impacts from wastewater disposal depend on the quality of the water and the characteristics of the receiving environment. Managing these impacts is rightly seen as a matter for the urban water sector as wastewater discharge arises predominantly from the sector. As with public health, the objective should not be to eliminate all impacts and risks entirely, but rather to reduce environmental impacts wherever the benefits to the community of doing so exceed the costs. This

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balancing task is not one for the providers of water services, but rather the appropriate regulator or minister as part of a transparent and objective process (chapter 11 considers such roles and responsibilities in more detail).

Flood mitigation

The urban water sector contributes to flood mitigation in two main ways. First, the primary purpose of stormwater services is to provide drainage so as to reduce the prevalence of localised flooding in urban areas. Second, dams that supply water to urban areas may also provide flood mitigation services by holding back water that might otherwise cause flooding in downstream areas. To accommodate this dual role, dam management strategies may be developed that effectively assign a proportion of the dam’s capacity to water supply and the remainder to flood mitigation.

It is appropriate, therefore, that the urban water sector be assigned a flood mitigation objective. There are, however, a range of activities needed for effective flood mitigation that are conducted outside the sector. For example, decisions on what types of development to allow in areas that may be affected by floods.

Water use efficiency and water conservation

Water use efficiency is sometimes put forward as an appropriate objective for the urban water sector. For example, the National Water Initiative specifies that urban water reform should ‘increase water use efficiency in domestic and commercial settings’ (COAG 2004, p. 19).

Improving water use efficiency is maintaining or increasing the level of useful output or outcome delivered, while reducing water consumption. For example, if two dishwashers do an equally good job of cleaning dishes the one that uses less water has a higher water use efficiency.

While increasing a form of efficiency sounds like a good thing to do, it is not always in the community’s interests to increase water use efficiency. This is because reducing water use may entail using more of other valuable resources, such as energy, materials or labour. For example, a commercial car wash might be more water efficient than home car washing, but involve greater energy use. Whether such tradeoffs are worth making depends on the value of the water saved relative to the value of the extra resources used.

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In commenting on what they see as the misplaced emphasis on water use efficiency in the National Water Initiative and elsewhere, Crase and O’Keefe stated: … elaborate capital investments at the household and commercial level can, in some cases, be used to offset water inputs, but this does not guarantee a low-cost means of production. To simply assume that water use efficiency is superior to the efficient use of all inputs belies the expansive economic literature in this field. (sub. 5, attachment p. 2)

The Commission strongly agrees that governments should pursue the efficient use of all inputs/resources within the economy. Seeking to increase water use efficiency without considering the implications of this for the use of other resources runs counter to this objective and, therefore, should not be encouraged by government policy. A distinction needs to be drawn between water use efficiency — which is only sometimes desirable — and water use that is economically efficient (more on this later). The Commission interprets the term ‘resource efficiency’ in the inquiry terms of reference as being equivalent to economic efficiency.

A concept related to water use efficiency is water conservation. Water conservation is sometimes defined to mean essentially the same thing as water use efficiency, but where it has a separate meaning it may be defined as: a reduction in water use that also causes a reduction in the level of useful output or outcome. Under this definition, watering a vegetable garden less is a water conservation practice if it reduces the yield of vegetables and a water use efficiency practice if it does not.

In the same way that water use efficiency is sometimes promoted regardless of the implications for the use of other resources, water conservation is sometimes encouraged or mandated regardless of the value of the output or outcome forgone. For example, mandating that sports fields cannot be properly watered even where this results in games being cancelled or injuries being sustained.

To extend an analogy used by Henry Ergas, putting less fruit on a pavlova could be described as conserving fruit or being ‘fruit efficient’ (Ergas 2009). Using these terms, however, does not change the fact that many people would prefer, and be prepared to pay for, a more plentiful topping. It is much the same with water. In general, there would seem to be no good reason for governments to override these preferences.

Commercial viability and dividends to government

An objective that is sometimes set is for government-owned water businesses to maintain ongoing commercial viability and pay dividends to governments that reflect a commercial return on capital.

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In sectors where private firms operate in competitive markets the ongoing commercial viability of individual firms is not guaranteed. Firms that do not keep pace with innovations and other efficiency gains made by rival firms are likely to decline and may cease to operate. Because innovation can deliver cost savings and product improvements this process generally benefits the community, even though the owners of firms that decline may suffer losses.

Since the 1990s, governments have sought to place government-owned urban water businesses and other government trading enterprises on a more commercial footing, for example by corporatising them. The motivation for this has been to try to generate some of the efficiency gains observed in competitive markets, even though the opportunities for actual competition are often limited by natural monopoly characteristics. The Commission has observed that: … governments have sought to give government trading enterprises a greater commercial focus and facilitate competitive neutrality by exposing them to capital market disciplines and regulations similar to those faced by private sector businesses. (PC 2007a, p. 152)

There is a possible tension between the role of governments in promoting efficiency in the sector and their position as owners of water businesses, and therefore the beneficiary of dividend payments. For example, where private sector businesses are able to successfully compete with the incumbent government-owned business in the provision of some services this may reduce the capacity of the incumbent to pay dividends. On the one hand, governments should welcome this development where it signals that efficiency gains are being achieved. On the other, declining dividends make it harder for governments to achieve budgetary targets.

In general, the overall interests of the community are best served when governments resolve this tension by focusing on promoting efficiency rather than ensuring that dividend payments are always maintained at a particular level. That is, there should be an expectation that government water businesses earn a normal commercial return from which dividends can be paid (otherwise capital allocation may be distorted), but not that dividends are maintained at a set level regardless of circumstances. Because of this, the objective of government-owned water businesses maintaining commercial viability and paying dividends should be pursued only to the extent that it is consistent with promoting efficiency.

3.2 Economic efficiency as an overarching objective

It can be seen from the above discussion that there are several valid objectives for the urban water sector. This means that tradeoffs between objectives are inevitable

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and there can also be tradeoffs within objectives. Water security can be pursued through supply augmentation or demand management — each approach has advantages and disadvantages. Public health risks and environmental impacts associated with the urban water sector can be reduced, but this comes at a cost.

The concept of economic efficiency provides a framework for making these tradeoffs in a way that produces the best overall outcomes for the community. Economic efficiency is related to cost–benefit analysis in that a proposal that is shown to have benefits to the community that exceed costs is also one that improves economic efficiency. The concept has three dimensions as outlined in box 3.5.

Box 3.5 Dimensions to economic efficiency Overall efficiency requires the pursuit of productive, allocative and dynamic efficiency. Productive efficiency requires that goods and services be produced at the lowest possible cost. For example, where there are several possible methods for producing a given quantity of water (of equal quality and reliability) the method that has the lowest cost offers the highest productive efficiency. Allocative efficiency requires that the set of goods and services produced from the available resources is the set that maximises value to consumers. In this context, ‘resources’ includes the available water as well as the labour, energy and capital used to deliver water and remove and treat wastewater. The efficient allocation of these resources provides the mix of goods and services, including environmental outcomes, that maximises society’s wellbeing. Dynamic efficiency requires that investments that are expected to produce more efficient production possibilities in the future (as technology evolves and the availability of inputs changes) are made whenever the expected benefits to consumers exceed the costs. Examples include investments in research and development and in upgrading the technology used in water supply systems. It is also the case that some reform options might create an environment that is more conducive to ongoing innovation in the water sector, and dynamic efficiency requires that this be taken into account.

For economic efficiency to be useful in determining how tradeoffs are made it needs to be defined broadly to include environmental and other costs and benefits that are not traded in markets. This allows short-term and long-term environmental and social considerations to be integrated into decision making, as required by the principles of ecologically sustainable development.

Ideally, this involves estimating the monetary value of changes in environmental and health outcomes, although other methods are available and this is an area of ongoing policy development. Different estimates and approaches can and should be debated prior to decisions being taken. As discussed in chapter 11, it should

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generally be governments (elected representatives) that make the final judgment, not water utilities.

With the possible exception of ‘universal and affordable access’, all of the valid objectives for the urban water sector discussed above can be encapsulated by the concept of economic efficiency. This possible exception arises because there are both equity and efficiency arguments for providing universal and affordable access and economic efficiency does not encapsulate the equity dimension (that is, how costs and benefits are distributed across different groups).

As discussed above, however, it is likely that most distributional issues are best dealt with outside the urban water sector through, for example, the taxation and social security systems. If this were accepted, then a single objective of delivering water, wastewater and stormwater services in an economically efficient manner would be appropriate for the urban water sector. If it is not, then the economic efficiency of the sector remains of primary importance, but some reduction in efficiency might be accepted where this is necessary to satisfy affordability objectives. However, this reduction should be no more than is necessary.

Chapters 5 to 9 of this report demonstrate that many of the current deficiencies in the urban water sector are at least partly due to a failure to make tradeoffs between multiple objectives in a way that maximises net benefits to the community. This suggests that adopting an overarching objective of economic efficiency in service delivery has the potential to be a catalyst for positive change that delivers real benefits to water users.

DRAFT RECOMMENDATION 3.1 The Australian, State and Territory Governments should articulate a common objective for the urban water sector in relevant policy documents along the following lines:

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4 The role of governments

Key points

• At present governments play a dominant role in the urban water sector. This report examines the case for introducing reforms to give markets a greater role.

• Under certain conditions market provision of goods and services can promote economic efficiency. However, they can perform poorly where there are so called ‘market failures’.

• Market failures (including natural monopoly elements of the supply chain, health and environmental externalities and public goods) are prevalent in the urban water sector.

• There are various measures that governments can implement to address market failures. Some of these influence the way markets operate (for example, regulation), while others replace markets (government service provision).

• These government responses can improve outcomes, but they also have the potential to introduce new sources of inefficiency. In some cases the ‘cure’ can be worse than the ‘disease’.

• Given the prevalence of market failures it is clear that governments should continue to play a substantial role in the urban water sector. – This role needs to be carefully designed, with clear separation of policy, regulatory and service delivery functions. – There may be some scope for markets to assume a greater role within the framework established by governments.

The previous chapter concluded that the primary objective of the urban water sector should be to provide water, wastewater and stormwater services in an economically efficient manner so as to maximise net benefits to the community. This requires economic efficiency to be broadly defined to encapsulate security, health, affordability and environmental dimensions. In deciding how to pursue this objective there is a fundamental choice about the respective roles that markets and governments should play.

The term ‘government’ covers elected representatives (ministers, other members of parliament and local government councillors), government departments, regulators and government-owned water utilities. This chapter is concerned primarily with the

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aggregate role of all these entities relative to the role of markets. It does, however, consider some high-level issues as to how this aggregate role should be assigned.

At present governments play a dominant role in the sector, in that they:

• set objectives

• develop policies

• regulate prices, health standards and environmental standards

• provide water, wastewater and stormwater services to consumers.

By contrast, the role assigned to markets is mainly limited to the provision of inputs. For example, the tasks of building and operating desalination plants, or providing maintenance or meter-reading services are often outsourced through competitive processes. Decisions to build new infrastructure are made predominantly through central planning processes, rather than markets.

This chapter puts to one side the current configuration of the sector to examine the underlying principles that should guide the design of the role of governments.

4.1 Market provision

Under certain conditions market provision of goods and services can promote economic efficiency. Experience from the electricity sector in Australia shows that reforms that introduce a greater role for competitive markets can achieve substantial efficiency gains (appendix D). Because of this, an important task for this inquiry is to examine the case for introducing market-based reforms in the urban water sector. Markets, however, can perform poorly where there are so-called ‘market failures’. There are several sources of market failure in the urban water sector as outlined below.

Natural monopoly elements of the supply chain

Natural monopoly occurs where it is more efficient for one firm to supply all of a market’s needs than it would be for two or more firms to do so. Natural monopolies are often the result of economies of scale and scope in production that result in the average cost of production falling as output increases (ERA 2008).

Conditions of natural monopoly create the potential for a profit maximising firm to set prices in such a way that the level of output is below that which would have been provided by a more competitive market, resulting in a loss in net benefits to

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the community. Governments can seek to remedy this inefficiency through government ownership of monopolies (and specification of relevant guidelines/obligations) or through price regulation. The existence of a monopoly is a necessary but not sufficient condition for the application of some form of price regulation in the urban water sector. What is required to determine whether regulation is necessary (and if so, in what form) is an analysis of the long-run incentives, and ability, of utilities to undersupply the market.

Bulk water transport and distribution and wastewater/stormwater collection and transport exhibit strong natural monopoly characteristics. It would clearly be inefficient to have two or more providers that each had their own system of pipes running down every street. This is the main reason, along with public health concerns, that water and wastewater services have historically been provided by vertically-integrated monopolies.

A lesson from reform in other utility sectors, however, is that the existence of natural monopoly elements of the supply chain does not preclude competition in the other elements. As explained by Frontier Economics (2008c, p. 28): The big idea underpinning competitive reforms in the utility sector is that the institutional arrangements for the physical network infrastructure can be separated from those for the underlying product or resource. This means that, provided access can be provided to the natural monopoly elements of the supply networks, the commodity itself (e.g. electricity, gas) can be traded across these networks. This enables competition in the potentially contestable functions (e.g. electricity generation, retail supply).

If there were to be a fundamental shift towards a much greater role for markets in the urban water sector it is likely to be through this type of separation. Reforms already undertaken in the rural water sector show that much more efficient allocation of a given water resource can result (appendix C). However, urban water markets would need not only to allocate a fixed quantity of water, but also to bring forth investment in supply augmentation (for example, new desalination plants, dams and recycling plants) in a way which achieved water security.

As discussed in chapter 3, urban water security needs to be maintained at virtually any cost and so there would need to be a high degree of confidence that markets could deliver on this before such reforms were made. The challenges are substantial, given that:

• the depth of competition in bulk water supply would likely be much less than in, say, electricity generation, given that it can be prohibitively expensive to transport water over very large distances

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• investments in supply augmentation are often large-scale, have long lead times and need to be undertaken in the presence of a high degree of uncertainty about future climate-driven supply

• a fully competitive urban water market (with ‘in-the-market’ competition for both customers and bulk water) does not currently exist anywhere in the world.

Later chapters consider these issues further.

Health externalities

In the days before network systems for the collection, transport and disposal of sewage became the norm, significant health (and amenity) problems arose from household’s attempts at local disposal. Only brief reflection on this situation is necessary to gain the insight that households benefit not only from an effective service that removes their own wastewater, they benefit from their neighbours having this service as well. This is also true for the provision of water, because washing in clean water helps reduce the spread of disease in the community.

Economist’s describe this phenomena as an ‘externality’. An externality occurs where an activity or transaction imposes benefits or costs on others who are not direct parties to the transaction. Water and wastewater services produce positive externalities, or more precisely, they prevent the occurrence of negative externalities.

If the provision of water and wastewater services were left entirely to markets it might be expected that the vast majority of households and firms would choose to purchase these services. Due to financial hardship or other cause, however, a small proportion might not. Even if other households were prepared to meet the costs associated with providing the service to this group, it may not be possible for them to arrange for, or compel, this consumption. Accordingly, there is an efficiency rationale for governments to take action to prevent the negative externality effects on the remainder of the population. (Governments may, of course, also decide to take action out of concern for the particular households involved.)

There are various types of action governments can take. These range from legal prohibitions on unauthorised disposal of wastewater to positive actions to ensure that universal and affordable access to water and wastewater services is provided. As with all instances of government intervention in response to a market failure, there is a need to examine the costs and benefits of the intervention to ensure that it will actually improve overall outcomes.

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Environmental externalities

There are also environmental externalities associated with water and wastewater services. As discussed in chapter 3, some of the environmental impacts associated with the urban water sector are best addressed outside the sector and others inside the sector. Of the latter, the most important relates to wastewater disposal.

A commercial provider of wastewater services would normally try to meet the needs of its customers at minimum cost. Customer needs relate mainly to the removal of wastewater and do not necessarily extend to ensuring that it is treated and disposed of in an environmentally sensitive way. There may be a tendency, therefore, for the provider to save on treatment costs and thereby fail to protect the environment to the extent that reflects community preferences. The negative externality here is the loss experienced by recreational users and others that care about degradation of the affected environment.1 Where disposal is to a river, downstream water users may also be affected.

Because of this externality, market outcomes may be inefficient and there is a possibility that government action may be able to produce net benefits to the community. That is, a government may be able to impose regulations that impose costs (for example, for greater levels of treatment) that are less than the benefits (for example, the value that the community places on the resulting environmental improvement). Alternatively, price incentives (taxes and subsidies) can be used to reduce the incidence of negative externalities.

Environmental and other public goods

As discussed in chapter 3, the urban water sector can enhance amenity and environmental services within urban landscapes through the management of water. Commonly, the beneficiaries of this are the large proportion of the population who enjoy green parks, gardens and other public spaces. The sector is, therefore, often providing these services to the broader community rather than to individual water users who can express their demand for water in a market. Such services are sometimes called ‘public goods’ meaning that their provision for one person means that they are available to all people at no additional cost. The enhanced amenity of lush, green parks is a public good, because the cost of providing them is the same regardless of whether one or a thousand people gain enjoyment from them, and because it is usually deemed impractical or undesirable to exclude anyone from using them.

1 Another way of characterising these issues is that there is an absence of property rights for, and a market in, environmental services.

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Stormwater services are also largely a public good. People living in low-lying areas may benefit the most from the reduction in floods resulting from these services, but everyone benefits to some extent from having well drained roads and public spaces.

Public goods tend to be underprovided by private markets because non-excludability and indivisibility make it difficult to get people to pay for them. This market failure can be addressed by governments making judgments about the community’s demand for public goods and providing them where warranted. In the case of environmental services and amenity from water in the urban landscape, it is managers of the public land in question who are generally best placed to do this.

Information failures concerning water use efficiency

Economic efficiency requires the efficient use of all resources, including water. Provided that water users face efficient prices they can, in general, be expected to use water efficiently. Sometimes, however, this will not occur because people lack information about efficient water use.

For example, someone might water their garden in the heat of the day because they are not aware that this will be less effective than watering in the early morning. This contrasts with someone who knows about evaporation but chooses to water mid-afternoon because this is the most convenient time for them, given other commitments. The former is economically inefficient water use, while the latter is efficient. A consumer, behaving efficiently, will not necessarily seek to minimise their water use.

Where information problems result in economically inefficient water use there may be a role for governments in supplying information or verifying market-supplied information. For example, by publishing water savings tips or ensuring that water using appliances carry information about water use at the point of sale. There are costs associated with such programs and this needs to be considered in deciding whether government action is warranted.

4.2 Government involvement

As discussed above, governments can respond to market failures in a variety of ways, including by:

• providing the service directly

• regulating market activity

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• using price incentives

• providing information

• deciding to take no action (for example, on the basis that there are no available options that can produce an excess of benefits over costs).

Best practice policy making demands that all of the available options are properly assessed to determine which is expected to produce the best overall outcome for the community. It is important in doing this to appreciate that government actions to address market failures can have unintended consequences and introduce new sources of inefficiency. Just as markets can fail to achieve efficiency in predictable ways, so too can governments. As Weimar and Vining (1992, p. 112) argue ‘[p]ublic policy … should be informed not only by an understanding of market failure but of government failure as well’.

While the theory of ‘government failure’ is not as developed as the theory of market failure, it does provide some useful insights into inefficiencies that might arise from governments providing, or otherwise being involved in, urban water services.

Rent seeking

Where governments face different options for how to provide or regulate a service it is common that the vast majority of the community will be only slightly affected by the decision taken, while a small minority stand to gain or lose significantly. Making an efficient decision requires that both diffuse and concentrated interests are taken into account, but the political process can err by giving undue weight to the latter.

The reason for this is that those strongly affected by a decision are most likely to be motivated to lobby for their preferred outcome, a practice known as rent seeking. For example, while the vast majority of water users might benefit slightly from some urban water being purchased from irrigators, it may be that the strongest lobbying would come from a relatively small number of businesses in irrigation areas that would face significant costs.

Limited time horizons

Decisions about the supply of urban water services often have long-term consequences because of the generally long-lived nature of assets in the sector. Accordingly, a consistent approach to factoring in costs and benefits over many years is a prerequisite for efficient decision making. The political process may work

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against such an approach being taken because the electoral cycle can result in an undue emphasis being placed on short-term costs and benefits.

Public agendas

Achieving efficiency in the urban water sector is complex and involves collating and analysing vast amounts of information. Because of this, it is unlikely that most voters will devote the time and resources needed to be fully informed on either the recent performance of government service provision or on the urban water policies each party takes to an election. In this environment the media can play a useful role in summarising issues and airing informed opinions.

There is the potential, however, for public agendas to be run through the media that promote approaches that are not in the overall interests of the community. Good policy proposals do not always come out ahead in media debates and this can create incentives for political parties to adopt popular but inefficient policies.

An additional issue is that the public interest is served by ministers being prepared to abandon past positions when new information indicates a change is warranted. The potential for a change in position to be portrayed in the media as a sign of error or weakness may make ministers more reluctant to do this.

Weak incentives for efficiency and innovation in government agencies

Government agencies that deliver services such as water have weaker incentives to minimise costs and seek out new and better ways of doing things compared to their private sector counterparts, for two main reasons. First, private firms that do not minimise costs may be driven out of business by more efficient rivals or disciplined by the capital market in a range of ways. Government agencies, including ones that are corporatised, do not face market tests for survival. Second, the profit motive is a powerful driver of efficiency and innovation for private firms, but does not operate for government agencies.

Government departments and regulators may also have relatively weak incentives to undertake their functions efficiently. Further, relevant data on the efficiency of these agencies is likely to be much less tractable than that which is available for water utilities.

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Addressing these problems

Australian governments have, across a variety of policy areas, recognised these problems and undertaken some reforms to try to overcome them. One important step is to clearly separate the policy, regulatory and service delivery functions. The policy function should reside with elected representatives to allow voters to hold them accountable for policy decisions and their implementation. In other words, when consumers are unable to express their preferences through markets, it is for elected representatives, not regulators or bureaucrats, to determine the community’s preferences.

One reform that has merit is to allocate service provision and regulatory functions to government-owned entities that are subject to governance arrangements designed to ensure:

• clear objectives (both commercial and non-commercial)

• managerial autonomy, with ad hoc government directions either eliminated or allowed only through transparent processes

• performance monitoring and other means are used to achieve transparency and accountability.

This type of reform can at least partially overcome many of the problems discussed above, provided they operate as intended. There are, however, likely to be residual inefficiencies, mainly because:

• there may continue to be some perceived or actual government pressure on the entities to make politically expedient decisions

• incentives for efficiency and innovation will continue to be weaker than for private firms operating in a competitive environment

• performance monitoring imposes costs and is an imperfect means of achieving the accountability of non-elected officials.

There is also merit in reviewing the tasks assigned to regulators to ensure that they are appropriate. For example, price regulation may be warranted where there is a serious risk of abuse of market power, but is not generally appropriate as a means of ensuring that urban water providers fully recover costs (chapter 5).

4.3 Conclusions

There is a range of market failures that have the potential to cause significant inefficiencies in the urban water sector. There are various ways that governments

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can respond to these failures, but these remedies can also introduce new sources of inefficiency. Reform proposals for the sector, therefore, need to take into account both possible market failures and government failures.

Given the prevalence of market failures it is clear that governments should continue to play a substantial role in the urban water sector. In particular, there is a role for elected representatives to set objectives, develop policy frameworks, define property rights for water, and put institutional and governance arrangements in place.

DRAFT FINDING 4.1 It is the role of governments (elected representatives) to:

• set objectives for policy development for urban water and relevant objectives for each agency

• develop policy frameworks and principles in relation to public health, the environment and service delivery that are consistent with these objectives

• define property rights for water

The principles-based discussion in this chapter can not fully resolve the question of what role governments should play in the urban water sector, particularly in the area of service delivery. It is necessary to also examine the evidence on the quantum and sources of inefficiencies within the sector at present. This is done in chapters 5 to 9. Later chapters return to the role of government and consider reform options designed to overcome market failures and government failures to the maximum extent possible. This will include consideration of options that assign an increased role for markets within a framework established by governments.

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5 Improving regulation of the urban water sector

Key points

• Regulation has an important role in setting boundaries for the urban water sector, and particularly in ensuring public health and protection of the environment.

• However, there are costs associated with regulation, particularly when multiple regulators with differing objectives or regulators with conflicting objectives are involved. Following good regulatory practice can minimise these costs.

• The major costs associated with regulation can be broadly categorised as compliance costs (including costs incurred by government in administering and enforcing regulation); costs associated with price distortions resulting in production or consumption losses; lobbying or ‘gaming’ costs; and costs associated with deterred or delayed investment.

• The six principles of good regulatory practice spelt out in 2006 by the Regulatory Taskforce represent a sound basis for regulation of the urban water sector.

• The use of regulatory impact statements, incorporating cost–benefit analysis, when assessing regulatory proposals should be seen as an essential part of good regulatory practice.

• The Commission does not consider price regulation as being an appropriate mechanism to deal with distributional concerns relating to the use of urban water, or to ensure that urban water providers fully recover costs.

As was highlighted in chapter 4, there are a number of market failures, particularly externalities, associated with the urban water sector that provide a basis for government involvement in the sector. In many cases, this involvement takes the form of regulation.

Regulation of the sector might provide significant public benefits. The urban water sector’s activities could potentially have major impacts on, for example, public health and the environment. Regulation has an important role in setting boundaries for the sector, and ensuring public health and the environment are protected.

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The Water Services Association of Australia saw many positives regarding regulation of the urban water sector, particularly in the area of health: Australia has been at the forefront of developing risk-based drinking water guidelines that have prevented the outbreak of major health incidents, without imposing an excessive compliance burden on the urban water sector. This approach represents a model that could be adopted by other regulators. Decisions are typically based on evidence and lead to national guidelines – rather than standards – developed with a national perspective. Importantly, such decisions are made following extensive consultation through the National Health and Medical Research Council’s Water Quality Advisory Committee. (sub. 29, p. 25)

However, there are costs associated with regulation, particularly when multiple regulators are involved with differing objectives. These costs can be minimised, however, by following good regulatory practice. That is the focus of this chapter. Some of the specific issues highlighted are discussed in more detail elsewhere in the report.

A number of participants have highlighted issues relating to regulation of the urban water sector. For example, Nubian Water Systems expressed concern about regulatory inconsistencies across jurisdictions: Regulation is possibly the greatest impediment to distributed systems making a contribution to achieving the objectives. There are multiple layers of regulation in each state with little uniformity, in policy and guidelines, among the states. In some cases state guidelines are opposed and with inexplicable rationale. (sub. 11, p. 3)

ACTEW Corporation pointed to the various factors regulators were expected to consider, and the uncertainty this created: The current framework for water regulation in the ACT provides a broad range of factors to be balanced by the regulator. This is a very difficult assignment that effectively results in considerable discretion to the regulator and significant levels of regulatory risk for the utility. (sub. 45, p. 4)

The Local Government Association of Queensland saw a greater role for outcome based regulation: The Queensland water industry has long requested a shift of focus from regulation of management plans to more outcomes-based regulation … A preferred model would be … [that] the regulator would monitor specific outcomes from implementing plans through exceedence-reporting of specific indicators, routine audits and targeted annual reporting. Penalties would be associated with wilful failure to meet mandatory requirements. (sub. 20, p. 25)

The Local Government and Shires Associations of NSW highlighted regulatory inconsistencies, suggesting there were inconsistencies between the initiatives of

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Integrated Water Cycle Management (IWCM) and the Building Sustainability Index (BASIX): …e.g. potential for BASIX targets … to override more stringent locally appropriate water conservation and demand management targets as identified by local water utilities in their Integrated Water Cycle Management plans; potential for BASIX to limit the options developed in IWCM plans (e.g. raintanks are being encouraged in areas where they may prove to be a less efficient option than other initiatives…) (sub. 63, p. 9)

The Water Services Association of Australia highlighted particular concerns about environmental regulation: Environmental regulation is problematic in most jurisdictions with water businesses frequently encountering:

• little regard to impact on water sector in environmental standards and regulations

• limited evidence of scientific basis for decisions

• failure to effectively consult with the water sector

• failure to quantify the community’s willingness to pay for certain environmental outcomes

• excessive focus on outcomes and prescriptions (rather than outputs)

• duplication and inconsistency between Commonwealth and State regulations

• some examples of seemingly contradictory regulations, such as requirements to increase water treatment that then contributes to increased carbon emissions

• focus on point source discharges when the optimal approach might be to deal with diffuse sources. (sub. 29, p. 23)

5.1 What are the costs of regulation?

The major costs associated with regulation can be broadly categorised as compliance costs (including costs incurred by government in administering and enforcing regulation); costs associated with price distortions resulting in production or consumption losses; lobbying or ‘gaming’ costs; and costs associated with deterred or delayed investment (PC 2009b).

Compliance costs

There are potentially significant costs associated with complying and administering regulation. The compliance costs faced by businesses involved in the urban water sector include:

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• management and staff time (including the potential need to hire additional staff, and costs associated with management being diverted from core business)

• hiring of external expertise (such as engineers or lawyers)

• purchase and maintenance of specially modified IT systems or other equipment required to ensure compliance

• training costs

• payments to regulators, where applicable.

Although these costs fall initially on businesses, many are likely to be passed on to consumers through higher prices especially in relatively uncompetitive industries. The burden of compliance costs in the urban water sector therefore falls mainly on consumers. There are also significant costs to government associated with design and enforcement of regulation.

Relatively high compliance costs associated with regulation can also act as a deterrent for (particularly small) private sector companies to enter the urban water industry.

Costs associated with production and consumption losses

If regulation leads to price distortions, production and consumption will deviate from the levels that would have prevailed in the absence of regulation. Where regulation increases prices charged for the urban water sector’s products, there will typically be fewer products produced or sold, leading to efficiency losses. There can also be flow-on effects to investment, which could fall given the reduced demand for urban water products.

Lobbying costs

A potential cost of regulation — particularly where regulatory outcomes are uncertain — is the diversion of resources into lobbying, both by businesses involved directly in the urban water sector and by other interested parties. The more discretion regulators (including elected representatives) have over outcomes, typically the greater the potential for resources to be diverted into seeking to influence regulatory outcomes.

The dividing line between compliance costs and lobbying costs can be quite ‘blurry’ in some cases. For example, water utilities typically have to provide economic regulators with detailed plans about their future activities (including investment).

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However, as would be expected, these plans are generally couched in terms seeking to persuade regulators to make decisions favourable to the providers.

Costs associated with ‘lost’ or delayed investment

Compliance costs and regulatory uncertainty have the effect of reducing the returns and riskiness associated with investments, thereby lowering their attractiveness. Regulatory delays also potentially reduce investment, and can lead to sub-optimal investment strategies. For example, if there is a need for supply augmentation and the most attractive investment (from a cost–benefit viewpoint) is delayed by the regulatory process, the delay might lead to a less efficient investment taking place because it can be delivered in the truncated timeframe. This leads to an inefficient outcome, relative to the preferred investment, that can be considered a cost associated with regulatory delay.

Kerry McIlwraith, the chief financial officer of ACTEW, highlighted the impact of regulatory uncertainty on supply augmentation decisions: So in a real options analysis once you introduce uncertainty what became apparent was that the dam would be chosen almost on every occasion because you had more possibility of [it proceeding] but the others just have been very difficult to get into place [due to the challenges associated with] getting interstate agreements, the environmental issues associated with each one and different environmental regulators. The Murrumbidgee–Googong pipeline had to go through New South Wales, the ACT and the Feds to get decisions and they had different views. We’ve managed to get two down and the third one we have an approval of sorts to proceed. But it’s the uncertainty of progressing those that makes it difficult. We’re still negotiating after some considerable period with Snowy Hydro about releasing the water in an amount that works for us as well. But to get that project to work we also need the pipeline so that we can pump the water, otherwise we wouldn’t be able to pump enough to make it a worthwhile proposition. (trans., pp. 83–84)1

5.2 Sources of unnecessary regulatory costs

While there are almost inevitably costs associated with regulation (even where it might provide net benefits), poor regulatory practice can unnecessarily increase these costs. These can generally be placed into three broad categories: (1) problems with regulations themselves, (2) poor enforcement and administration, and (3) unnecessary duplication and inconsistency (PC 2009b).

1 Construction of the Murrumbidgee to Googong pipeline has now received final approval with the NSW Government issuing its licence for construction in early March 2011 (Downie 2011).

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Problems with regulations themselves

There are a number of ways in which problems with regulations themselves can unnecessarily increase the costs associated with them:

Unclear objectives: where objectives are unclear, uncertainty is created for both regulators and those being regulated. It also increases the potential for regulators to use their own discretion in determining the intent of legislators, meaning regulators might be making decisions in areas never envisaged by legislators. It also means different regulators might interpret the same piece of legislation differently. (Regulators, and particularly economic regulators, often undertake public consultation before making regulatory determinations, and sometimes utilise surveys to assist in determining public preferences. The importance of public consultation is discussed in chapter 11.)

Conflicting objectives: urban water providers are likely to be subject to legislation with conflicting objectives. For example, water providers often have both commercial objectives (encouraging them to sell more water) and water conservation objectives (encouraging them to sell less). South East Water has also highlighted conflicts between the need for emergency repairs, and requirements for environmental approvals (SEW 2008).

Excessively prescriptive regulation: prescriptive regulation is less flexible than outcome-based regulation, can stifle innovation, and will often mean the objectives of regulation are not delivered at least cost. Prescriptive regulation is often unnecessarily onerous. For example, the Commission’s 2006 report on road and rail freight infrastructure pricing found there would be benefits in moving from prescriptive to performance-based regulation of road freight transport (PC 2006c). That said, there are circumstances where prescriptive regulation is unavoidable, or where prescription will have benefits by providing businesses with information about precisely what they need to do to comply. Therefore, the optimal degree of prescription is a matter for ‘case-by-case’ assessment.

Unnecessarily complex regulation: more complex laws require greater interpretation and are therefore likely to be costlier to comply with (and, for regulators, costlier to administer). For example, the 2009 Hawke Review of the Environment Protection and Biodiversity Act 1999 (Cwlth) (Hawke Review) found the Act to be ‘too repetitive, lengthy, unnecessarily complex and, in some areas, overly prescriptive’, adding that making the Act easier to use would ‘reduce the regulatory and resource burden on those impacted by the Act’ (Australian Government 2009b, p. 49).

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Redundant regulation: regulation often remains in force long after changed circumstances have rendered it unnecessary. Although such regulation provides no benefits, it is likely to have costs associated with compliance and, if it overlaps with more recent regulation, can cause regulatory confusion. In 2009, the Australian Parliament passed the Statute Stocktake (Regulatory and Other Laws) Act 2009 (Cwlth), repealing various laws seen as redundant including obligations on digital data providers that had been overtaken by technology, and laws designed to protect consumers during the transition to the goods and services tax introduced in 2000 (Tanner 2009).

Poor enforcement and administration

There are a number of potential reasons for poor enforcement and administration of regulation:

Excessive reporting requirements: compliance costs are unnecessarily increased if reporting or recording requirements are beyond the minimum required to enforce a regulation or to obtain necessary information. The Local Government Association of Queensland highlighted concerns about significant duplication in the collection of water sector data. For example, the Association stated that the Bureau of Meteorology and the Australian Bureau of Statistics currently collect the same information separately because they are unable to coordinate their databases (sub. 20).

Inadequate expertise or resourcing of regulators: if regulators lack resourcing, or expertise, time taken for regulatory decisions is likely to be unnecessarily long. It can also prompt regulators to seek additional information beyond that that should be necessary to reach a regulatory decision. Regulators might also become reliant on outside parties (such as consultants), which can lead to further delays. The Commission’s 2009 report on regulation of the upstream petroleum sector found inadequate resourcing of regulators to be an issue, especially at times when there were a large number of approval applications (PC 2009b).

Regulatory creep: while under-resourcing of regulators can be a problem, over-resourcing of regulators can also be problematic if it results in excessively zealous regulation, regulators moving into areas never intended by legislators or micro-management of regulated businesses.

Regulatory bias or capture: regulators are sometimes captured by particular interests and therefore make decisions favourable to those interests. Such interests can include the businesses being regulated, consumers or lobby groups. For example, if price regulators displayed bias towards consumers they might set prices

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at sub-optimal levels and discourage investment (which might not be in consumers’ long-term interests). Regulators might also be captured by governments or by populism.

Regulatory error: poor enforcement of regulation can stem from mistakes by regulators. Mistakes can have a number of sources, including errors in interpretation of regulations, calculation errors, failure to adequately consult key stakeholders or regulatory misjudgements.

Constraints of earlier decisions: regulators can feel constrained by previous regulatory decisions (either of their own or by other regulators) even where these decisions might have been shown to be wrong or not particularly relevant to the matter at hand (for example, precedents from unrelated industries). This can compound any initial regulatory errors.

Asymmetric information: regulators typically do not have as much information about an industry as participants in that industry. This will often result in regulators asking those regulated to provide a significant level of information, and can ultimately lead to regulatory error. Sometimes, where asymmetric information is seen as an intractable problem, it is prudent to change the way industries are regulated. The adoption of ‘safety case’ regulation for the offshore oil and gas industry is such an example (PC 2009b).

Second guessing of consumer preferences: regulators can base decisions on ‘second guessing’ of consumer preferences which might be wrong. Regulators might also demand higher quality standards than actually demanded by consumers. Decisions regarding tradeoffs between price and quality are often likely to be better made by enterprises responding to consumer demands.

Risk aversion: regulators might be unnecessarily risk averse, especially following a previous adverse event. They might also place undue emphasis on events that are extremely unlikely. Risk aversion can also lead to slow decision making.

Inadequate accountability: where there are limited avenues of appeal (or especially if there are none) against regulatory decisions, the accountability of regulators is diminished and the scope for regulatory error is increased.

Institutional self-interest: once regulation is introduced into an area, there is a risk the relevant regulator will seek to maintain the regulation even when it might be unnecessary, or might seek the status quo where regulatory reform would produce benefits. This is a reason why reviews of existing regulation should generally be done by an entity other than the relevant regulator.

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Unnecessary duplication and inconsistency

Regulatory duplication and inconsistency between jurisdictions should not be viewed as inherently ‘bad’. It might legitimately stem from different circumstances between jurisdictions and, from a competitive federalism perspective, can lead to better overall outcomes. However, there are costs imposed from duplication and inconsistency:

Duplication of regulation: can unnecessarily increase compliance costs if information has to be provided to multiple regulators, or if there are multiple regulatory processes. For example, in a 2008 submission to the Hawke review, South East Water suggested duplication of approval processes between the Environment Protection and Biodiversity Act and the Water Industry Act 1994 (Vic) increased the costs associated with capital improvements (SEW 2008). The existence of multiple regulators also creates opportunities for ‘forum shopping’ where participants might seek the forum in which they believe they are likely to get the most favourable outcome.

Inconsistency of regulation: can occur both within and across jurisdictions. It is likely to present particular problems for businesses operating in multiple jurisdictions (and in the urban water sector these might typically be small, relatively innovative businesses). Regulatory inconsistency can often follow an adverse event.

Variation in definitions and reporting requirements: can occur between regulators within a jurisdiction, but is more likely to be a problem for businesses operating in multiple jurisdictions (PC 2004b, PC 2005c, PC 2009b, Regulation Taskforce 2006).

5.3 Promoting good regulatory practice

‘Best practice’ regulation is about ensuring that regulation imposes the smallest burden necessary to achieve its underlying policy objectives (thereby seeking to maximise its net benefit to the community).

In 2006, the Regulation Taskforce spelt out six principles of good regulatory practice (box 5.1). It also stated that it believed, had these principles been applied more consistently, ‘less regulation would have been made or retained, and the implementation of the regulation that was made would have provided much less cause for complaint’ (Regulation Taskforce 2006, p. 147). The Taskforce’s principles have subsequently been endorsed by the Australian Government (Australian Government 2006).

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Box 5.1 Principles of good regulatory practice In its 2006 report Rethinking Regulation, the Regulation Taskforce devised six principles of good regulatory practice:

• Governments should not act to address ‘problems’ until a case for action has been clearly established: – This should include establishing the nature of the problem and why actions additional to existing measures are needed, recognising that not all ‘problems’ will justify (additional) government action.

• Only the option that generates the greatest net benefit for the community, taking into account all the impacts, should be adopted.

• Mechanisms are needed to ensure that regulation remains relevant and effective over time.

• There needs to be effective consultation with regulated parties at all stages of the regulatory cycle.

Source: Regulation Taskforce (2006).

There is scope for improving regulation in the areas of design, administration and enforcement.

Regulatory design

Areas where good regulatory design can assist in maximising net benefits include:

• ensuring regulatory objectives are clearly stated

• minimising complexity

• favouring outcomes-based regulation over prescriptive regulation (with some exceptions where prescriptive regulation might provide greater certainty)

• minimising unnecessary inconsistencies across jurisdictions and levels of government (allowing for genuinely different circumstances across jurisdictions and the benefits of ‘competitive federalism’)

• periodic review of regulation

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• use of regulatory impact statements (incorporating cost–benefit analysis for regulatory options considered)

• inclusion of sunset clauses (PC 2007b).

Administration of regulation

Areas where the administration of regulation can help ensure regulatory best practice include:

• ensuring reporting requirements are the minimum necessary to administer the regulation

• increasing coordination between agencies

• providing information and support to those being regulated in order to reduce compliance costs

• placing time limits on approval processes

• ensuring adequate appeals processes

• maintenance of separation between regulatory design and subsequent administration (PC 2007b).

Enforcement of regulation

Regulatory enforcement refers to those measures taken by government to ensure regulation is adhered to. Excessive enforcement of regulation is likely to unnecessarily increase the costs associated with regulation, while too little enforcement will reduce its credibility.

Measures that could assist in ensuring regulatory enforcement was consistent with good practice include:

• ensuring there is explicit provision for the enforcement of the regulation

• minimising the number of agencies involved in enforcement, and ensuring adequate coordination where the involvement of multiple agencies is necessary

• use of risk-based enforcement strategies

• publishing of enforcement strategies and outcomes (PC 2007b).

There is further discussion of how to improve regulatory outcomes (and particularly how to ensure independence of regulators) in chapter 11.

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DRAFT RECOMMENDATION 5.1 Urban water sector regulators should rigorously apply the six principles of good regulatory practice spelt out by the Regulation Taskforce in 2006.

5.4 Weighing up the costs and benefits of regulatory proposals is important

Many of the Commission’s concerns about regulation of the urban water sector stem from the presence of regulations that, while providing benefits, might not have net benefits. That is, sometimes the costs associated with a regulation mean that, in net terms, it reduces community welfare.

Jim Cox, the Chief Executive Officer of IPART, highlighted the need to ensure benefits exceeded costs when, for example, raising government-imposed regulatory standards: I think an important cost driver has been government-imposed standards; obviously minimum standards are important to protect public health and the environment and to provide consumer protection. So these standards are important. Nevertheless, I think we have seen in recent years an increase in standards and hence an increase in prices and that is running up against the willingness of the community to pay. This is not to say that improved standards are a bad thing - I think they’re a good thing - but I think we do need to pay greater attention to ensuring that, where standards are increased, we are persuaded that the costs of doing so are less than the benefits. I think there’s something there about a more consistent use of cost–benefit analysis of increase in standards. I think that is a message that applies to IPART as well as some other regulators, as we are ourselves a setter of standards and I’m not sure our practice has been ideal either. (trans., p. 25)

In highlighting the need for continued stringent health regulation, the Chief Executive Officer of Water Quality Research Australia, Jodieann Dawe, also noted the need to properly account for the associated costs: It must be recognised, however, that there is a cost in meeting legislative requirements, resourcing, monitoring and reporting costs. These are often intrinsic, often hidden costs at the moment, that are needed to develop, maintain and audit compliance. These costs should be duly acknowledged as a necessary cost of business. (trans., p. 275)

It is important to subject proposed regulations to cost–benefit analysis (CBA). A CBA of a regulatory proposal involves systematically evaluating all of its impacts on the community and the economy, and not just the immediate or direct effects, financial effects or effects on one group. It should, to the maximum extent possible, value the gains and losses from a regulatory proposal in present day monetary

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terms, thereby enabling assessment of whether the benefits of the proposal exceed the costs. Such analyses should be made available to the public and it is highly preferable that the public be able to comment upon them prior to final decision making.

The Australian Government’s Office of Best Practice Regulation has described CBA as useful because it:

• provides decision makers with quantitative and qualitative information about the likely effects of a regulatory proposal

• encourages decision makers to take account of all the positive and negative effects of a regulatory proposal, and discourages them from making decisions based only on the impacts on a single group within the community

• assesses the impact of regulatory proposals in a standard manner, which promotes comparability, assists in the assessment of relative priorities and encourages consistent decision making

• captures the various linkages between the regulatory proposal and other sectors of the economy (for example, increased safety might reduce health care costs), helping decision makers maximise net benefits to society

• helps identify cost-effective solutions to problems by identifying and measuring all costs (Australian Government 2010a).

Further, the Australian Government has made regulatory impact statements (RISs) mandatory for all significant decisions made by the Government or its agencies that are likely to have a regulatory impact on business or the not-for-profit sector, including amendments to existing regulation and the rolling over of sunsetting regulation. A RIS is designed to formalise and provide evidence about the key steps taken during the development of a regulatory proposal. It incorporates CBA, although does not necessarily involve direct comparisons of options.

The Commission considers RISs, incorporating the use of CBA, to be an essential part of good regulatory practice.

Environmental regulation

One area of regulation where not all costs and benefits are always accounted for is environmental regulation. Although it is obviously important that environmental regulation places a high priority on protecting the environment, to ensure the benefits of such regulation are maximised it is important to take an ‘ecologically sustainable development’ (ESD) approach to regulating.

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The ESD approach requires striking a balance between environmental, social and economic factors when making regulatory decisions regarding the environment. As consideration of all these factors is important in ensuring environmental regulation produces net benefits, the Commission considers it is important to always take an ESD approach to regulating the environment.

As highlighted by the Hawke Review, there is also a need for transparency about how the balance has been struck between the conflicting factors: An inherent tension arises from weighing the competing principles of ESD. Decision-making outcomes will often differ depending on the proportionate weighting afforded to environmental, social or economic considerations in each case. As much of the decision-making under the Act involves weighting of these considerations and value judgements, a high degree of transparency is needed if the public and proponents are to have trust in the system. (Australian Government 2009b, p. 53)

The Commission shares this view that there are benefits in providing the public with information about how decisions have been reached in an ESD context. Ideally such information should be made available for public comment prior to final decision making.

5.5 When should regulation not be used?

Regulation is often used to solve problems that would likely be better dealt with in other ways. Moreover, regulators are increasingly being asked to make decisions regarding the ‘public interest’ that are properly the preserve of ministers. Ministers and local councillors ultimately have a mandate from voters to act in the ‘public interest’ while regulators have no such mandate.

There are two particular areas where the Commission considers the benefits of the involvement of regulators have been significantly overstated. One relates to ensuring affordability of water services. Regulators increasingly appear to be involved in decisions about whether the pricing regimes for water should have redistributive elements to them. The Commission considers decisions regarding distributional aspects of pricing structures are most appropriately decisions for government or, if government does not see a reason to be involved, best left to water providers (who are likely to have a better understanding of their customers than regulators).

Further, if distributional considerations are left to regulators, there are a relatively limited number of options available to them. As has been be discussed in chapter 3 (and will be dealt with more fully in chapter 9), distributional considerations are likely to be best dealt with through the taxation or social welfare systems or, if

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concessional pricing is to be used, through the provision of community service obligation payments to providers by government. Regulators are not able to utilise these policy options.

The other area where the Commission considers the role of regulators to be problematic relates to full cost recovery and the implementation of the National Water Initiative pricing principles. Although the Commission considers moves toward full cost recovery are necessary, it does not consider that the goal of full cost recovery represents a justification for maintaining or extending economic regulation, and in particular regulatory price setting in the urban water sector.

It is often argued that the major benefit of having independent regulation of water authorities is that governments are no longer directly involved in pricing decisions. This is primarily because, in the past, governments have let political considerations influence pricing decisions for water, often leading to under-recovery of costs and subsequent underinvestment in infrastructure.

However, the role of price regulation has traditionally been to deal with concern about excessive pricing by infrastructure providers with market power. The Commission does not consider it appropriate for regulation to be used to ensure full cost recovery. Given the costs associated with price regulation, it also represents a very expensive way of ensuring water providers move towards more efficient pricing. If governments have committed themselves to pricing involving full cost recovery, where they own monopoly water providers they can simply instruct them to price in a manner that generates adequate revenues but not in such a way that would result in ‘excessive’ profits. Similar outcomes could be achieved for council-owned utilities via existing local government laws in most states. What is required is monitoring against a well defined policy objective, not price setting by a regulator, and this could easily be undertaken by a policy agency, as is currently the case in New South Wales, with jurisdictional governments applying appropriate sanctions to directors and councillors for non-compliance.

For these reasons (and others), the Commission considers it is time to rethink the need for price regulation in the urban water sector. There is further discussion of this in chapter 11.

DRAFT FINDING 5.1 Price regulation is not an appropriate mechanism to deal with affordability concerns or to ensure that urban water utilities fully recover costs.

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6 Supply of water, wastewater and stormwater services

Key points

• Costs to the community of inefficient supply augmentation in recent years in Melbourne and Perth could be of the order of $3.1 to $4.2 billion over a 20 year period, based on modelling by the Commission. There is also evidence that augmentation in Sydney and Adelaide in recent years has imposed substantial unnecessary costs.

• The scope for efficiency gains through making better supply augmentation decisions over the next 10 years will be less than in recent years for the simple reason that some cities now have surplus capacity and so are unlikely to make major augmentation investments. – Even so, the scope for efficiency gains is still large and will increase over time. – The main impediments to these gains being realised are implicit or explicit policy bans on particular options, unclear roles and responsibilities for making augmentation decisions and targets/subsidies for water recycling and reuse.

• System operations and asset management in the urban water sector have become considerably more efficient over the last decade or two, in part due to the contracting out of operational tasks and capital projects.

• Incentives for increased efficiency and innovation are weak relative to other utility sectors, due to low competitive pressures. There is scope for efficiency gains from introducing greater competition but these are inherently difficult to estimate.

• Some current approaches to integrated water cycle management are inefficient because they assume that greater recycling and reuse is in the community’s interests, without examining costs and benefits. – A better approach would be to seek to remove impediments to integration (such as lack of appropriate property rights for wastewater and stormwater), thereby allowing efficient recycling and reuse projects to be implemented.

• Factors such as low population densities and low and/or highly variable water availability make the task of delivering water and wastewater services to many regional areas inherently difficult and costly. Nonetheless, substantial efficiency gains could be achieved through some form of amalgamation or alliance between small regional water utilities. There may also be a case for disaggregating utilities that service very large geographic areas.

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This chapter examines the scope for efficiency gains in the supply of water, wastewater and stormwater services, and the impediments that are preventing these gains from being realised. Where there are impediments that can be removed through changes in government policies, recommendations for this are made. Impediments that relate to institutional, governance, regulatory and structural arrangements are identified, but recommendations on these are left to chapters 11 to 13 of this report, which present integrated reform options.

Scope for efficiency gains are considered in relation to:

• making better supply augmentation decisions (section 6.1)

• improving system operations and asset management — covering general issues across the water, wastewater and stormwater sub-sectors (section 6.2)

• opportunities in the supply of wastewater and stormwater services — covering issues that are specific to wastewater and stormwater services (section 6.3)

• achieving integrated water cycle management — covering coordination between the water, wastewater and stormwater sub-sectors (section 6.4)

• scope for efficiency gains in regional urban areas — covering specific issues for regional areas (section 6.5).

6.1 Making better supply augmentation decisions

Making the best possible supply augmentation decisions is important for the overall efficiency of the urban water sector because the costs involved are substantial and there is often a wide range of feasible choices that may produce very different outcomes. This section examines the scope for efficiency gains in three important aspects of supply augmentation decision making.

Considering supply augmentation and demand management options together

Achieving water security at least expected cost requires that supply augmentation and demand management be considered together. As stated by Crase and O’Keefe ‘… uncoupling demand and supply choices can result in serious violations to economic efficiency’ (sub. 5, attachment, p. 1). This is because supply augmentations and demand management activities are both means for increasing the quantity of water that is available to meet future requirements.

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Until recent decades, the approach taken to supply augmentation planning in Australia largely ignored the benefits of considering supply and demand options together. In general, supply augmentations were decided on to meet a fixed demand projection, which was in turn based on population growth estimates and trends in household, commercial and industrial consumption. The main demand management option used was water restrictions, which played a ‘backstop’ role during droughts.

More recently, jurisdictions have agreed to adopt the National Urban Water Planning Principles (box 6.1). One of these principles is to ‘[c]onsider the full portfolio of water supply and demand options’, which is explained as meaning: Selection of options for the portfolio should be made through a robust and transparent comparison of all demand and supply options, examining the social, environmental and economic costs and benefits and taking into account the specific water system characteristics. The aim is to optimise the economic, social and environmental outcomes and reduce system reliability risks, recognising that in most cases there is no one option that will provide a total solution. Readiness options should also be identified as part of contingency planning. (DSEWPC 2009)

While this principle is sound, it is necessary to examine whether it is reflected in current practice.

Box 6.1 National Urban Water Planning Principles As part of the national urban water reform framework developed by COAG in 2009, jurisdictions agreed to adopt the national urban water planning principles. These principles are as follows. 1. Deliver urban water supplies in accordance with agreed levels of service. 2. Base urban water planning on the best information available at the time and invest in acquiring information on an ongoing basis to continually improve the knowledge base. 3. Adopt a partnership approach so that stakeholders are able to make an informed contribution to urban water planning, including consideration of the appropriate supply/demand balance. 4. Manage water in the urban context on a whole-of-water-cycle basis. 5. Consider the full portfolio of water supply and demand options. 6. Develop and manage urban water supplies within sustainable limits. 7. Use pricing and markets, where efficient and feasible, to help achieve planned urban water supply/demand balance. 8. Periodically review urban water plans.

Source: DSEWPC (2009).

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Current situation

Current urban water strategies reveal that jurisdictions are generally not considering supply augmentation and demand management options together in a way that leads to a least expected cost balancing of supply and demand. The approach that is commonly taken has evolved from the traditional approach (described above) in that the supply augmentation task is not simply determined based on fixed demand projections. Rather, targets are set for modifying demand and so the supply augmentation task is reduced accordingly. Box 6.2 describes this approach as it has been applied in Victoria.

This approach is deficient for three reasons. First, supply augmentation and demand management are not generally being determined according to their relative net benefits. It is assumed that increasing water conservation, water use efficiency and water reuse/recycling is lower cost up to a certain point, but there is often little or no sound analysis to support this. Much of the analysis that is done has been criticised for being simplistic and overly optimistic as to the water savings that can be achieved (Beatty, Coombes and Kozorovski 2009). The benefits that consumers derive from the use of water is also sometimes ignored (chapter 8). In some cases, the targets that are set for demand modification appear to be arbitrary.

Second, there is insufficient recognition that the value of water saved through conservation and water use efficiency can vary over time as dam levels and the costs of supply augmentation change. The same targets apply whether dams are at low levels or are full to overflowing (although temporary water restrictions are used as an additional demand management option during periods of acute water scarcity).

Third, there has been a reluctance to use flexible (or scarcity) pricing, which is potentially an efficient demand management option (chapter 7).

Some water utilities appear to have a sound understanding of the appropriate role for demand management activities. For example, Sydney Water stated: What we have learned through the last decade is a portfolio approach to balancing supply and demand of water, and we have basically looked at how to get supply and demand in balance, subject to getting enough volume at the lowest combination of costs and with the appropriate reliability. So we have looked at each of our options, which in broad terms are dams, desalination, recycled water and water efficiency measures. But within those there’s a number of different schemes and we have tried to balance our approach to all of those, to balance supply and demand, but choose the ones that give us volume, reliability and least cost combinations. (trans., p. 93)

In the main, the greatest inefficiencies appear to arise where these sorts of judgments by water utilities are overridden by government-imposed targets.

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Some jurisdictions, however, are moving towards an approach that is more consistent with the National Urban Water Planning Principles. In Victoria, for example, the recently released Draft Sustainable Water Strategy for Gippsland Region explicitly takes into account the cost effectiveness of demand management options (box 6.2).

Box 6.2 Demand management in Victorian water strategies The Victorian Government prepares 10 year Sustainable Water Strategies for four regions. The current strategy for the Central region, that encompasses Melbourne and surrounding regional areas, was released in 2006. It states: The best way to live within our water means is to stop water wastage and to try and use less water at home, work and play. Our starting point must be to ensure that we place a high value on water by conserving it wherever we can and using it as efficiently as possible. As water resources become scarcer, water will become more valuable. Water conservation is the only remaining low-cost option for securing water supply. (DSE 2006, p. 38) The strategy goes on to set water conservation targets as follows: The Government requires water authorities throughout the Central Region to work with the community to reduce total per capita water usage by at least 25 per cent by 2015, increasing to 30 per cent by 2020. The basis of comparison is the 1990’s average water use. (DSE 2006, p. 39) The more recently released draft Sustainable Water Strategy for Gippsland region (which includes a number of urban centres, including Traralgon, Sale and Bairnsdale) signals a move away from targets: Conservation targets have been an important mechanism for kick-starting water saving efforts and for providing information to communities on conservation and efficiency measures and achievements. In future, water conservation and efficiency measures will focus on balancing supply and demand into the longer term, taking into account cost effectiveness, system reliability, available and fit for purpose supplies. (DSE 2010, p. 72)

Scope for efficiency gains

The scope for efficiency gains through better integration of demand management options within water supply planning are likely to be substantial. Positive steps have been taken in some jurisdictions but there is still substantial scope for improvement. The potential gains are a subset of the gains available from improving demand management for water and wastewater more generally. Accordingly, quantitative estimates are left to chapters 7 and 8.

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Impediments to achieving these gains

The main impediment to achieving these gains is the view among many policy makers that water conservation and water use efficiency are objectives that should be pursued in their own right (chapter 3). The need to refocus water conservation and water efficiency policy is explained further in chapter 8.

Another impediment is that the responsibility for setting targets and implementing demand management options is spread across a range of entities, including water utilities, Australian, State and Territory Government departments (sometimes with a role for both water and planning departments) and Local Governments. This makes it difficult to fully integrate demand management options within water supply planning.

Considering all supply augmentation options

Different supply augmentation options have different attributes such as degree of rainfall dependence, capital cost, operating cost, greenhouse gas emissions and impact on native vegetation. It is important that options are not ruled in or out on the basis of one negative or one positive attribute. Achieving efficient supply augmentation requires that all of the costs and benefits of each option are considered (and compared with demand management options, as discussed above).

As technology has developed, the range of feasible options has expanded to include seawater desalination and various wastewater and stormwater reuse/recycling options, in addition to rivers, dams and groundwater. It is also increasingly being recognised that an urban water system’s available supplies can be increased by creating physical connections to rural systems and other urban systems.

Current situation

In recent years, a range of commentators have expressed concern that supply augmentation decisions have been made without transparent consideration of the costs and benefits of all available options. For example, the National Water Commission (NWC) has stated: … the Commission believes that barriers to the adoption of some cost-effective new and alternative sources remain. The Commission is of the strong view that, rather than outright policy bans, options should be selected through a robust, open-minded and transparent comparison of all options, examining the social, environmental and economic costs and benefits and taking into account the specific water system characteristics, in consultation with the community. (NWC 2009a, p. 236)

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The Australian Water Association also argued that ‘… analyses are frequently undermined by subsidisation of supply options or the imposition of policy bans’ (sub. 42, p. 8). Similarly, the Business Council of Australia contended that ‘it is not always clear that governments have been prepared to select from the full list of [supply augmentation] options or have chosen the lowest cost options for supply’ (sub. 66, p. 3).

The potential inefficiencies from policy bans and subsidies are obviously greater during periods, such as the last few years, when investment levels in supply augmentation are high.

While most jurisdictions have planning processes that allow for the consideration of a range of supply augmentation options, there is evidence of options being rejected or given preference without transparent consideration of costs and benefits, as discussed below.

Scope for efficiency gains

Restrictions on rural–urban trade

Allowing trade in water between the rural and urban sectors generally provides benefits for irrigators, urban water users and the community more broadly. As with other trades that are freely entered into, both the buyer and seller are made better off. The community benefits because trade allows water to move from lower to higher value uses (where value is expressed through willingness to pay). Trade within the rural sector has assisted irrigators to adjust to changing circumstances, particularly during drought (appendix C). Removing restrictions on rural–urban trade has the potential to provide further benefits.

Various arguments have been made opposing rural–urban trade in water, but these do not usually consider costs and benefits to the entire community. The three main arguments are considered below.

First, is the argument that rural–urban trade would reduce food production and food security. Although some rural water is used to produce cotton, wine and other non-food products, rural to urban trade is likely to reduce food production by irrigators. However, the value of water for food (and other agricultural) production determines the price that irrigators are willing to pay for it. Where the urban water sector is willing to pay a higher price, it can be inferred that trade will allow water to be reallocated to a higher value use. While a kilogram of rice or a litre of milk is of value, for many people so to is creating an attractive garden or playing in a pool

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on a hot day. Where irrigators have a higher willingness to pay, trade may go in the other direction, from the urban water sector to irrigators.

Second, it is sometimes argued that such trade will impose costs on irrigators. However, the Commission has found that there are both benefits and costs for irrigators (PC 2010a). The entry of new buyers of water into a rural water market will tend to make the price of water entitlements higher than it would otherwise be. Irrigators who own entitlements benefit from this, whether or not they choose to sell some of their entitlements. Irrigators looking to purchase entitlements or seasonal allocations may be worse off, as they may have to pay a higher price. Another consideration is that trade to urban areas may leave fewer irrigators to share the fixed costs associated with irrigation infrastructure. However, these costs would be offset by the termination fees that are levied on departing irrigators (PC 2010a).

Third, there is concern that allowing trade will disadvantage regional communities that rely on the irrigation sector. As previously stated by the Commission: In addition to the direct impacts on irrigators, there could be indirect impacts on regional businesses that service irrigated agriculture and that are likely to experience a reduction in demand for their services if there is a contraction in irrigated agriculture due to reduced supply or higher cost of irrigation water. These negative impacts may lead to flow-on effects, where other businesses providing inputs into the production of the initially-affected business are also adversely affected. (PC 2010a, p. 99)

These flow-on effects may produce net financial and social costs for particular regions, but these are likely to be modest in most cases because:

• urban water use is often small compared to rural use and so a small proportion of rural water can make a large contribution to urban supplies (for example, the 100 gigalitre (GL) annual capacity of the Sugarloaf (Goulburn River-Melbourne) pipeline is equivalent to around 7 per cent of high reliability water entitlements under Goulburn Murray Water (DSE 2011b))

• water trade allows water to be sourced from those who value it least, such as those who are easily able to reconfigure their irrigation businesses to use less water and those whose production per megalitre of water is relatively low

• many regional economies have diversified over recent decades and now rely less on agriculture (Stayner 1996; PC 2005d).

Even so, it is appropriate for governments to take the potential for negative effects on regional communities into account. These should, however, be weighed up against the potentially large benefits that can result from allowing rural–urban trade. In the Commission’s view, governments should allow trade and assist individuals and communities to adjust to the resulting change, rather than seek to preserve the

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status quo. As with all water trades, environmental impacts from rural–urban trades (which may be positive or negative) need to be managed.

At a high level, governments appear to have accepted that trade is desirable, as evidenced by them agreeing to ‘facilitate water trading between and within the urban and rural sectors’ as part of the National Water Initiative (NWI) (COAG 2004, p. 19). Some progress has occurred in this regard, as there are examples of trades and other transfers between irrigators and the urban water sector (chapter 2). However, despite the commitments entered into through the NWI, unwarranted restrictions on, and impediments to, rural–urban water trading remain.

For example, Adelaide has sourced water from the Murray River for many years and in recent drought years extra seasonal allocations have been purchased from irrigators to meet urban demand shortfalls. During 2008-09, 106 GL of temporary water (seasonal allocation) was purchased for critical human needs, and a further 60 GL was purchased in 2009-10 (Maywald, 2009; Caica 2010). On average the Murray River provides about 40 per cent Adelaide’s mains water and in a drought year this can be as high as 90 per cent (South Australian Government 2005).

It would appear that supply augmentation needs for Adelaide could have continued to have been met through water purchases (either seasonal allocations or entitlements), but instead a desalination plant capable of producing 100 GL of water per annum, equivalent to 71 per cent of Adelaide’s total consumption in 2007-08, is being constructed. The Australian Government initially provided a grant of $100 million towards the construction of this plant, but in 2009 committed a further $228 million on the condition that the plant’s capacity was expanded from 50 to 100 GL (Wong 2009).

Analysis based on the limited information available to the Commission, suggests that it would have been considerably less costly (and more economically efficient) to obtain extra water through purchases from irrigators in the southern connected Murray-Darling Basin (box 6.3). The fact that a desalination plant was preferred suggests that there may have been an implicit government veto on the purchasing option, due to its political sensitivity.

It appears that a hybrid approach of building a small desalination plant and purchasing entitlements or seasonal allocations as needed would also have been more efficient than the option chosen. Accordingly, the Australian Government’s intervention to double the plant’s capacity is likely to impose a high cost on the community for little benefit.

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Box 6.3 Comparison of augmentation options for Adelaide The Port Stanvac desalination plant is being built at an estimated cost of $1.83 billion and is to have the capacity to supply 100 GL per year of water to Adelaide. The operating costs for desalination plants in Australia vary from about $0.50 to $1.10 per kL (PC 2011a), and presumably the Adelaide plant will be within this range. If instead of building this plant, 105 GL of high reliability Victorian Murray entitlements had been purchased, this would have cost around $190 million (based on the average price in the February 2011 tender round of the Australian Government’s environmental water purchasing program (DSEWPC 2011)). According to the Australian Government, this quantity of entitlements would be expected to yield an average of 100 GL per year. There is existing infrastructure capable of transporting this quantity of water to Adelaide. Operating costs associated with this option (mainly for pumping and treatment) would be likely to be lower than for the desalination plant. This simple comparison suggests that the capital costs for the entitlement purchasing option might be not much more than one-tenth of those for the desalination plant. In addition, operating costs would also be expected to be lower. On this basis, the entitlement purchasing option appears to be vastly superior. There are, however, two additional considerations that are important — flexibility and reliability. There is some flexibility in the desalination option because production levels can be lowered to save on operating costs when dam levels are high. However, the majority of the costs are in construction and these costs are sunk. The entitlement purchasing option is very flexible because any unneeded allocations can be sold to irrigators and there are no significant sunk costs. The entitlement option is, therefore, more flexible than the desalination option and this is an important additional advantage. The desalination option is very reliable because production levels are independent of rainfall. Barring breakdowns of the plant, 100 GL can be produced each and every year. In contrast, allocations on entitlements are dependent on rainfall. For example, during the ten-year dry period ending in 2008-09, the average annual allocation for high reliability Victorian Murray entitlements was 87 per cent, and they fell to a low of 35 per cent in 2008-09. Due to climate change, it is possible that there will be a downward trend in allocations in future. There are, however, fairly low cost ways of managing the risks associated with the reliability of allocations, such as carrying over water in dams and purchasing additional allocations (this latter option could be reasonably costly in a year like 2008-09, but on average it would be much lower). Another aspect of reliability relates to water quality. Being at the end of the Murray-Darling system, salinity and other water quality problems can arise in the stretches of the Murray River from which Adelaide’s water is taken. Climate change could exacerbate these problems in future. However, the Australian Government is investing over $8 billion in programs designed to improve the health of the Murray-Darling system (PC 2010a) and it would be expected that this would reduce risks associated with water quality. In summary, while the desalination option is likely to be more reliable than purchasing entitlements, this advantage appears not to be significant enough to overcome its cost and flexibility disadvantages.

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The Commission has undertaken this analysis using available data. A number of assumptions have been made and, as these may not all be accurate, the results should be regarded as indicative only. It might even be that alternative analysis shows the desalination plant to be a preferable option to purchasing rural water. To the Commission’s knowledge, however, no such alternative analysis is publicly available. When asked whether analysis supporting the desalination decision was made public, the South Australian Department for Water stated that the decision was made through a cabinet process, implying that analysis was not publicly available (Department for Water (SA), trans., p. 289). The Commission is also not aware of any analysis undertaken by the Australian Government in determining that it was appropriate to provide financial assistance for this project.

In Victoria, the previous government built a pipeline connecting the Goulburn River system to the Sugarloaf Dam, which is part of Melbourne’s water supply system. The intention was to transfer up to 75 GL per annum to Melbourne, with this water representing a share of water savings resulting from government funded upgrades to irrigation infrastructure. On one hand, this project was a significant step towards removing the costly separation that has existed between rural and urban water. On the other, the method used to source the water, indirect purchase through funding irrigation infrastructure upgrades, has been found to be generally less cost effective than the alternative of purchasing the water from willing sellers (PC 2010a). In addition, the decision to cap the volume at 75 GL per annum, well below the pipe’s capacity, unnecessarily constrained the net benefits available from rural–urban transfers.

The Sugarloaf pipeline, which cost $750 million, was completed and commenced transporting water in 2010 (chapter 2). There was a change of government in Victoria in late 2010 and the new government’s policy is to shut down the pipeline and only use it in the event of a ‘critical human needs emergency’ (Austin 2010). An election policy document states: The Liberal Nationals Coalition has always maintained that the pipeline is destined to become a very expensive white elephant and with Melbourne’s storages rapidly filling, it would seem this will soon be true. When Melbourne Water requires water from the pipeline it is highly likely the Goulburn catchment will be in a worse drought than the Melbourne catchments (Liberal Victoria and the Nationals for Regional Victoria 2010, p. 6)

The claim that the pipeline is likely to become a ‘white elephant’ is difficult to reconcile with plans outlined in the same document to increase recycled water production by an amount greater than the pipeline’s capacity. If the pipeline is unnecessary so too is increased water recycling. Also, contrary to what the document implies, the pipeline is able to contribute to Melbourne’s water supply

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during droughts by utilising whatever seasonal allocations are made, carrying over water in dams and by purchasing on the temporary water market if needed.

Modelling by the Commission has been used to estimate the cost to the community of the decision to not use the Sugarloaf pipeline. The central estimate is that costs over the next 20 years equate to $312 million in present value terms, with a minimum estimate of $229 million and a maximum of $736 million (PC 2011a). This modelling does not factor in use of the pipeline in a critical human needs emergency, as allowed under current policy. However, this does not make a material difference to the estimates because the modelling incorporates optimal supply augmentation and demand management actions that effectively reduce the chances of such an emergency to extremely low levels.

Prohibition on the planned potable use of recycled water

It is possible to treat stormwater and wastewater to a standard that makes it suitable for human consumption. Water that is recycled in this way can be piped into water supply dams or injected into aquifers that are used as a source of potable water. Where wastewater is used, recycling offers a source of water that is largely independent of rainfall. A major advantage of using recycled water for potable rather than non-potable use is that separate distribution infrastructure is not required. Various countries, including the United States and Singapore, use recycled water as a source of drinking water in a planned way (ENTOX, TOXIKOS and the University of NSW 2008).

There are many instances, in Australia and elsewhere, of wastewater being treated and discharged to a river system that supplies downstream communities with potable water. This practice is known as unplanned potable use of recycled water. For example, most of the ACT’s wastewater is treated and discharged into the Molongolo River, which flows into the Murrumbidgee River which in turn flows into the Murray River. Along the way this water forms part of the water supply for many cities and towns, including Adelaide. The Commission is not aware of any major health concerns associated with this source of supply.

In contrast, more direct and planned use of recycled water for drinking is less common and remains contentious. Indeed, the NWC reports that New South Wales, Victoria and South Australia have policy bans that preclude the use of this option (NWC 2010b), despite these states utilising unplanned potable use of recycled water originally sourced from the ACT and elsewhere. In Queensland, three advanced water treatment plants have been built that have the capacity to supply south-east Queensland with drinking water, but a decision has been taken that they are only to be used for this purpose when dam levels fall below 40 per cent (Queensland

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Government nd).1 Recycling was also proposed for Toowoomba; however, government support for this project was withdrawn following community opposition (box 6.4).

Box 6.4 Toowoomba recycled water proposal Toowoomba is located 127 kilometres west of Brisbane in the headwaters of the Darling River. It is one of Australia’s largest inland cities, with a population of 95 000. The population of the greater Toowoomba region is 135 000. In the face of declining dam levels in the early 2000s, Toowoomba City Council began to assess various options for augmenting supply. These options included new dams, water produced from coal seam gas operations, groundwater and piping water from the Brisbane River system. For cost, environmental and reliability reasons, planned potable reuse of wastewater was identified as a preferred option. The environmental benefits related mainly to reduced nutrient and salt exports to the Darling River. This option involved building an advanced water treatment plant (using reverse osmosis technology) to process more than 5000 megalitres of wastewater sourced from the city’s wastewater treatment plant. Most of this water was to be piped to an existing dam to become part of the city’s potable water supply, with some lower quality water being used for other purposes, including coal washing and irrigated agriculture. The estimated cost of the project was $68 million and Council sought part-funding from the Australian Government’s Water Smart Australia program in 2005. There was fierce debate about this proposal in Toowoomba. People opposing the project ran a high-profile public campaign warning of possible public health risks, even though the plant was to produce water of a higher quality than the existing supply. This campaign reportedly extended to measures such as displaying babies’ bottles with toilet paper in them. According to the then mayor, the Australian Government took the unusual step of requiring that a poll be held to gauge the level of support for the project in Toowoomba before a decision on funding would be made. The poll was held in July 2006. The vote in favour of the project was 38 per cent, with 62 per cent opposed. In light of this result the project did not proceed. Subsequently, a 38 kilometre pipeline was constructed to transport water from Wivenhoe Dam (Brisbane’s main dam) to Cressbrook Dam near Toowoomba at a cost of $187 million.

Sources: Toowoomba City Council (2005); Diane Thorley, trans., pp. 419–31.

It could be argued that governments that impose policy bans on the potable use of recycled water are responding appropriately to the health and other concerns of the

1 The SEQ Water Grid Manager reported that there are significant savings on operating costs from not utilising this source when dam levels are higher (DERM, sub. 60).

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community. It would appear, however, that the weight of scientific evidence is that the risks of using recycled water for drinking purposes can be satisfactorily managed (NWC 2010b). Given this, the Commission is in agreement with the NWC that rather than impose outright policy bans: … decisions on whether to use recycling for drinking purposes should objectively consider the risks, the costs and the benefits through a transparent and participatory process. (NWC 2010b, p. 1)

Unwarranted preference given to water reuse and recycling for non-potable use

The Australian, State and Territory Governments give preference to supply augmentations that involve reusing or recycling water for non-potable uses by subsidising them or mandating their use. Although reuse and recycling options can provide benefits in addition to water supply, the Commission’s view is that the preference given to these options is in most instances not justified by these additional benefits. Evidence and analysis of this issue are presented later in the section on integrated water cycle management, and this suggests that the costs to the community of unwarranted preference being given to water reuse and recycling for non-potable use are substantial.

Impediments to achieving these gains

One impediment to achieving these gains is the existence of implicit and explicit policy bans on certain augmentation options.

• rural–urban trade (to allow water to be allocated to its highest value use)

• planned potable reuse (unplanned potable reuse occurs commonly without any apparent ill-effects).

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A further impediment is government subsidies for particular supply augmentation options. This involves both small scale augmentations, like rainwater tanks (discussed in the later section on integrated water cycle management) and larger scale augmentations.

There are a range of programs that provide subsidies for larger scale supply augmentations and for other urban water infrastructure. The Australian Government provides subsidies through the following programs:

• National Urban Water and Desalination Plan

• National Water Security Plan for Cities and Towns

• Water Smart Australia

• Strengthening Basin Communities.

Further details on these programs is included in box 6.5. This box shows that the reuse and recycling options referred to earlier feature heavily in the programs funded, but that subsidies have also been provided for desalination plants, pipelines, water treatment plants and other water and wastewater infrastructure. State and Territory Governments also provide subsidies for supply augmentations and for other urban water infrastructure. For example, they have co-funded some of the projects listed in box 6.5 and some jurisdictions also provide subsidies to regional water utilities (Midcoast Water, sub. 51).

The Australian Water Association reported: Sustainable urban water management demands that all sources of water be considered equally. Governments have tended, however, to subsidise some water supplies over others. Rainwater tanks have commonly been subsidised and more recently major infrastructure projects have been subsidised, notably the desalination plant in South Australia and various other desalination and stormwater reuse initiatives. Where this occurs, a water source may be brought on line earlier than necessary, building unnecessary supply into a system at considerable cost to the community. (sub. 42, p. 17)

The Independent Pricing and Regulatory Tribunal (IPART) argued: I think there have been some recent cases where government at all levels have rushed in to subsidise urban water infrastructure and you might wonder about the wisdom of that, or whether that’s not actually distorting what infrastructure gets built or moving us away from the most efficient ways of meeting people’s water needs. (trans., p. 25)

Midcoast Water commented specifically on the Water Smart Australia program:

• The majority of the projects provided [with] funding subsidies … should have been funded by the commercial pricing of the water utilities.

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• Few of the projects demonstrate innovation that would lead to the improved future performance of the water industry and its service provision.

• Much of the funding went to projects that had already been committed to by councils and had funding plans in place. The result is that infrastructure is being built which is not being funded by the users under a transparent commercial arrangement that reflects the true cost.

• The outcome of the vast majority of funding has been to reinforce the old “hand-out” mentality of many local governments thereby eroding the benefits of the 1994 COAG water reforms. (sub. 51, p. 16)

Box 6.5 Australian Government subsidies for supply augmentations and other water infrastructure

National Urban Water and Desalination Plan The National Urban Water and Desalination Plan is a $1 billion program that commenced in 2008. It provides grants for desalination plants and recycling and stormwater harvesting infrastructure in urban areas with populations of more than 50 000. Under the program, $20 million has also been allocated to each of two National Centres of Excellence to support the development and commercialisation of innovative technologies in desalination and water recycling. Grants made under the program include (amounts have been rounded):

• $328 million for the 100 GL per year Adelaide Desalination Plant

• $64 million to the Department for Water (SA) to coordinate the delivery of seven projects, including the City of Salisbury’s Unity Park Biofiltration and Reuse project (stormwater harvesting) and the City of Onkaparinga's Water Proofing the South Stage 2 project (stormwater harvesting)

• $30 million for the Glenelg to Adelaide parklands water recycling project

• $20 million for the Geelong–Shell water recycling project

• $18 million for the southern seawater desalination plant in Western Australia

• $10 million to Yarra Valley Water for the Kalkallo Stormwater Harvesting and Reuse project.

National Water Security Plan for Cities and Towns Funding of $255 million has been committed through the National Water Security Plan for Cities and Towns for projects that save water and reduce water losses in cities and towns with populations of less than 50 000. Grants made under this program include:

• $52 million to improve water and wastewater services in 17 Indigenous communities in remote areas (in various jurisdictions)

(Continued next page)

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Box 6.5 (continued)

• $20 million for the Rockhampton to Gladstone pipeline (Queensland)

• $10 million for the Derwent Estuary recycled water scheme (Tasmania)

• $10 million for a rollout of water meters in Tasmania

• $10 million for the Black Rock recycled water scheme (Victoria)

• $6 million for the Midcoast Water Recycling & Reuse Program (New South Wales)

• more than $5 million for water saving projects (including installing smart metering systems and replacing mains) in Maryborough (Queensland).

Water Smart Australia Water Smart Australia is a $1.6 billion program, with funding over seven years until 2011. Its aim is to ‘accelerate the development and uptake of smart technologies and practices in water use across Australia’ (DSEWPC 2010c). The program has provided funding for a wide range of infrastructure projects to benefit irrigators, urban water systems and the environment. Grants for urban projects include:

• $408 million for the Western Corridor recycling project (Queensland)

• $115 million for the goldfields ‘superpipe’ to Bendigo and Ballarat (Victoria)

• $80 million for the Mardi Mangrove link project for pump stations and pipelines to increase water security for the Central Coast region (New South Wales)

• $46 million for the Mackay wastewater recycling project (Queensland).

Strengthening Basin Communities Strengthening Basin Communities is a $200 million program that targets communities in the Murray-Darling Basin. It provides grants for Local Governments to assist in communitywide planning for a future with less water and grants to support projects that improve water security by reducing demand on potable water supplies. Examples of the latter types of grant include:

• $9 million to secure the water supply to Lake Cargelligo, Murrin Bridge, Tullibigeal and Kikiora townships (New South Wales)

• $7 million for the Cowangs Reservoir to Bauloora Reservoir pipeline replacement project (New South Wales).

Sources: DSEWPC 2010c; Swan and Wong (2008).

The Commission broadly agrees with the arguments made by these participants. Such subsidies can not only distort the choice of augmentation, but also result in them being made at the wrong time or scale. Where water utilities fund augmentations and other infrastructure projects, they generally have the discipline of knowing that costs will need to be recovered through water charges and they may

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also be required to justify their actions to an economic regulator. By contrast, the funding guidelines for government programs that provide subsidies provide a weaker form of discipline and may actually preclude the most efficient option from being selected. For example, the National Urban Water and Desalination Plan only funds projects that involve desalination, recycling or stormwater harvesting (DEWHA 2008).

A further problem with subsidies is that they can result in consumers not paying the full cost of water, which can lead to inefficiently high consumption. The provision of subsidies is also inconsistent with the cost recovery objectives for urban water outlined in the NWI.

A possible argument in favour of subsidies is that they can be used to promote better environmental outcomes. For example, a subsidy might secure the use of a supply augmentation option that has better environmental performance than the one that might have been chosen otherwise.

In the Commission’s view, however, it is preferable for governments to ensure that water utilities and stormwater managers face environmental constraints and incentives that result in environmental matters being appropriately factored into their decisions, rather than using subsidies. For example:

• setting wastewater discharge standards that need to be met through improved treatment and/or recycling of wastewater

• ensuring that electricity prices have any environmental costs associated with greenhouse gas emissions built into them so as to create a financial disincentive to using emissions-intensive augmentation options.

This approach has the potential to lead to better investment decisions and result in the price of water services being appropriately influenced by their environmental costs (that is, the externality is internalised).

There might, however, be some cases where environmentally-motivated subsidies are appropriate to produce environmental outcomes that are unrelated to the service delivery responsibilities of water utilities. For example, subsidies might be warranted where there are environmental benefits, such as better control over environmental water flows, from an urban water supply dam being larger than required for water supply purposes. In such cases, environmental flows can be seen as a joint product with water storage for urban use and the obligation to fund this joint product should not rest with water consumers.

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DRAFT RECOMMENDATION 6.2 The Australian, State and Territory Governments should not provide subsidies for supply augmentations and other urban water infrastructure, except where:

• a formal process has identified that a particular community should be exempted from the requirement to fully recover costs through water charges (see draft recommendation 13.3).

A final impediment to achieving these gains is the existence of institutional, governance and structural arrangements that do not promote the selection of supply augmentation options based on costs and benefits. For example, water utilities are often given a range of conflicting objectives and this can prevent them from focusing on finding least expected cost solutions. Also, utilities may have little incentive to look beyond options developed ‘in-house’ and so innovative proposals by the private sector may not be sufficiently encouraged or considered. Chapters 11 and 12 put forward reform options designed to overcome these impediments.

Taking a real options approach

What is a real option approach?

Making supply augmentation decisions efficiently requires a sophisticated approach to dealing with uncertainty. There is large uncertainty about future water supply, as well as some uncertainty about future demand. No one knows how wet the next one, five or 20 years will be, and therefore how much water will flow into urban water supply dams. The historic record for many parts of Australia shows great variability in rainfall, but the prospect of ongoing climate change means that the range of possible future outcomes is wider still. For example, current projections indicate that the southern Murray-Darling Basin is likely to become drier by 2030, but the possibility that it will become wetter can not be ruled out (CSIRO 2008). More extreme weather events are predicted (CSIRO 2008).

An important aspect of dealing with this uncertainty is recognising that as time elapses some uncertainties are partially or fully resolved. Dam inflows over the next 12 months are uncertain, but in a year’s time they are a known fact. It follows from this that there can be a value in being able to delay major investment decisions until more information becomes available. One way that this can be done is by not

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committing to augmentation projects earlier than absolutely necessary. Another is by taking actions that enable decisions to be delayed in a way that does not threaten water security. For example, doing preparatory work that reduces the lead time for bringing a supply augmentation on stream. In some cases this value can be large and certainly worth funding. It is these insights that are at the heart of the ‘real options’ approach to investment under uncertainty that has been developed over the last twenty or thirty years.

Where a major supply augmentation can be safely deferred for a year or two the subsequent pattern of rainfall can result in the augmentation not being needed for a decade or more, which provides a major cost saving. An example of the type of situation that a real options approach may be able to avoid is provided by Grafton and Ward: Santa Barbara, California, built a desalination plant during a 1991 drought; the drought ended before the plant was on-line, and the plant has been mothballed since construction. (Grafton and Ward 2010, p. 1)

Under a conventional approach, a fixed supply augmentation plan is developed taking into account future climatic and other uncertainties. Under a real options approach, there is no fixed plan, rather decisions are made over time depending on actual outcomes.

As stated in Borison et al. (2008): Real options is now being applied by managers in both the public and private sectors as a way of thinking, a specialized analytic tool for evaluating complex investments, and an organizational process for guiding strategy. (Borison et al. 2008, p. 8)

Adopting real options as a way of thinking is the first step. Achieving the potential offered by real options, however, requires that specialised analytical tools be developed and then used by organisations responsible for making augmentation decisions. A range of analytical tools have been developed using different methodologies. Borison et al. (2008) identify the ‘risk-adjusted decision tree method’ as appropriate for urban water resource planning. This is the method that has been adopted by the Commission for the modelling undertaken for this inquiry (PC 2011a).

Current situation

The urban water sector has been giving increasing attention to real options approaches to supply planning. Evidence for this includes:

• the Water Services Association of Australia (WSAA) commissioning a study into the approach (Borison et al. 2008)

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• increasing recognition of the importance of adaptive management, a concept related to real options, in urban water plans (for example, NSW Office of Water 2010c)

• ACTEW (sub. 45) reported that the approach it takes to supply augmentation decision making is consistent with real options analysis.

It would appear, however, that this attention has not yet translated into widespread changes to the way supply augmentation decisions are made. ACIL Tasman, which has been active in articulating the benefits of a real options approach to the urban water sector, reported: Source planning in many jurisdictions … is predicated on an approach that seeks an approximately least cost strategy under one assumed forward scenario regarding climate change and demand, coupled with stress testing to ensure that the strategy is robust enough to deal with the assumed ‘worst case scenario’. This typically means planning a strategy that is reasonably cost effective in relation to either the worst case scenario or a highly conservative, low inflow scenario. (ACIL Tasman 2007a, p. viii)

This contrasts with a real options approach that considers all plausible future scenarios and seeks to achieve a least expected cost means of balancing supply and demand.

Scope for efficiency gains

There is no point in bringing the wisdom of hindsight to supply augmentation decisions, for example, by claiming that an existing desalination plant did not need to be built because subsequent rainfall has filled dams. The best that can be achieved is for decisions to be made that enable supply and demand to be balanced at least expected cost. An inefficient augmentation decision is one that can be demonstrated to have not met this test. And an inefficient approach to making decisions is one that can be shown to perform less well against this test than another feasible approach.

Sydney example

One source of evidence that there are efficiency gains from using a real options approach in place of current approaches to supply planning is the review of the NSW Metropolitan Water Plan 2004, undertaken by the Institute for Sustainable Futures, ACIL Tasman and SMEC Australia, and commissioned by the NSW Cabinet Office (White et al. 2006). The review describes the original strategy set out in the 2004 Metropolitan Water Plan as being ‘relatively deterministic’ and ‘designed to invest sufficiently to cover ‘worst case’ possibilities’ (White et al.

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2006, p. 6). It advocated replacing this strategy with ‘a more adaptive strategy that can insure against worst-case possibilities at a much lower up-front cost’ (White et al. 2006, p. 6).

Features of this adaptive strategy included:

• planning and preparation for a 125 megalitre (ML) per day desalination plant (to reduce the lead time for construction)

• investigating groundwater resources with a view to extracting groundwater during drought

• undertaking a range of recycling and demand management initiatives

• proceeding with the desalination plant when dam levels dropped below 30 per cent (with a view to lowering this ‘trigger’ point pending more information).

The review also suggested that further options be investigated, including the use of scarcity pricing. While the initial strategy entailed proceeding with the desalination plant immediately, the adaptive strategy employed a range of real options to allow the desalination plant to be deferred without threatening water security.

The review estimated that expected savings of around $1.1 billion were available from adopting the 30 per cent trigger relative to immediately committing to constructing the desalination plant with dam levels at 48 per cent (48 per cent was chosen in part to ‘approximate the immediate context’ (White et al. 2006, p. 90)). White et al. (2006) found that there was a small probability that the trigger would be reached within a few years (resulting in a fairly small cost saving), but a much higher probability that the trigger would not be reached for several decades (resulting in a much larger cost saving). Their estimate is an average based on these probabilities and is claimed to be conservative.

The authors of the review provided an interim report in February 2006, and by the time the review was released the NSW Government had adopted an adaptive strategy with a 30 per cent trigger (White et al. 2006). In the lead up to the March 2007 state election, however, the NSW Government committed to proceeding with the desalination plant when dam levels were at 34.3 per cent (table 6.1). Dam levels rose during the election campaign and over the following few months. Despite this, the returned government delivered on its election commitment to build the plant.

A plausible interpretation of these events is that a real options/adaptive management approach to supply augmentation was adopted, but then abandoned due to the political environment created by a looming election. It is easy to imagine that committing to concrete action to ‘solve’ a high profile problem was judged to be a stronger campaign message than adopting a wait and see approach. It is worth

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noting that both major parties committed to a major supply augmentation project during the election campaign. This interpretation is consistent with the discussion in chapter 3 about the inefficiencies that can arise when political decisions are made about the supply of a service.

Abandoning a real options approach in this way seems likely to impose a high cost on water users in Sydney. The NSW Government announced the preferred tenderer for the desalination plant when Sydney’s dam levels were at 51.4 per cent and signed contracts when they were 57.2 per cent full (table 6.1). It is inferred from this that the ‘point of no return’ for the project was reached when dam levels were above 50 per cent. Based on the estimate outlined above, the expected cost of proceeding with the plant in these circumstances, rather than adopting a 30 per cent trigger, would be greater than $1.1 billion.

Table 6.1 Sydney desalination plant: event timeline

Date Dam Event levelsa

February 2006 44.6% NSW Government announces that a desalination plant will be built for Sydney if dam levels drop to around 30 per cent April 2006 41.2% Expert review endorses the 30 per cent trigger level (and suggests moving to a lower trigger level once more information becomes available) February 2007 34.3% Reported that the forthcoming election in New South Wales will be dominated by water Premier Iemma commits to proceeding with a desalination plant Opposition leader Debnam announces a plan for a wastewater recycling plant and states that voters will be ‘offered a clear choice between recycling and desalination’ (McDougall 2007) 24 March 2007 38.4% Labor returned to government at the state election 12 April 2007 38.2% Review author, Professor Stuart White, says that the desalination plant should only be built in the unlikely event that dam levels hit 30 per cent. He states that constructing the desalination plant regardless of storage levels would be ‘a significant burden on the public purse, and is in direct contrast to the advice that was provided to, and accepted by, the NSW Government in 2006’ (Clennell 2007) 25 June 2007 51.4% Premier Iemma announces the government’s preferred tenderer to build and operate the desalination plant (cost to be $1.76 billion, with the plant having a capacity of 250ML per day, twice that originally planned) 18 July 2007 57.2% Sydney Water and Blue Water Joint Venture sign contracts relating to the design, construction, operation and maintenance of the desalination plant — a contract to construct the water pipeline for the project is also signed around this time January 2010 52.7% The completed plant starts supplying desalinated water a Available storage in Sydney’s dams as a proportion of full operating storage. Sources: Clennell (2007); Hildebrand and Sikora (2007); McDougall (2007); Sydney Catchment Authority (2011b); Sydney Water (2007 and 2011a); White et al. (2006).

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Melbourne example

The Victorian Government released a water plan in 2007 that involved two major augmentations to Melbourne’s water supply system — a desalination plant with a 150 GL per annum capacity (capable of expansion to 200 GL) and the pipeline connecting the Goulburn River system to the Sugarloaf Dam, discussed earlier (Victorian Government 2007). The combined initial capacity of these augmentations is equivalent to about 60 per cent of Melbourne’s water consumption in 2007-08.

Simultaneously committing to two such large supply augmentations can be seen as the antithesis of a real options approach. Such a plan seems to seek to answer the question ‘what can we do now to achieve water security, assuming the worst case scenario eventuates?’. By contrast, a real options approach asks ‘how can we make decisions over time to achieve water security at least expected cost, given uncertainties about future inflows?’.

Modelling by the Commission estimates the excess cost to the community of this plan relative to an optimal strategy to be $1.5 to $2.2 billion over a 10 year period and $2.7 to $3.7 billion over a 20 year period, depending on modelling assumptions (PC 2011a). These estimates include costs associated with having a fixed plan rather than taking a real options approach, and of choosing desalination when lower cost augmentations were available. The modelling assumes that all investments are efficiently financed.

To isolate the benefits of real options, the Commission also modelled the best possible 10 year fixed plan, starting in 2007, for augmentation of Melbourne’s water supply and compared this with an optimal real options strategy. The resulting estimate is that the cost advantage of the real options strategy is about $900 million over 10 years (PC 2011a).

The inefficiencies associated with supply augmentations over the next 10 years is likely to be lower than in recent years for the simple reason that, with surplus capacity coming on stream, it seems unlikely that such major augmentation investments will be made. However, the current Victorian Government went to the last election with a policy of setting recycling targets that would require consumption of recycled water to increase by 135 GL over the next 20 years. While this might not require substantial investment in new recycling plants, as water from Melbourne’s wastewater treatment plants could be used, it would require infrastructure to be built to distribute non-potable water, which is costly. Committing to such ambitious recycling targets over 20 years, regardless of future

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rainfall, is fundamentally inconsistent with a real options approach and could impose a high (and unnecessary) cost on the community.

Perth example

In 2005, the WA Water Corporation stated that it was actively pursuing three new sources of supply for the Integrated Water Supply Scheme, which supplies Perth and other areas of Western Australia (Water Corporation 2005). The first two of these, the Kwinana desalination plant and a water trade with Harvey Water were subsequently implemented. The Water Corporation planned to complete the third — utilisation of the south-west Yarragadee aquifer to supply 45 GL per annum — by late 2009.

In 2007, the then Premier announced that a second seawater desalination plant would be Western Australia’s next major water source and that the Water Corporation’s plan to utilise the south-west Yarragadee aquifer would be shelved (Carpenter 2007). The aquifer option had by that stage ‘effectively received environmental approval’ (Carpenter 2007).

The Commission estimates that the fixed strategy of building the second desalination plant was more costly to the community than a real options strategy in which the south-west Yarragadee aquifer could be utilised. The difference being $247 to $282 million over a 10 year period and $421 to $557 million over a 20 year period, depending on modelling assumptions (PC 2011a).

To isolate the benefits of real options, the Commission also modelled the best possible 10 year fixed plan, starting in 2007, for augmentation of Perth’s water supply and compared this with an optimal real options strategy. The resulting estimate is that the cost advantage of the real options strategy is about $227 million over 10 years (PC 2011a).

Impediments to achieving these gains

In the Commission’s view, the main impediment to realising the gains available from taking a real options approach to supply augmentation is current institutional and governance arrangements. In most jurisdictions these are characterised by:

• absence of clarity over the roles and responsibilities of cabinet, ministers, government departments, water utilities and regulators, which can cause delays and uncertainties that erode the benefits available from a real options approach

• political involvement in decision making that can bring with it an undue level of risk aversion and other incentives that work against achieving a least expected

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cost balancing of supply and demand, as illustrated by the Sydney example discussed above.

Other impediments relate to poor information, regulation and the technical complexity of real options analysis. Taking a real options approach relies on access to information about consumer demand, costs for supply augmentation and demand management options, the value of water in storage and other factors. On the value of water in storage, Coliban Water stated: We … need to consider the cost of drawing down storages. I think it’s this … point which represents the very significant change in thinking, compared to the way water businesses have operated in the past. Historically water would have been considered valueless or even valued at net cost. (trans., p. 198)

Even once this change of thinking has occurred, obtaining the necessary information is difficult. This is because markets only play a limited role in the urban water sector and so prices that would reveal values in a market setting are often not available.

Regulation can impede the use of a real options approach in two ways. First, delays and uncertainties in gaining approvals from environmental regulators and other government agencies can mean that some options become unviable. For example, ACTEW reported that uncertainties about time frames for gaining environmental approvals, and approvals for interstate water trades, effectively narrowed their range of options: So in a real options analysis once you introduce uncertainty what became apparent was that the [expansion of Cotter] dam would be chosen almost on every occasion because you had more possibility of getting it up and its been borne out as we’ve gone through it but the others [purchasing water and a pipeline option] just have been very difficult to get into place. (trans., p. 83)

Second, economic regulation can be an impediment, as explained by WSAA: … some of the challenges that we see … is around understanding how … [a real options approach] would be treated by economic regulators, given that it’s a complex process and it leads to complex outcomes that are potentially difficult to explain. (trans., p. 134)

Taking a real options approach often entails significant expenditure on developing options that are subsequently abandoned because, as events unfold, they prove not to be needed. The challenge referred to by WSAA is demonstrating the efficiency of this expenditure to regulators, given that the value created is in having enabled other investments to be deferred rather than in having actually increased water supply. A related challenge is gaining public and political acceptance that delaying and/or abandoning projects is not always a waste of money.

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Finally, taking a real options approach can be technically difficult, requiring sophisticated computer models to be developed and validated. It inevitably takes time to overcome these difficulties.

6.2 Improving system operations and asset management

The previous section examined the scope for efficiency gains through making better supply augmentation decisions. This is of course only one aspect of the urban water sector. Decisions must also be made about other matters, such as building and upgrading water treatment plants, and maintaining and expanding water pipe networks. And all decisions must be implemented. This section, and the following two, examine the scope for efficiency gains in these other aspects of the sector.

More efficient system operations

Reform of other utility sectors, such as electricity, has produced substantial gains in operational/productive efficiency by, for example, allowing labour use to be reduced while output was maintained or increased (appendix D). A valid question is whether similar gains are possible in the urban water sector, given that it has to date undergone less fundamental reform than other utility sectors.

However, while there has been only limited structural reform in the urban water sector, greater commercialisation and outsourcing has occurred and this has increased efficiency over the last decade or two. For example, Sydney Water stated: Corporatisation in the late 1980s and early 1990s began a process of continuous improvement in the water industry. … By way of illustration, in 1980 Sydney Water had nearly 14 000 staff. In 2009-10, Sydney Water had 2987 staff. (sub. 21, p. 12)

Over 80 per cent of Sydney Water’s total expenditure over the five years up to 2009-10 was delivered by external sources (that is, outsourced), with competitive processes used to select private sector providers for many major categories of expenditure (Sydney Water, sub. 21).

In relation to overall efficiency, IPART argued: The NSW metropolitan water industry made significant efficiency gains throughout the 1990s and early 2000s. For example, Sydney Water’s operating costs were less in 2005 than they were in 1993, measured in real terms.

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However, the water industry has not sustained those gains in recent years. Costs have increased driven in part by higher standards; funding of otherwise nonfinancial recycled water schemes; and major capital additions to improve security of supply. Much of this increase reflects increased capital works. (sub. 58, p. 8)

Notably, the factors that IPART cite as being responsible for cost increases relate to supply augmentation decisions (which, as discussed earlier, have been heavily influenced by the NSW Government) and regulation of standards (for example, wastewater discharge standards), rather than water utility performance in managing and operating the system.

Coliban Water reported: Over the last decade, Coliban Water has exposed many of its functions to the discipline of the market by contracting out core services through a range of fit for purpose approaches including Build, Own, Operate schemes. Customers have benefited as this approach has driven down costs and driven up standards of service by making outputs an explicit contractual obligation. (sub. 73, p. 2)

WSAA provided evidence that the practice of contracting out (or outsourcing) of both operating tasks and capital projects is the norm among large water utilities (table 6.2).

Table 6.2 Proportion of expenditure outsourced, 2009-10a

Water utility Operating expenditure (%) Capital expenditure (%)

Water Corporation (WA) 30 93 Sydney Water 72 94 Sydney Catchment Authority 64 99 Melbourne Water 73 100 South East Water (Victoria) 42 90 Yarra Valley Water (Victoria) 58 98 Hunter Water (NSW) 65 100 SA Water 65 94 a WSAA provided data for outsourcing by ACTEW that has not been included here. This is because much of their outsourcing is to ACTEW/AGL, a related entity, and so the data are not comparable. Source: WSAA sub. 29, p. 31.

Outsourcing can help to drive efficiency through the incentives it creates for firms to lower their costs in order to be profitable in an environment where they must secure contracts through competitive processes. However, as IPART argued, competitive tendering arrangements: … help minimise the costs for a given solution but do not ensure that the adopted solution is the most efficient or that the institutional arrangements underlying service delivery are efficient. (sub. 58, p. 9)

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Outsourcing can create efficiency enhancing competition among prospective suppliers, but does not increase competitive pressures on water utilities. In the urban water sector these pressures are low relative to those in other utility sectors, such as electricity and gas, although in all these sectors there are natural monopoly elements that limit the role of competition. Accordingly, there is scope for efficiency gains through pro-competitive reforms in the sector, although these are inherently difficult to estimate. As Ruff and Sweir argued: … after competitive reform occurs, innovative ideas and processes ‘come out of the woodwork’ to change – and usually improve – the sector in ways nobody predicted. (sub. 47, p. 4)

In summary, the urban water sector has become more efficient over the last decade or two due to past reforms and increased outsourcing. Given what has already been achieved, the scope for further gains in the efficiency of system operations may be relatively modest, although the scope will vary from place to place. Further gains may, however, be achievable from reforms that introduce greater levels of competition. Chapter 12 considers this issue further.

Issues arising from increased system complexity

Many urban water systems are becoming more complex and, because of this, so too are decisions about which sources to use and how to move water around the system. One reason for increased complexity is increased diversity in sources of supply. Systems that traditionally relied solely on dams (and possibly groundwater) are being augmented with desalination plants, water recycling plants of various kinds and pipelines that can transfer water from rural areas.

Some of these alternative supply sources have lower dependence on rainfall, but much higher operating costs, than traditional sources (chapter 2). Where there is such diversity in supply sources, system operating rules need to take account of the tradeoff between increasing water security and increasing operating costs. When dams levels are very low it will generally be efficient to operate a desalination plant to increase water security. Conversely, when dams are nearly full it will often be efficient to shut a desalination plant down to save on operating costs (particularly where dam capacity is several times annual consumption). Complex hydrological and economic calculations are required to determine exactly when such a plant should be started up and shut down.

Another source of complexity arises from the expansion of urban water systems, through physical interconnections being made between systems. Such expansion can greatly increase the complexity of decisions concerning which sources of

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supply to utilise, which water treatment plants to operate and what movements of water to make between dams. Notable examples of system expansions include the creation of the south-east Queensland water grid and various interconnections being made to the Melbourne system, including the Melbourne–Geelong interconnector.

System expansion can create opportunities for efficiency gains, as explained by the SEQ Water Grid Manager in relation to the south-east Queensland water grid: … benefits of interconnection are significant. Operated as a connected network, the system yield of current sources of supply is at least 14 per cent higher than the sum of their individual yields. Asset utilisation will also improve, exploiting latent capacity and thereby deferring or avoiding the need for system capital expenditure. (DERM, sub. 60, attachment, p. 21)

It is the physical expansion/interconnection that creates these types of potential efficiency gains, but the extent to which they are realised will depend on the institutional, structural and other arrangements in place.

The Commission is not aware of any strong evidence of major inefficiencies in system operations as a result of increased complexity. The issue is more that new challenges and opportunities are emerging and jurisdictions are still in the process of considering how best to respond to these, as evidenced by the following example.

It has been announced that the Melbourne desalination plant is to be operated continuously from the time it is commissioned until dam levels reach 65 per cent (Ker 2009). This may be a sensible position for the initial year or two of operations to ensure the plant’s performance and reliability. Subsequently, however, there is a need for detailed economic analysis to be done to determine the most economically efficient operating rules for the plant. This will require an understanding of the economic value of water in storage, something that is not presently available. This value could be estimated administratively, but introducing market-based reforms may be a superior way of revealing information about the value of water to inform decisions about the plants operation.

In general, major increases in system complexity necessitate a review to determine if the current arrangements should be amended in light of the new challenges and opportunities.

Improving asset management

IPART identified a range of asset management tasks for the urban water sector, including:

• asset inventory

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• asset planning incorporating both business and technical risk assessments

• maintenance of adequate records and robust and reliable data

• asset replacement, rehabilitation, augmentation, creation/acquisition and/or substitution (asset and non-asset substitutions)

• management of service provision, including contracts

• monitoring and condition assessment

• proactive and reactive maintenance

• operations

• training and resourcing

• contingency planning covering both emergency management and business continuity

• asset rationalisation and disposal. (sub. 58, p. 16)

Given that the urban water sector is highly capital intensive, efficient management of assets is crucial to overall efficiency. Inefficiencies in the management of assets can result in unnecessary costs, for example from:

• using larger than necessary water and sewerage pipes (allowing for the fact that having spare pipe capacity to allow for future increases in use is often a sound strategy, given the high cost of later upgrades)

• laying pipes in an inefficient manner

• incurring water losses due to leaks, or having to replace pipes due to a failure to properly maintain them

• maintaining reliability standards at a level that is higher than what is justified by the incremental costs and benefits.

Inefficient asset management can also lead to inadequate levels of service (for example, providing unsafe drinking water due to a failure to upgrade treatment plants) and poor environmental outcomes (for example, from groundwater contamination due to leaking sewerage pipes). Efficient service provision requires that assets are neither replaced prematurely nor belatedly.

The evidence on the scope for efficiency gains through improved asset management is both sparse and mixed.2 WSAA provided evidence that at least some large Australian urban water utilities perform well relative to their international counterparts:

2 This is leaving aside asset management relating to supply augmentation decisions, which was dealt with earlier in this chapter.

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The 2008 Asset Management project incorporating 42 participants from Australia, New Zealand, Abu Dhabi, Sultanate of Oman, Canada, China and United States was co-sponsored by the International Water Association (IWA), and delivered through a consultant consortium led by GHD Pty Ltd and including Marchment Hill Consulting and CH2MHill. … Australia was identified as a world leader in Asset Management scoring at a ‘mature’ level of asset management practice, with the Middle East, Hong Kong and North America characterised as ‘developing’ and ‘established’. (sub. 29, p. 31)

Increasing outsourcing of capital projects through competitive processes has likely been responsible for efficiency gains over recent years. However, as discussed earlier there are limitations to what can be achieved through outsourcing and it is possible that there are further efficiency gains that could only be achieved through pro-competitive reforms that increase incentives for efficiency and innovation.

In addition, there is scope to increase the efficiency of asset management in some regional areas, as discussed in section 6.5.

Overall, system operations and asset management in the urban water sector have become more efficient over the last decade or two due to the commercialisation of water utilities and increasing use of competitive outsourcing. However, further gains may be achievable, given that incentives for increased efficiency and innovation in the sector are still weak relative to other utility sectors.

6.3 Other opportunities in the supply of wastewater and stormwater services

This section addresses opportunities for efficiency gains that are specific to the wastewater and stormwater sub-sectors. Opportunities that relate to improving the coordination of these sub-sectors with water supply are left to the following section on integrated water cycle management.

Wastewater

Reducing regulatory burdens

While reducing regulatory burdens is an issue across the urban water sector, some inquiry participants identified wastewater discharge standards as particularly important in this regard (IPART, sub. 58; WSAA, sub. 29; Sydney Water, trans., pp. 101–2). IPART reported that increasingly stringent requirements were

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being placed on urban water utilities and that this was driving up costs. It argued that standards should only be increased where the benefits exceeded the costs and that there was a need to ensure that all options for achieving particular environmental outcomes were explored (sub. 58).

The Commission agrees with this assessment and considers that there are likely to be significant efficiency gains from improved regulation of wastewater discharge. Chapters 5 and 11 examine ways in which this could be achieved.

Emerging opportunities

Management of wastewater has traditionally focused entirely on collection, treatment and disposal. These remain core functions, but there is increasing recognition that there may be opportunities to create saleable products from wastewater. Recycled water is one example (considered in the next section), but there are others such as energy and nutrients. Sydney Water commented on these opportunities as well as the emergence of cost saving technologies in wastewater treatment: Emerging technologies, particularly in wastewater treatment, may result in future cost efficiencies. These may include the adoption of nano-technology and advanced microbiological processes in Sydney Water’s treatment systems, improvements in nutrient capture from wastewater, and likely improvements over time in energy efficiency and energy recovery. (sub. 21, p. 12)

The extent to which efficiency gains can be made from exploiting these opportunities in future depends on factors such as the rate of technological advance and whether a greenhouse gas emissions tax or trading scheme is introduced.

Stormwater

Inadequate infrastructure

Some inquiry participants and other commentators argued that increasing pressure was being placed on stormwater infrastructure, particularly from infill development, and that more investment was needed to meet flood mitigation objectives. The City of Salisbury stated: Because flooding is an infrequent event, and difficult to predict [investment in stormwater infrastructure] has been underfunded and the systems under-maintained. Much of the existing drainage system was constructed to standards of protection which are now considered inadequate. No system for funding the upgrading of these works

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has been devised. The effect of climate change, to increase the severity of rainfall events and hence flooding, compounds this shortfall. (sub. 10, p. 2)

Assessment by Engineers Australia concluded that major changes are required for stormwater infrastructure in Australia to be fit for its current and future purpose (Engineers Australia 2010b). It rated stormwater infrastructure as being at a lower overall standard than either potable water or wastewater infrastructure.

Institutional arrangements for the management of stormwater vary greatly across Australia (chapter 2). Accordingly, it is likely that the adequacy of existing infrastructure varies across jurisdictions and regions. Where inadequacies exist the key impediment to improvement would appear to be current funding arrangements, including developer charges, an issue addressed in chapter 7.

Improving environmental outcomes

The primary purpose of stormwater services is flood mitigation; however, they also have an important influence on environmental and amenity outcomes in urban areas. For example:

• slowing the flow of stormwater through urban landscapes can improve the environmental health of urban waterways

• various management practices, such as filtering stormwater through vegetation, can reduce the quantity of nutrients and other pollutants entering waterways

• opting for a vegetated stormwater solution (for example, a constructed wetland) over an engineered system can have environmental and amenity benefits.

Recycling/reusing stormwater is one approach that can be used to improve the environmental outcomes from managing stormwater. In the Commission’s view there is an overemphasis on this approach and, at times, an insufficient focus on actually improving environmental outcomes. Targets are often set for recycling, but in general less attention is given to attaining desired environmental improvements in a cost effective way. Research into using market-based mechanisms for this purpose suggests that significant efficiency gains may be achievable (Nemes et al. 2010). The following section explains why focusing on increasing recycling can produce inefficiencies.

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6.4 Achieving integrated water cycle management

Integrated water management, integrated water cycle management, water sensitive cities and water sensitive urban design are terms that are often used interchangeably. Engineers Australia reported: Integrated water cycle management was initially called water sensitive urban design. State and local government regulators and the stormwater industry have seen water sensitive urban design as primarily dealing with stormwater matters instead of a holistic concept. This is the only reason for a distinction being drawn … (sub. 4, p. 5)

It defines integrated water cycle management as: … a holistic multi-dimensional approach to urban water management where all water resources are used optimally based on the fit for use concept. Water quality and water quantity for all streams of water, including potable water, wastewater and stormwater, are managed together to meet economic, social and environmental objectives in accordance with sustainable development principles. (Engineers Australia, sub. 4, p. 5)

A strong theme in the literature on integrated water cycle management is that traditional approaches that focus separately on water supply, wastewater and stormwater services can produce poor outcomes because interrelationships are ignored. For example, focusing on stormwater harvesting and reuse solely as a water supply option, ignores the avoided costs and environmental benefits that can result from reducing the volume of stormwater. Figure 6.1 provides an illustration of the integrated water cycle for urban water systems.

Current situation

Governments have implemented a range of policy measures that are at least partly aimed to improve integrated water cycle management and/or water sensitive urban design. These include:

• requiring new dwellings to be designed to use less potable water (for example, the BASIX scheme in New South Wales)

• adopting stormwater and/or wastewater recycling targets (for example, the current Victorian Government went to the 2010 state election with a policy to ‘[e]stablish a target of 200 billion litres by 2030 of water to be substituted with water drawn from rainwater, treated stormwater or recycled water’ (Liberal Victoria and the National for Regional Victoria 2010, p. 18))

• subsidising water recycling projects (box 6.5)

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Figure 6.1 Illustration of the integrated water cycle for urban water systems

136

• requiring water utilities to develop integrated water cycle management strategies (for example, regional utilities in New South Wales are required to do this (NSW Government, sub. 65).

A number of inquiry participants gave details of projects they saw as representing good practice in integrated water cycle management (box 6.6).

Box 6.6 Integrated water cycle management examples

• Western Corridor Recycled Water Scheme: comprises three plants that treat sewage effluent to purified recycled water standard for industrial use and potentially to supplement potable water supplies for south-east Queensland. The scheme has the capacity to supply 232 ML of water per day (which suggested an annual capacity of over 80 GL). 25 GL was supplied to the region’s power stations from August 2007 to September 2009 (DERM, sub. 60; Queensland Government nd).

• Pimpama/Coomera Dual Reticulation Scheme: under which urban demand is met from reticulated town water, rainwater and class A+ treated sewage for external use and toilet flushing. The class A+ recycled water is provided from the Pimpama Recycled Water Treatment Plant, which has a capacity of 9 ML per day (which suggests an annual capacity of around 3 GL) (DERM, sub. 60; Degremont nd).

• Doncaster Hill Urban Village: in which recycled and treated stormwater and sewage are to be delivered to residential apartments through a third pipe system. Compared to conventional servicing, it is expected that potable water consumption will be reduced by 64 per cent, wastewater exports by 53 per cent and stormwater exports by 42 per cent (Yarra Valley Water, sub. 19).

• Orange City Council’s Blackmans Swamp Stormwater Harvesting Scheme: is an indirect-to-potable project. The scheme is capable of providing between 1.3 to 2.1 GL of water into Orange’s potable water supply each year, enough to meet up to 40 per cent of the city’s total water needs (LGSA NSW, sub. 63).

• Rosehill Recycled Water Scheme: is a private sector project that will supply recycled water for industry and irrigation in western Sydney. Parts of a disused gas main network are being incorporated into the scheme’s 20 kilometre recycled water transportation network. The scheme is due to commence in mid 2011, with initial production levels of 4.7 GL, which may be increased over time (AquaNet, sub. 49).

• Salisbury stormwater reuse: The City of Salisbury in northern Adelaide has systems in place to provide over 8 GL per year of non-potable water for parkland irrigation, industry and residential use. Initial efforts to harvest stormwater by Council were motivated by the desire to prevent pollution entering the Barker Inlet and damaging mangrove forests (City of Salisbury, sub. 10; Hains 2009).

Those putting forward these examples tended to highlight the fact they involved recycling or reuse of water, without providing evidence that the benefits of the

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project outweighed the cost. The Salisbury stormwater reuse project is somewhat of an exception in that it has reportedly successfully mitigated a clearly identified environmental problem.

Notwithstanding these initiatives, some inquiry participants argued that there was still much to be done to fully realise the potential of integrated water cycle management (Engineers Australia, sub. 4; City of Salisbury, sub. 10; Centre for Water Sensitive Cities, sub. 75).

Scope for efficiency gains

There are broadly two types of efficiency gains available from better integrated and coordinated water management. First, gains from removing unwarranted impediments to water reuse and recycling. Second, gains from redesigning or eliminating government actions that promote inefficient water reuse and recycling. The net result from realising these gains would be that reuse and recycling would be undertaken where it produces net benefits to the community.

Removing impediments

There are undoubtedly instances where a more integrated approach to urban water management would produce efficiency gains through increased reuse and recycling to provide fit-for-purpose water products. The types of gains that may be achieved include:

• reducing the scale and cost of water, wastewater and stormwater infrastructure, for example, through the use of distributed systems that reduce the load on this infrastructure

• improved environmental outcomes, for example, by reducing the quantity of sediment and nutrients entering sensitive waterways.

It is difficult to quantify these potential efficiency gains; however, quantification is not necessary to make progress. In the Commission’s view, the best approach is to identify the impediments to good outcomes and to take cost-effective action to address them. Five of the main impediments are outlined below.

First, there is sometimes a failure to factor in financial costs and benefits accruing across the entire water cycle, either because several organisations are involved or because different functions are considered in isolation within the one organisation. For example, the Australian Water Association (sub. 42) suggested an optimal infrastructure solution that involved higher initial costs for the developer was

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unlikely to be implemented where ongoing savings accrued to other parties, such as Local Governments.

Second, there is sometimes a failure to put an economic value on changes in environmental outcomes and factor these into decision making.

Third, property right arrangements for stormwater and wastewater are often unclear and this can create uncertainty and discourage investment in water recycling projects (box 6.7).

Fourth, underpricing of potable water can prevent efficient recycling projects from being commercially viable (chapter 7).

Fifth, there are barriers to innovation created by water utilities, and health and environmental regulators. For example, Nubian Water Systems argued that there was a compelling case to rapidly increase the use of greywater and other distributed systems but that water utilities and regulators impeded uptake: The Urban Water Sector is characterised in many cities and regions by a structure of monopoly or near-monopoly suppliers. This structure leads to monopoly behaviour. Incumbent centralised suppliers and water authorities are often threatened by the perceived competition that distributed systems bring to the market. (sub. 11, pp. 2–3)

The barriers to innovation created by inconsistencies in regulation is considered further in chapter 5.

Avoiding inefficient reuse and recycling

There is a tendency among some proponents of integrated water cycle management and water sensitive urban design to assume that increased reuse and recycling and decreased reliance on centralised water supply systems are always in the community’s interests. For example, Wong (2006, p. 1.2) states ‘[t]he objectives of water sensitive urban design include … reducing potable water demand through water efficient appliances, rainwater and greywater reuse’.

Such assumptions appear to have had a significant influence on government policy in many jurisdictions, as evidenced by the widespread adoption of water recycling targets and subsidies, and mandatory requirements for new dwellings to be designed to use less potable water. For example, the Victorian Government’s targets referred to earlier appear to be influenced by a parliamentary committee inquiry report that stated: The Committee acknowledges that significant challenges are associated with developing and implementing recycled water schemes (e.g. demand and cost). However, given that only one-quarter of treated wastewater is recycled, the Committee

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Box 6.7 Property right arrangements for wastewater and stormwater Well designed water rights facilitate efficient management of water, which benefits the community. Rights for both consumptive uses and environmental uses of water are needed. In the rural context, irrigators often hold a water right, such as a licence or an entitlement and some of these are tradeable. These rights give individual irrigators a degree of protection from being adversely affected by the water use of others. Without such protection, investing in an irrigation business would be much more uncertain and people would be less likely to do it. Those who did invest could find their business ruined by people upstream taking all the water. Tradeable water rights allow water to be allocated to those who can put it to its highest value use. In urban areas, property rights for wastewater and stormwater have been given much less attention because this water has been seen as a problem to be managed, rather than as a potentially valuable resource. With interest in water recycling and reuse increasing, there is the potential for problems, such as underinvestment and inefficient resource allocation, to emerge. Frontier Economics (2008b) studied these issues in detail and came to a range of conclusions with which the Commission agrees, including the following.

Wastewater

• Where the proportion of wastewater being recycled is relatively low, property rights-related problems are unlikely to arise, but over time allocation mechanisms may be required to provide secure access to the resource.

• Simple approaches, such as providing secure access to existing sewer mining operators and allowing new entrants only where this does not compromise existing operations may be suitable, at least as an interim measure.

• In inland areas, treated wastewater discharged into local waterways can be environmentally beneficial. Wastewater recycling can reduce these environmental flows, and this may need to be addressed through property right arrangements.

Stormwater

• Stormwater can flow through the drainage assets of more than one Local Government (or other stormwater manager). This means that secure access to water for reuse in ‘downstream’ local government areas can be compromised by the actions of ‘upstream’ local governments.

• Institutional and planning changes that allow a whole-of-catchment perspective to be taken on stormwater issues may be a useful first step to achieving appropriate resource security for stormwater reuse projects.

• In some cases it may be beneficial to introduce basic access licences and allocation rules (akin to those that currently exist in some unregulated river systems).

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believes that considerable potential exists to increase the volume of water recycling at Melbourne’s sewage treatment plants. Accordingly the Committee recommends that … The Victorian Government set enforceable water recycling and reuse targets. (Environment and Natural Resources Committee 2009, p. 173)

Although severe drought over recent years may partly explain this way of thinking about reuse and recycling, it is one that is likely to lead to poor outcomes. Demand and cost should not be regarded simply as challenges to be overcome in meeting what someone has arbitrarily decided is the right target. They are important determinants of whether particular reuse and recycling projects make the community better off.

A feature of many current policies is that they promote or mandate water reuse or recycling activities consistently across a broad geographic area, even though their benefits may vary widely depending on the local circumstances. Yarra Valley Water argued: … I want to talk about … this issue about decentralised versus centralised infrastructure, that’s also a major debate in the industry, and also cities of the future or integrated water management seem to be catchcries at the moment. We have done a lot of work in that regard at Yarra Valley Water … and the conclusion we have come to is there certainly isn’t a one-size-fits-all, that what works in one area will not work in another area, and that’s not just physical constraints but by looking at environmental impacts. So having blanket rules that you see in a lot of jurisdictions — … every home should have this facility or that facility, a rainwater tank for example — [which] doesn’t stack up when you look at a sophisticated environmental analysis which is trying to look at alternatives and the overall impacts on the environment. (trans., p. 220)

The scope to achieve efficiency gains through redesigning or eliminating policies that promote inefficient reuse and recycling, relates to measures for rainwater tanks, greywater systems, third pipe recycling systems and the like. The following analysis indicates that the potential efficiency gains from reforming policies relating to rainwater tanks alone may amount to tens of millions of dollars annually.

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Rainwater tank example

In some rural areas rainwater tanks function as the sole source of supply, whereas elsewhere they provide a partial substitute for reticulated water supply. Some domestic rainwater tanks are used exclusively for outdoor watering, while others are also used for toilet flushing and clothes washing. Some people drink untreated tank water in preference to mains water due to the taste; however, health regulators have concerns about this practice (Marsden Jacob Associates 2007).

The use of rainwater tanks has become more common over recent years. Twenty six per cent of Australian households used a rainwater tank as a source of water in 2010 compared with 17 per cent in 2004 (ABS 2010c). Over this period the number of households with a rainwater tank increased by about 664 000, with most of this growth occurring in capital cities (ABS 2010c). Many schools, sports facilities and businesses have also installed rainwater tanks.

If there were no government policies that promoted or discouraged the use of rainwater tanks, decisions about installing them would depend on their costs relative to the costs of mains water and people’s perceptions of their other advantages and disadvantages. For example, some people might have a preference for rainwater tanks for environmental reasons, while others might be put off by the need to maintain them.

Such a ‘hands off’ approach by governments would not produce efficient outcomes if there were significant positive (or negative) externalities from the use of rainwater tanks. That is, people would tend not to install and use rainwater tanks to the extent warranted by their overall net benefits to the community. Where there are significant positive externalities there may, therefore, be an efficiency rationale for governments to encourage their use.

In Australia, governments do encourage the installation of rainwater tanks directly by providing rebates and through regulations that require rainwater tanks, or other measures that reduce mains water use, to be installed for new dwellings (box 6.8). In addition, the use of water restrictions indirectly promotes the installation of rainwater tanks for those households that can afford them, as it provides a source of water that can be used for any purpose, including to maintain gardens in a healthy condition. Survey results indicate that rebates, regulations and water restrictions are a reason for the installation of rainwater tanks in between one-third and one-half of cases (ABS 2010c).

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Box 6.8 Rainwater tanks: examples of subsidies and regulations

Subsidies

• The Australian Government provides rebates for the purchase and installation of a new rainwater tank(s) which is connected to the toilet and/or laundry by a licensed plumber. The rebate for tanks with a capacity of between 2000 and 3999 litres is $400. A $500 rebate applies for tanks with a capacity greater than 4000 litres (DSEWPC 2010a).

• The Water Smart Gardens & Homes Rebate Scheme is a Victorian Government scheme that offers rebates for the installation of rainwater tanks, as well as other water saving appliances. Over 200 000 rebates (for all water saving items) have been claimed under this scheme. Rainwater tank rebates range from $150 to $1000. The $1000 rebate is for a tank with a capacity of at least 4000 litres that is connected to the toilet and laundry.

Regulations

• BASIX is a mandatory NSW Government initiative that aims to ensure that homes are built to be more water and energy efficient, by setting energy and water reduction targets. It requires new houses and residential units in Sydney and some other areas of the state to be designed to use at least 40 per cent less potable water compared to the average NSW dwelling (BASIX ndb). 90 per cent of new homes in New South Wales are covered by this target. While a range of measures can be used to help meet the target, the most common means is installation of a rainwater tank.

The efficiency of these measures depends on how well they align with the externalities associated with rainwater tanks, as well as on their administrative and compliance costs. Three commonly cited reasons for government policies to encourage the installation of rainwater tanks are to:

• lessen the need for investment in large-scale water supply augmentation

• reduce water and stormwater infrastructure costs

• achieve environmental benefits associated with reduced stormwater flows.

First, increased use of rainwater tanks does have the potential to lessen the need for investment in large-scale water supply augmentation, but this does not provide a valid rationale for government intervention. This is because such reduced investment would only be brought about by thousands of small-scale investments in rainwater tanks. The need for investment is not avoided, there is just a change from one type of investment to another. Efficient investment in supply augmentation can be promoted by ensuring that mains water is priced efficiently (chapter 7) and

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leaving people to decide for themselves whether or not to buy a rainwater tank. There is no augmentation-related externality that would justify a subsidy.

Second, the use of rainwater tanks reduces water flows through the mains water system. If a large proportion of households in an area use rainwater tanks this might allow smaller mains water pipes to be laid, which would provide a cost saving. Also, some water may be captured in rainwater tanks during storm events, lessening the volume of runoff. With reduced runoff, the scale of stormwater infrastructure that is needed to provide adequate flood protection might be reduced and this might allow cost savings to be made. Where either type of cost saving occurs, rainwater tanks may produce a positive externality because the savings generally accrue to the community generally.

Marsden Jacob Associates (2007) found, however, that the potential cost savings were largely confined to greenfield sites. In other areas, infrastructure is already in place and reducing its use would generally not translate into a cost saving. Sydney Water reported that this was not always the case: Generally Sydney Water’s water, wastewater and in some areas stormwater systems have capacity to accommodate new infill development. In some areas though, there are capacity constraints. In these areas, the costs of system upgrades may be reduced [by a range of measures, including stormwater detention, regulatory measures such as BASIX and small-scale localised recycling units]. (sub. 21, p. 9)

Marsden Jacob Associates (2007) also found that rainwater tanks were not always effective at reducing the necessary scale of stormwater infrastructure. Stormwater infrastructure is generally designed for peak events. Marsden Jacob Associates analysed the top ten rainfall events for Sydney over the last 100 years and determined that in many cases rainwater tanks would have been full or nearly full prior to the event (due to rainfall over preceding days) and, therefore, would have caused only a negligible reduction in runoff. In general, whether rainwater tanks are effective at reducing the necessary scale of stormwater infrastructure will depend on the size of tanks, the area of roof from which they receive water, whether they are used for indoor as well as outdoor uses and climatic factors.

Third, capture of runoff in rainwater tanks may reduce the quantity of nutrients entering environmentally sensitive waterways, thereby providing an environmental benefit. For example, Melbourne Water have identified that rainwater tanks can reduce the amount of nitrogen entering waterways. In recognition of this benefit, they do, under certain circumstances, reduce developer charges where rainwater tanks are installed. For example, the reduction for rainwater tanks connected to a large roof area (150m2) was $160 in 2007 (Marsden Jacob Associates 2007).

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This appears to be an example of a sound approach to encouraging the installation of rainwater tanks as the incentive is aligned with the environmental benefit. It contrasts with approaches by the Australian and State and Territory Governments that do not generally bear any relationship to environmental benefits.

In summary, if policies to encourage the use of rainwater tanks are to be efficient they need to be aligned with the positive external benefits they provide and have low administrative and compliance costs. There is evidence that the external benefits are generally fairly small (relative to the cost of rainwater tanks), but in specific circumstances may be substantially higher due mainly to infrastructure cost savings or environmental benefits. By contrast, the incentives for installing rainwater tanks resulting from government policies are generally high and do not vary according to circumstance.

It can be concluded, therefore, that current policies to encourage the installation of rainwater tanks are likely to be inefficient and that redesigning or discontinuing them could provide an efficiency gain. Marsden Jacob Associates (2007) examined the communitywide costs and benefits of installing rainwater tanks in the five largest capital cities and found that in most cases costs exceeded benefits by more than $2000 per tank. While this does not include the intangible benefits that some people experience from owning a rainwater tank, and the figures are a few years old, this analysis suggests that the inefficiencies associated with current policies may amount to several tens of millions of dollars per annum. The inefficiencies will tend to be highest in regions that currently have surplus water supply capacity.

6.5 Scope for efficiency gains in regional urban areas

In broad terms, the opportunities for efficiency gains discussed in the other sections of this chapter apply to both metropolitan and regional urban areas. There are, however, some opportunities that are less or more significant for regional areas compared to metropolitan areas. For example:

• decisions to build desalination plants appear to have resulted in major inefficiencies in some metropolitan areas but this has not been the case in regional areas (where such plants are usually not considered feasible)

• restrictions on transfers of water between irrigation and urban use are generally less prevalent in regional areas and so the scope for efficiency gains from removing them is less (there are, however, barriers to trade between regional urban water utilities that impede efficiency (chapter 11))

• a significant number of regional water utilities fail to meet the water quality standards of the Australian Drinking Water Guidelines and/or issue ‘boil water’

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alerts, whereas this is rare in metropolitan areas (Armstrong and Gellatly 2008; Local Government Association of Tasmania, sub. 64)

• it would appear that inefficient asset management is particularly prevalent in some regional areas, due to a shortage of staff with appropriate skills and experience and/or lack of financial resources to undertake asset upgrades (Midcoast Water, sub. 51; Kempsey Shire Council, sub. 30; Tasmanian Water and Sewerage Corporations, sub. 43; AWA 2008).

On the latter two points the Tasmanian Water and Sewerage Corporations reported that reforms in that state were driven mainly by ‘concern at the state of water and sewerage assets and the adverse public health and environmental outcomes that were being observed as a result of infrastructure deficiencies’ (sub. 43, p. 3). The Local Government Association of Tasmania (sub. 64) stated that prior to reform, 70 per cent of council-run water utilities had no strategic asset management plan.

In considering the scope for efficiency gains in regional urban areas it should be recognised that factors such as population density, population growth, proximity to metropolitan areas and the endowment of water resources strongly influence the costs and challenges of providing urban water services. These factors vary greatly across regional areas, for example, there are:

• coastal areas that have relatively high population densities, are growing and are close to a capital city (for example, Geelong, Mandurah, the Gold Coast and the Sunshine Coast)

• areas that share the above characteristics, but that are more distant from a capital city, making interconnection of water supply systems less economic (for example, Port Macquarie and Cairns)

• inland cities and towns that are close to major rivers and whose urban water supply system shares infrastructure with the irrigation sector (for example, Albury, Wodonga, Mildura and Renmark)

• areas that are proximate to, or share water resources with, major industrial or resource projects and facilities that have significant water needs (for example, Gladstone and Karratha)

• regions with reasonably low population densities that are remote from both capital cities and major irrigation industries (for example, north-west Tasmania, and the Eyre Peninsula)

• remote regions that have very low population densities, with isolated communities, including Indigenous communities, that rely on reticulated water supply systems (for example, much of the Northern Territory).

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Because of this diversity it is not valid to simply observe differences in costs or service levels between regions and draw conclusions about the performance of regional water utilities. For example, NWC and WSAA (2010a) shows that water and sewerage operating costs per property tend to increase as the size of water utilities decrease. There is no easy way to tell, however, the extent to which this is due to small utilities facing a more difficult operating environment and the extent to which it is due to them underperforming relative to larger utilities (if at all).

There is, however, evidence to suggest that substantial efficiency gains could be achieved by some form of amalgamation or alliance between small regional water utilities, which could be combined with governance reforms. This opportunity exists mainly in parts of New South Wales and Queensland, as other jurisdictions, including Victoria and Tasmania, have already implemented reforms to aggregate small utilities. It is striking that there are 177 urban water utilities that service regional New South Wales and Queensland, and only about 30 that service the remainder of Australia (chapters 2 and 13). Many utilities in regional New South Wales and Queensland service fewer than 10 000 connected properties, with some servicing fewer than 1000.

Relevant sources of evidence include:

• the Report of the Independent Inquiry into Secure and Sustainable Urban Water Supply and Sewerage Services for Non-Metropolitan NSW (Armstrong and Gellatly 2008)

• the Review of Regional Water Quality and Security prepared for Infrastructure Australia (AECOM 2010)

• material put forward by several inquiry participants (Kempsey Shire Council, sub. 30; Australian Water Association, sub. 42; Midcoast Water, sub. 51)

• Australian and international studies on economies of scale of water utilities (for example, Tynan and Kingdom 2005)

• reviews of amalgamations undertaken to date (for example, Martin 2004).

Many small water utilities, however, are operated by local governments and it is possible that their remaining functions would become less efficient if water were separated out into larger regional entities. That is, the removal of water services from local governments may reduce their economies of scope and/or scale. The reform challenge, therefore, is to more fully exploit economies of scale, while recognising possible impacts on the efficiency of local government. Chapter 13 assesses the available evidence and makes recommendations for reform.

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At the other end of the spectrum, the vast majority of Western Australia, South Australia and the Northern Territory are each serviced by one water utility. In these cases, there may be diseconomies of scale currently present and other benefits may flow from disaggregation, a proposition that is also tested in chapter 13.

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7 Pricing of water and wastewater

Key points

• Pricing plays an important role in providing the signals that guide behaviour on both the demand and supply sides of the urban water sector.

• All elements of the urban water supply chain need to be priced in a way that reflects the efficient cost of providing those services to consumers, and need to be transparently identified on customer bills.

• More flexible pricing of bulk water would facilitate better allocation of water resources and supply investment decisions by ensuring that the price of water reflects its relative availability. It would work together with other reforms, such as removing policy bans on supply augmentation options, and adopting a real options approach to planning, to unlock these gains.

• Recycled wastewater and stormwater are currently underpriced. In many places, recycled water prices are below potable water prices, despite the costs being much higher. Recycled water should be subject to the same efficient pricing principles as potable water.

• Current pricing structures for water and wastewater transmission and distribution infrastructure are broadly in line with efficient pricing principles. However, there is scope to enhance efficiency by reforming developer charges for the provision of infrastructure to new sites to better reflect the costs involved.

• Flexible pricing at the retail end would have additional benefits from being able to influence consumption patterns in line with the availability of water and better match individual preferences of consumers. It would not need to be introduced in a prescribed way. It could take place within efficient pricing guidelines that include: – more comprehensive use of consumption-based pricing, including the direct charging of water usage to tenants – moving away from inclining block tariffs to a single flat volumetric charge – moving away from postage stamp pricing to more location-specific pricing that reflects the costs of service provision in different locations, where justified by a cost–benefit analysis – the flexibility for utilities to offer greater choice in product service offerings, so that consumers can choose tariff structures that best suit their preferences for price stability and security of supply.

• The National Water Initiative pricing principles are unclear and provide too much flexibility in implementing pricing policies that are not necessarily in line with the principles of economically efficient pricing.

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Pricing is a mechanism by which resources are allocated in the economy. It provides the signals that guide behaviour on both the demand and supply sides of the urban water sector.

On the demand side, prices are used to ration the use of existing scarce resources. Non-price tools such as restrictions, and water efficiency and conservation measures, are another way of managing demand. To date in Australia, reliance has been placed primarily on non-price tools (Byrnes, Crase and Dollery 2006). These are discussed in chapter 8.

To maximise benefits to the community, prices need to reflect the efficient costs of providing a good or service (Bonbright, Danielsen and Kamerschen 1988). When prices unnecessarily exceed costs, they act as a tax on consumers. Households are left with less income for other uses, and the competitiveness of businesses is reduced. When prices are below costs, consumption is being subsidised, thereby encouraging excess consumption, placing pressure on existing capacity, and bringing forward the need to expand capacity.

On the supply side, prices are used to induce production and signal the need for investment in capacity. Prices are also the primary means by which water businesses obtain revenue to recover the costs incurred in service provision. For a business to continue operating in the long run, prices need to be sufficient to generate enough revenue to enable both capital and operating costs to be recovered. This includes an appropriate risk weighted return to investors, interest payments on debt, labour, purchases of other inputs into production, and the cost of any externalities (BIE 1995). When this is not the case, there will not be an adequate return on existing assets and, of greater relevance for economic efficiency, there will not be adequate incentives for infrastructure providers to undertake efficient investment in either upgrading or augmenting infrastructure.

In this chapter, the efficient pricing of each element along the urban water supply chain is examined, according to its particular cost structure and demand and supply characteristics. Establishing what represents efficient pricing for each element of water and wastewater services provides a benchmark against which current pricing arrangements can be assessed and, in turn, the scope for efficiency gains from reform can be determined.

This chapter treats each element as distinct even if, for reasons such as economies of scale or scope, multiple elements are in practice supplied by the same entity. This is because the prices of the various supply chain elements need to be transparent even when there is a single provider of water and wastewater services.

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This chapter also focuses on the principles of efficient economic pricing which hold irrespective of the ownership of utilities and the prevailing structural, institutional and regulatory arrangements, all of which are discussed in detail in chapters 11–13 of this report.

Section 7.1 examines bulk water pricing, and a case is made for a more flexible approach to pricing bulk water.

The pricing of wastewater and stormwater services is discussed in section 7.2, including pricing issues associated with recycling.

Pricing of the water and wastewater transmission and distribution networks is discussed in section 7.3, with a focus on the natural monopoly characteristics of these networks and the effect this has on the way they are priced. Developer charges associated with the expansion of networks to service new customers are also examined.

Final retail prices are analysed in section 7.4. Retail prices are essentially a pass-through to consumers of the price of each element previously discussed, together with a retail margin. The merits of current pricing practices, such as inclining block tariffs and postage stamp pricing are examined, as well as the desirability and feasibility of introducing more flexible pricing.

Section 7.5 provides an assessment of the current National Water Initiative (NWI) pricing principles, in light of the Commission’s main findings and recommendations.

7.1 Pricing of bulk water

In this report, pricing of bulk water refers to the price paid for extracting water from bulk supply sources (such as dams, aquifers, rivers and pipelines) or, in the case of desalination, manufacturing water; storing it; transporting it to a treatment plant; treating it to a fit-for-purpose standard; and transferring it to the shared transmission network.

Current bulk water pricing approaches

Current pricing approaches provide a benchmark against which efficiency gains to be achieved by moving to flexible pricing of bulk water can be assessed.

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Approaches to pricing bulk water differ across jurisdictions and, in some cases, within jurisdictions, particularly between metropolitan and regional urban areas.

A key distinction can be made in the pricing approach for those urban water systems where bulk water is vertically separate from the retail–distribution function. This occurs in Melbourne, Sydney and south-east Queensland.

• Melbourne Water’s bulk water charges are regulated by the Victorian Essential Services Commission (ESC) and set every four years. Bulk water is priced as a two-part tariff. The volumetric charge to the five retailers serviced by Melbourne Water is set in accordance with Melbourne Water’s long-run marginal cost (LRMC), and the fixed charge is set as the residual to ensure cost recovery.

• Bulk water charges for Sydney Catchment Authority (SCA) are set by the Independent Pricing and Regulatory Tribunal (IPART) every three years.1 The volumetric prices charged to Sydney Water and the Local Governments (Shoalhaven City Council and Wingecarribee Shire Council) supplied by SCA are set in reference to LRMC, and account for about two-thirds of SCA’s revenue. Sydney Water is also charged a fixed water service fee as a residual to meet the annual revenue requirement of SCA (IPART 2009a). The two Local Government utilities are not charged a fixed component. – The Sydney Desalination Plant Pty Ltd (SDP) is a wholly owned subsidiary of Sydney Water. Consistent with the vertical separation of bulk water supply, it is intended that the prices Sydney Water pays for water from SDP will be regulated by IPART in the same way as the SCA’s bulk water prices (Sydney Water, sub. 21). For prices to be regulated, SDP would need to be declared as a monopoly under section 51 of the Water Industry Competition Act 2006 (NSW). This has not happened to date. Prices are currently determined bilaterally between SDP and Sydney Water.

• Bulk water charges in south-east Queensland are set by the Government. Only a volumetric component is charged. The Government has set a 10 year price path starting from 2008, targeting a 4 per cent rate of return, lower than the 7 per cent recommended by the Queensland Water Commission (Council of Mayors, sub. 77). The price path was then adjusted down in December 2010.2 A common final price point has been set for all Local Governments, but the price path over a

1 Treatment of water is not included in SCA bulk water charges. This is because treatment is conducted by private parties in Sydney. Water treatment charges therefore form part of Sydney Water’s retail tariff determination. 2 According to a report by the Monash University Centre for Regulatory Studies prepared for the Council of Mayors SEQ ‘these changes were made possible by not building the Traveston Dam, putting the Tugun desalination plant and Gibson Island water treatment plant in standby mode, and merging Seqwater and Watersecure’ (Cousins 2010, p. 19).

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10 year period to reach this point differs, with some Local Governments reaching it in earlier years than others. Once the final price point is reached, bulk water price increases are based on inflation. – The Queensland Competition Authority (QCA) will take over price determination from 1 July 2013 (QCA 2010a).

All other metropolitan and regional urban water systems are serviced by vertically-integrated water providers:

• In some cases, such as the statewide utilities in Western Australia, South Australia, the Northern Territory and the ACT, as well as in regional urban areas in Victoria (not serviced by Melbourne Water), and in the Hunter Valley and Broken Hill, final retail prices are regulated and, therefore, bulk water forms part of that final price determination (section 7.4).3 – In the ACT, a Water Abstraction Charge is set by the ACT Government and is payable by ACTEW Corporation. The charge is designed to account for the costs of catchment maintenance and Government expenditure, the scarcity value of water, and the costs to the environment from the flow of water downstream (ActewAGL 2011a).

• In regional urban areas in New South Wales and Queensland (excluding the south-east region), neither bulk nor retail prices are regulated. Final prices are set by utilities annually according to guidelines (which are provided by the Office of Water in New South Wales, and set out in the Local Government Act 2009 (Qld) and the QCA’s pricing principles in Queensland), and the bulk water component of that is determined internally within the vertically-integrated utility.

Scope for efficiency gains in moving to more flexible pricing

As explained in chapter 6, the Commission’s view is that large efficiency gains could be achieved from better allocating water resources and making better supply augmentation decisions. To facilitate this, bulk water prices need to:

• allocate water optimally between periods of time using dam storages and inflows

• send efficient signals about the size and timing of supply augmentation, in the presence of uncertainty about future inflows

• cover the cost of the resources used in supplying capacity.

3 From 2012, this will also be the case in Tasmania, when independent economic regulation of price is introduced (trans., p. 400). Currently, final prices are set in line with provisions in an interim price order.

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This can be achieved using a flexible pricing mechanism.

What is flexible pricing for the bulk water sector?

Under flexible pricing, prices adjust to the demand–supply balance and, in doing so, reflect the opportunity cost of water.

Opportunity cost refers to the value of the best alternative that is foregone when inputs are used to produce water. Where there is excess capacity in bulk water (supply exceeds demand), the opportunity cost of water is approximately equal to the short-run marginal cost (SRMC) of supplying water from the cheapest supply source. Where there is a capacity constraint in place (demand exceeds supply) the opportunity cost also incorporates the scarcity value of water. As water can be stored, at all times (with and without excess capacity) the opportunity cost also includes the expected value of water stored and carried over for use in the future. This value increases as current (and expected future) water availability decreases.

When prices are allowed to adjust to reflect the opportunity costs under flexible pricing, the efficient price will be state-dependent, meaning it will vary depending on the prevailing conditions of supply and demand and, critically, the current availability of water. It will be the greater of the market clearing (opportunity cost) price in that period or the SRMC of supplying water from the cheapest source of supply. Price rises will be driven by decreased water availability due to lower rainfall or an increase in environmental allocation, as well as increases in demand caused by, among other things, population growth (Sibly 2006b).

Investment decisions and cost recovery under flexible pricing

The bulk water sector involves large lumpy investments and, as such, there will be excess capacity over significant ranges of output, average costs will be declining over this range, and SRMC will be lower than average costs. Pricing at SRMC will, therefore, result in losses.

Therefore, for an investment to be economically viable ex ante, there needs to be an expectation that price will be above SRMC often enough to ensure that capital costs are recovered over the life of the asset. The extent to which price is expected to be above SRMC will influence the size and timing of investment.

Once the asset is built, the availability of water will increase and the price will therefore decline, potentially leading to losses on the new source of supply until scarcity emerges (demand exceeds supply), inducing an increase in price, and generating a scarcity rent that goes toward recovering capital costs. Higher prices

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will eventually signal the need for further investment. This will occur only when the present value of the expected revenue from the investment exceeds the expected cost of building the new plant. And the cycle continues, leading to a ‘saw tooth’ pricing pattern (for more detail, see PC 2011a).

This pattern means that even if there are substantial economies of scale and decreasing average costs, capital cost could still be recovered over the life of the asset through the scarcity rents earned at times when capacity is constrained.

Whether or not this actually occurs ex post will depend on how closely actual rainfall and demand outcomes match those that were expected at the time the ex ante investment decision was made:

• If there is more rainfall than was expected at the time of the investment decision, the value of the water from the new plant will be low and the investment might be loss making. Water will still be supplied from the investment whenever the market price exceeds SRMC, but a loss will be made on the investment if prices and sales over time do not generate revenue in excess of operational costs to cover capital.

• If there is less rainfall than was expected, the value of the water will be higher than expected and a profit will be made.

These ex post outcomes highlight the risky nature of investments in bulk water infrastructure related to the uncertainty about future inflows to storages (see below). Although the ex ante decision to invest is optimal on an expected value basis, the ex post result can be quite different from what would have optimally been chosen had the future been known with certainty.

What are the efficiency gains?

Prices set at LRMC over a number of years, or according to a government-determined price path, are not flexible. They involve a price with a mark-up over SRMC that is averaged over time and fixed in all periods. This can lead to inefficient outcomes when there is a high degree of uncertainty involved, as there is in the water sector with rainfall events (Sibly 2006b):

• When there is a water shortage, LRMC significantly underprices water because it fails to reflect the opportunity cost of current water consumption, which will at times be greater than the LRMC. This leads to over consumption of water and will tend to bring forward investment in supply augmentation.

• At times of high storage levels and low demand, water is overpriced. This will cause some people to forgo some water consumption that they would have

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valued and will delay investment in supply augmentation that would benefit the community.

Flexible pricing, on the other hand, allows the mark-up over SRMC to vary in line with changes in the supply–demand balance. In doing so, it accounts for the variability in rainfall and inflows, and aligns prices more closely with the opportunity cost of water.

Under flexible pricing, the first response to a reduction in the availability of water is to raise the volumetric price. If a small increase in the volumetric price reduces demand sufficiently, then the benefits of expanding capacity are unlikely to outweigh the costs. On the other hand, if a more sizeable increase in price is required to reduce demand, then it is possible that the benefits of additional capacity outweighs the cost. Therefore, flexible pricing can beneficially postpone investment in supply augmentation (Grafton and Ward 2010).

Essentially, a flexible pricing approach better prices the water resource itself. In contrast, a regulated LRMC price focuses on pricing the infrastructure used to supply that water. Flexible pricing sends more appropriate signals about when to draw on various water sources, leading to a more efficient allocation of water resources. It also sends more appropriate signals on when, and how much, to invest in new sources of supply, leading to increased dynamic efficiency. Flexible pricing goes hand-in-hand with the measures identified in chapter 6 aimed at better allocating water resources and making investment decisions, such as introducing a real options approach to supply augmentation decisions.

Where utilities are fully integrated entities, there are no bulk water prices as such and resource allocation decisions are made internally within the firm. These decisions are made according to the opportunity cost of their available bulk supply sources, subject to the various other (non-bulk price) constraints imposed on them such as policy bans and regulated retail prices. Nevertheless, the principles of flexible pricing should still be used by vertically-integrated utilities as a discipline on their decision making processes. Furthermore, the fact that there are no bulk prices expressed for vertically-integrated utilities does not distract from the merits of an options-based approach to making supply augmentation decisions.

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The benefits from more efficient flexible pricing of bulk water are likely to be greatest where they reduce the need for investment in supply to cover consumption in low rainfall periods. Now that the urban water system in most jurisdictions is facing excess capacity for potentially several years ahead (following the large investment in supply augmentation that has taken place recently), the gains to be had from flexible pricing will be less in the short run since the need for the next supply augmentation is likely to be several years away.

Impediments to achieving these efficiency gains

There are some impediments to moving towards a more flexible pricing regime for bulk water.

Price regulation

A major impediment to introducing more flexibility in bulk water pricing is the regulated price setting environment existing in some jurisdictions. In this situation, prices are set for several years at a time. For flexible pricing to operate effectively, bulk water prices need to be free to move in line with changes in the demand– supply balance.

Within an appropriate governance framework, a price monitoring regime would allow flexible pricing whilst maintaining oversight of potential abuse of market power if there was concern of this occurring.

The issue of price regulation is discussed in chapter 11.

Achieving cost recovery

As explained above, under flexible pricing, ex ante investments in new supply will only be made if revenues are expected to recover the expected costs of the investment over the life of the asset. Ex post, however, prices could equal SRMC for long periods of time if rainfall is higher than expected, or demand is lower than expected. This could mean losses for bulk water service providers for many years and the risk that capital costs are never recovered. If costs are not recovered, this could lead to:

• reduced incentives to maintain and expand capacity, and reduced quality of service

• the bulk water service provider eventually ceasing operations

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• potential entrants into the bulk water market being discouraged from entering the market.

Equally, it is also possible that gains will be made if, ex post, lower rainfall results in increased demand for the new bulk water source, leading to a mark-up above SRMC, possibly for considerable periods of time.

The uncertainty of the ex-post outcome reflects the fact that bulk water investments are risky. On an ex post basis, sometimes the investment will be profitable, and at other times the investment will make a loss. The outcome will depend on patterns of rainfall compared with what was expected at the time the investment decision was made, which essentially determines the level of demand for the new bulk water source. This point was made by Sydney Water: The suggestion that temporarily higher prices (of an unknown duration) will create an incentive for entry to the bulk water market needs to be thoroughly tested. While private sector involvement is extensive in the water industry, the private sector has not to date shown an appetite to accept significant demand risk. (sub. 68, p. 6)

In addition, AquaNet stated: Water infrastructure investments are generally long-lived and depend for their viability on predictable cash flows, especially in early years. In the issues paper, the Commission canvasses scarcity pricing as a means of managing demand in the face of supply variability. The NWC also discusses this option. In AquaNet’s view scarcity pricing, if implemented, would add greatly to the risk of infrastructure investments that are already marginal. (sub. 49, p. 4)

Bulk water service providers cannot be made to bear all of the demand risk, as this will deter commercial involvement altogether. But nor should they face none of this risk. Guaranteeing the recovery of costs for the bulk water service provider by shifting all of the risk on to the retailer–distributor, which can always recover its costs by levying a fixed charge on consumers (who, in the absence of retail competition, have no choice but to purchase water from them) could result in inefficient bulk water investment decisions.

Risks need to be appropriately shared between the two parties to the contract: the bulk water service provider and the retailer–distributor. This can be achieved through the contractual agreement reached between the parties for the investment. Some contractual options include:

• a guaranteed volume to be purchased each year, with the price varying according to a pre-determined relationship between price and total available water in storage

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• a two-part tariff regime to allow revenue certainty, where the fixed charge increases when there is excess capacity and volumetric prices are set at SRMC, and decreases (and possibly falls to zero) when the volumetric price rises in response to scarcity.

Over time, as market mechanisms in urban water develop, the opportunities to reduce risk will increase.

To the extent that the retailer–distributor takes on risks, or to the extent that the bulk water supplier and retailer are the same entity, the risks will tend to be borne by the final consumers of the water when there is no retail competition. This is because, in the absence of retail competition, consumers cannot opt out of using the services of the incumbent retailer–distributor.

In summary, concerns regarding cost recovery under a system of flexible pricing do not present a strong impediment to introducing flexible pricing. Bulk water investments are risky and ex-post returns cannot be guaranteed. However, risks can be shared between bulk water service providers and retailer–distributors under clearly defined contractual arrangements.

7.2 Pricing of wastewater and stormwater services

This section analyses the efficient pricing of bulk wastewater and stormwater services, as well as recycled wastewater and stormwater. Wastewater, as defined in this inquiry, comprises sewage from households, and tradewaste for industrial businesses, and these are both covered in this section. The network infrastructure related to wastewater is discussed in section 7.3.

The bulk wastewater service system comprises:

• wastewater treatment plants to remove the sludge or biosolids from the wastewater, and treat the wastewater to varying levels (for example, primary or tertiary treatment, depending on the receiving environment and prevailing environmental standards)

• disposal of the wastewater via transport and discharge to rivers or the ocean or by providing it for recycled water generation.

Stormwater services refer to the collection, transportation and discharge of stormwater. The stormwater system includes:

• the local drainage system that collects stormwater and transports it to the main drain

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• main drains that transport stormwater to its discharge location or to water recycling facilities.

Current pricing practices

Wastewater

Household sewage services tend to be charged as a single fixed periodic charge on either a per property basis or meter size basis (ESC 2007). The exceptions are for some Victorian retailers and Hunter Water in New South Wales, where a two-part tariff for sewage is charged, with the volumetric component set according to a formula based on assumptions about the volume of water coming into a property that is discharged to the sewer system (ESC 2009c).

Tradewaste charges typically comprise:

• fixed one-off and annual fees, such as application and agreement fees

• volumetric charges — based on the volume and composition of tradewaste discharge.

Stormwater

Stormwater tends to be priced as a fixed periodic charge. In some areas, it is funded by Local Government rate collections.

Scope for efficiency gains in pricing of bulk wastewater and stormwater

Wastewater

The cost structure of the bulk wastewater sector is very similar to the bulk potable water sector. It has variable costs associated with treatment and pumping of wastewater, and fixed costs associated with the related treatment plant infrastructure.

Therefore, there might be an efficiency case for a volumetric charge for wastewater since its treatment and pumping involve variable costs, and sometimes these are considerable (chapter 2). However, the costs need to be weighed against the benefits of volume-based charging.

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Significant costs might be incurred in developing and implementing the systems for volume-based charges. The benefits are a more efficient waste management system and extension of the life of existing disposal facilities.

Volume-based charging is likely to be of most benefit where disposal costs are high.

Household sewage

The cost of installing separate wastewater meters in households is unlikely to be outweighed by the benefits of doing so.

One less costly option to enhance efficiency is to price according to the relationship between water supplied and wastewater discharged, so that volumetric charges for water use could approximate the variable cost of both supply and wastewater management. This is done by Hunter Water in New South Wales, and some retailer–distributors in Victoria (including the three largest metropolitan retailer– distributors), which have a usage component for wastewater charged per kilolitre. As noted above, the volumetric sewage charge is based on assumptions of the volume of water coming into a property that is discharged to the sewer system (ESC 2009c). Some make further adjustment to account for reduced estimated sewage discharges in summer in line with greater outdoor usage. The sewage disposal charge usually averages about 70 per cent of metered water use in Victoria.

However, for this approach to be economically efficient, account needs to be taken of the fact that the relationship between water use and sewage discharge will not always hold tightly. Because some households water their gardens and fill their pools while others do not, the ratio between water supplied and water returned to the wastewater system will vary across consumers. Therefore, trying to build into the volumetric charge a component of price to reflect the variable cost of wastewater would have efficiency implications. Further, the cost of fitting meters to separately monitor outdoor use, for example, would be very costly.

The three major metropolitan retailer–distributors have proposed to combine their existing volumetric charges for water and wastewater into a single charge, because: the volumetric sewage charge is not well understood by the public, and because customers see water and sewage use as one decision and rarely differentiate between ‘water in’ and ‘water out’ (ESC 2007). According to Yarra Valley Water, this is supported by customer research (Yarra Valley Water, pers. comm., 24 March 2011).

More generally, it is unlikely that demand for domestic sewage services can be influenced by price to the same degree as demand for water overall, given that

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households have less scope to adjust their use of indoor (as opposed to outdoor) water in response to price changes, which is what determines wastewater production (IC 1992).

The costs associated with volumetric charging of household sewage are likely to outweigh the benefits achieved by more accurately reflecting costs. As household sewage already tends to be priced as a fixed charge in most jurisdictions, there is little scope for efficiency gains from moving away from this, unless metering technology advances greatly to reduce the cost of installation.

Tradewaste

Load-based pricing of tradewaste is becoming more widespread. Load-based pricing of tradewaste reflects the cost drivers of treatment, disposal and management of tradewaste. It signals to customers the costs of discharging to the wastewater system compared with waste minimisation and on-site treatment.

Where the costs of measuring load factors do not outweigh the benefits, there are efficiency gains associated with moving to more load-based pricing of tradewaste. This is likely to be most relevant for large industrial users, where the benefits of sending a price signal are likely to be greatest.

With improvements in measurement techniques, new and lower cost opportunities for measuring the contaminants in different tradewaste are likely to become available. This might facilitate more refined differential charging systems for tradewaste of different pollution loads (Freebairn 2008).

There is likely to be scope for efficiency gains in load-based pricing of tradewaste for large industrial users where the benefits of doing so are most likely to outweigh the costs of installing metering technology.

Stormwater

There are very few variable costs in providing stormwater services. For example, treatment primarily involves little more than screening of stormwater outlets or passage through natural or artificial wetlands (IPART sub. 58). As such the stormwater sector can be thought of as being an entirely fixed cost operation.

Given that stormwater services are already currently charged as a fixed fee, there is little scope for efficiency gains in changing the way that stormwater services are priced. Indeed, much of the stormwater infrastructure in Australia is provided by Local Governments as part of their general infrastructure and is funded from their

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general revenues. The Commission has no evidence of any distortions being created by this approach.

Recycling of wastewater and stormwater

Current pricing practices

The NWI called for the states and territories to develop pricing policies for recycled water and stormwater by the end of 2006, that are ‘congruent with pricing policies for potable water, and stimulate efficient water use no matter what the source’ (COAG 2004, p. 14). The 2010 NWI pricing principles subsequently provided further guidance to assist the states and territories meet this commitment. The nine principles articulated are:

• flexible regulation

• a beneficiary pays approach to cost allocation (see below)

• a volumetric charge component

• regard to the price of substitutes

• prices that reflect differentiation in the quality or reliability of water supply

• prices that reflect the role of recycled water as part of integrated water resource planning

• full recovery of efficient costs

• transparency

• a gradual approach to pricing.

In New South Wales, IPART regulates the price for mandatory recycling schemes, but not voluntary schemes. Its pricing approach for voluntary recycled water customers does, however, include high-level pricing principles to be used in pricing negotiations. These were developed in 2006 (IPART 2006b).

In Victoria, recycled water prices are regulated through a combination of scheduled prices and pricing principles. The pricing principles were developed in 2007 and apply in cases where recycled water services are provided to large non-residential or unique customers. Prices charged for third-pipe recycled water services must be reflected in the businesses’ proposed tariff schedules and are subject to the annual price approval process.

In South Australia, the Essential Services Commission of South Australia (ESCOSA) is in the process of advising the State Treasurer on the form of

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economic regulation that should be applied to recycled water in South Australia (ESCOSA 2010). Among the options being considered is a light-handed ‘pricing principles’ approach.

In most jurisdictions, low volumetric prices are charged for recycled water — it is usually priced below or at the same level as water from traditional sources, even though the cost of supplying it is higher. For example, in Sydney, the recycled water usage charge for the Rouse Hill Development Area is set at 80 per cent of the potable water usage charge. This is designed to encourage the development and use of the recycled water (IPART 2006b).

Scope for efficiency gains in pricing recycled water

The principles for pricing recycled wastewater and stormwater are no different from those for potable water. Essentially, the prices should reflect the cost of providing the water to users.

The key issue is the assignment of the costs of treating wastewater and stormwater to a higher standard than that required for it to be discharged into the environment. A user pays approach is one option, where those who use the recycled water pay.

A broader approach is a beneficiary pays approach. This was advocated in a report by the Centre for International Economics (CIE) commissioned by the NWC, and adopted in the NWI pricing principles: In many cases, determining who should pay for products or services, a beneficiary pays approach—which is broader than a user pays approach—should be used in order to acknowledge that benefits accrue to others beyond the direct customer base being supplied with recycled water. Sewer dischargers and potable water users (other than those also supplied with recycled water) may be such beneficiaries who can also be appropriately charged, since they may enjoy the benefit of avoided or deferred costs that would otherwise fall on them for recovery in the absence of a recycling scheme. The beneficiary pays approach underscores the fact that recycling schemes can have system-wide cost impacts, and benefits can accrue to other users as a result. (CIE 2010a, p. xii)

The beneficiary pays approach has also been adopted by IPART: The Tribunal has decided that the total costs of a recycled water scheme should be shared between the direct users of the recycled water and other water or sewerage customers. The contribution of the former should reflect their willingness to pay for recycled water, while the contribution of the latter should be no more than the amount of avoided or deferred costs generated by the scheme. (IPART 2006b, p. 33)

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It is the Commission’s view that clarity on who should pay for the costs involved in recycled wastewater and stormwater will be best achieved once property rights over water, wastewater and stormwater are more clearly articulated (chapter 6).

In any event, pricing recycled water below its incremental cost creates incentives for the excessive use of recycled water. It sends the wrong signals to consumers on the consumption of recycled water, and to suppliers on the viability of investments in recycled wastewater and stormwater schemes.

Impediments to achieving these gains

The main impediments to achieving the gains associated with better pricing of recycled water include:

• unclear statements of property rights over wastewater and stormwater (chapter 6)

• State and Territory Government mandated targets for recycled water, which result in potentially unviable recycling schemes going ahead, and the need to thereby underprice to encourage use of the recycled water produced by those schemes (chapter 6).

7.3 Pricing of water and wastewater transmission and distribution networks

This section deals with the efficient pricing of the water and wastewater transmission and distribution networks. Transmission networks consist of the large main trunk pipes that transport water from treatment plants to distribution networks, and wastewater from wastewater distribution networks to wastewater treatment plants. Distribution (reticulation) networks consist of the smaller pipes that transport water from the transmission pipes to final users, and wastewater from households and businesses to wastewater transmission pipes.

Current pricing practices

• Melbourne Water owns and operates the water and wastewater transmission networks. Prices are regulated by the ESC, and determined every 4 years. A two-part tariff is in place. The volumetric component is set according to LRMC and the fixed charge is set as a residual. – The water and wastewater distribution networks are owned and operated by the retailer–distributors. The price is regulated and forms part of their final price determination.

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• Sydney Water owns and operates the water and wastewater transmission and distribution networks, and charges are regulated by IPART and form part of the retail price determination.

• In south-east Queensland, water transmission is part of the government set bulk water price path. Water distribution, and wastewater transmission and distribution, are part of the prices set by Local Governments.

• In Western Australia and South Australia, prices for transmission and distribution networks form part of the final retail prices set by the respective State Governments.

• In regional urban areas, water is provided by vertically-integrated entities, and transmission and distribution network costs form part of the final retail price.

Scope for efficiency gains in pricing of transmission and distribution networks

The transmission and distribution networks comprise a significant proportion of total overall costs, and it is generally uneconomic to duplicate this infrastructure (IPART 2007). As such, the networks can be considered to be natural monopoly infrastructure (chapter 4). Infrastructure with natural monopoly characteristics often involve large and costly investments, have very low variable costs, and exhibit increasing returns to scale where, as output increases, average costs fall, and for each additional unit of output, marginal cost is less than average cost.

Transmission

The variable operating costs of utilising the transmission network are small compared with the fixed capital costs, and equate to the pumping costs of transporting water and wastewater through the system.

The capital costs are driven by the pipeline capacity required to service expected peak volumes over the life of the asset (IPART 2007). As such, the pipelines will be built to ensure excess capacity for many years due to the size of the economies of scale involved. However, a greater number of connections to a distribution network will increase the volume of water and wastewater going through the transmission pipes so that, over time, they might need to be upgraded or expanded.

Transmission pipes are utilised by all users of the system and, as such, the large capital costs are common and should be shared amongst all users. As the costs are driven by the volume going through the pipes, such costs should be recovered through a volumetric price.

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Pricing at SRMC or some notion of ‘flexible’ pricing is not a feasible option due to the very low variable operating costs, and the fact that there will be excess capacity for very long periods of time. As a result, the business would run at a loss for possibly many years, leaving no incentive to maintain the infrastructure.

A two-part tariff could be employed to cover revenue, but this would result in most of the charges being levied on the fixed component, as the variable component would be very low. This raises the question of how to distribute the fixed charge across consumers. The most efficient way to do so would probably be via some notion of the volumes consumed or expected to be consumed, to ensure that those placing higher demands on the shared infrastructure pay a higher proportion of the capital costs. In this case, all of the charges are effectively levied according to volumes, rather than being ‘fixed’.

This resembles a long-run cost methodology, of which there are two options — the LRMC and the long-run average cost (LRAC) of supplying the transmission network infrastructure. As transmission is essentially a constant cost industry with minimal change in technology over time (to date), the cost of incrementally adding to infrastructure (the LRMC) is likely to be the same as the cost of existing infrastructure (adjusted for age). This means that the LRMC is likely to be close to the LRAC. LRMC pricing would, therefore, come close to achieving cost recovery. Indeed, LRAC pricing itself could provide even more certainty over cost recovery and is another efficient pricing option.

Distribution

In contrast to transmission networks, distribution network costs are driven by the number of customers, more so than the volume of water and wastewater travelling through the pipes. Volumes will ebb and flow over time but there is likely to be excess capacity over the life of the asset, since they are built to service the peak expected demand of the customers serviced. Once laid, therefore, distribution pipes are much less likely than transmission pipes to ever need expanding.

As the capital costs are largely independent of the volume of water and wastewater travelling through the distribution network, a volumetric charge is not appropriate. Costs should instead be priced as a fixed charge on a connection basis. As this is generally the current practice, there is little scope for efficiency gains in changing the way that transmission and distribution infrastructure is priced.

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Developer charges

Developer charges are up-front charges that water utilities levy on developers for the infrastructure costs that utilities incur in the provision, or upgrading, of water supply, sewerage and drainage facilities for new developments. Although expansion of the transmission and distribution network infrastructure will drive most of the need for developer charges, the concept is also relevant for bulk water infrastructure.

Developer charges are generally seen as serving two purposes (Frontier Economics 2008a):

• Price signalling — to encourage efficient patterns of development by signalling to developers and those who purchase land, the costs associated with development in different locations.

• Cost recovery — a means of recovering the costs associated with the extension or upgrade of infrastructure.

Current approaches

Development contributions are applied and collected in different ways across Australia. They may include levies (calculated either per lot, hectare or dwelling, or as a proportion of development value depending on the location and type of development) or impact fees (which recognise the actual impact of the proposal on particular local infrastructure or amenities) (PC 2011d). There is no formal development contribution scheme in South Australia and Tasmania (where developers may negotiate agreements with Local Governments) (PC 2011d).

Some of the evidence on current developer charges across jurisdictions includes:

• In December 2008, the New South Wales Government set the maximum developer charge for water and sewerage for Sydney Water and Hunter Water at zero. Local Government water authorities are still permitted to levy developer charges (IPART, sub. 58).

• An AEC Group (2009) report found that the level of infrastructure charges levied in a number of Local Governments in Queensland were well below the actual costs incurred in providing infrastructure to service new developments. It reported that in many instances, the level of cost recovery from infrastructure charges is only of the order of 50–70 per cent.

• According to the Commission’s 2011 draft report on the Performance Benchmarking of Australian Building Regulation, Planning, Zoning and Development Assessments, greenfield infrastructure charges were generally

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higher than for infill developments, particularly in Sydney, Melbourne and Perth. This is the result of full cost recovery, rather than incremental cost, approaches adopted in these jurisdictions, which have been applied more strictly to greenfield as opposed to infill development (PC 2011d).

Scope for efficiency gains

Imposing developer charges leads to gains in efficiency as they convey location-based, differential price signals. In doing so, they encourage efficient patterns on the location, nature and timing of decisions by developers, by signalling the costs of those developments (Frontier Economics 2008a).

As noted by Australia’s Future Tax System Review Panel: In principle, efficient provision of infrastructure would be encouraged where its users pay for the construction of infrastructure that would be avoidable (that is, not needed) if the development did not proceed. By levying infrastructure charges that reflect these costs, State and local governments provide signals to develop housing in ways and places of greatest value. (2009, E4-5)

There are, however, difficulties associated with how to estimate the appropriate level of developer charges so that they actually send efficient pricing signals.

Efficient charging regimes for infrastructure development were discussed at length in the Commission’s 2004 inquiry into First Home Ownership and are discussed further in PC (2011d). Broadly, the appropriate allocation of capital costs hinges on the extent to which infrastructure provides services to those in a particular location, relative to the community more widely. Key findings include that developer charges should:

• relate specifically to the directly attributable costs being incurred at that location, and not the sunk costs of common shared infrastructure

• be itemised by service type (such as water, wastewater or drainage) and infrastructure type (such as transmission or distribution system)

• avoid over-recovery of the efficient costs incurred by the service provider, to avoid ‘gold-plating’ infrastructure and double charging for infrastructure through both developer charges and recurrent charges.

Developer charges might also need to account for the environmental externalities associated with development (chapter 6). For example, developers might need to pay fees for the increased level of nitrogen discharged into waterways due to increased stormwater runoff from urban development.

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These principles are embodied in the NWI pricing principles on developer charges, which state: Developer charges should reflect the investment in both new and existing assets required to serve a new development and have regard to the manner in which ongoing water usage and service availability charges are set. Where there are benefits beyond the boundary of the development, the developer charge should have regard to the share of capacity required to serve the development. Developer charges should not exceed the costs of serving new developments which includes investment in both new and existing assets required to serve a new development. To avoid over-recovery, revenue from developer charges should be offset against the total revenue requirement either by excluding or deducting the contributed assets from the [regulated asset base] RAB or by offsetting the revenue recovered using other mechanisms. (COAG 2010, p. 11)

There is also the question of whether developer charges should be set periodically on an ‘across utility’ basis, or be specific to the development in question. Where there are large differences in costs across developments, it tends to be more efficient to levy developer charges on a case-by-case basis.

Difficulties can arise in setting developer charges when developments occur as urban infill, as opposed to when they occur in greenfield sites. The location-specific costs of expanding networks for greenfield developments are much easier to isolate and measure.

This is a particularly important issue to resolve given the high proportion of growth accounted for by urban infill. For example, according to Sydney Water (sub. 21), up to 80 per cent of development is accounted for by urban infill.

In its 2004 inquiry into First Home Ownership, the Commission proposed the following principles for allocating capital costs (PC 2004a):

• upfront charges should be used to finance major shared infrastructure, such as trunk infrastructure, for new developments where the incremental costs associated with each development can be well established and where such increments are likely to vary across developments

• infill development where system-wide components need upgrading or augmentation that provide comparable benefits to incumbents should be funded out of borrowings and recovered through rates or taxes (or the fixed element in periodic utility charges)

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• for local drainage, it is efficient for developers to construct them, dedicate them to local government and pass the full costs on to residents (through higher land purchase prices) on the principle of beneficiary pays.

The latter point provides an alternative to imposing developer charges. Instead, developers could be required to build the necessary infrastructure according to standards set by the utility. The developer can then retain ownership of the infrastructure and operate it, or transfer it to the utility once the development has been completed. This alternative might have advantages associated with reducing costs and encouraging innovation. It would, however, be important that appropriate warranties are in place to ensure the ongoing quality and maintenance of the infrastructure. In the case where the developer maintains operational control, there would also need to be provisions in place to deal with situations where the entity becomes financially distressed.

Impediments to achieving these gains

One potential impediment to achieving the gains associated with more efficient developer charges could be the desire for Local Governments to promote urban development in the areas that they service, therefore providing them with an incentive to undercharge developers to ensure that development proceeds.

Another impediment could be resistance from utilities to allowing developers to incorporate innovative solutions to water and wastewater provision.

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INFORMATION REQUEST

7.4 Final retail pricing

Retail prices are essentially a pass-through to residential and business consumers of the price of each element along the water and wastewater supply chain, together with a retail margin. To be efficient, therefore, retail prices need to reflect the sum of all the efficient prices for bulk water, transmission, distribution, wastewater and stormwater described above.

This section outlines the efficient components of retail pricing. It then examines some of the features of current retail structures, such as inclining block tariffs and postage stamp pricing, and assesses the scope for efficiency gains in reforming the way that retail prices are set

Current retail pricing practices

As outlined in chapter 2, water prices tend to be set by regulators or governments in metropolitan areas, as well as regional urban areas in Victoria, Western Australia and South Australia.

In regional urban areas in New South Wales, as well as in most regions of Queensland, prices are determined by Local Government-owned utilities, in accordance with guidelines (which are set by IPART in New South Wales, and enshrined in legislation in Queensland).

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Two-part tariffs and inclining block tariffs

Retail prices are usually characterised by a two-part tariff. The volumetric charge tends to be set in accordance with the LRMC of supply, and the fixed charge is set as a residual to achieve cost recovery.

For households, volumetric charges, however, are rarely uniform — it is common for there to be an inclining block tariff (IBT) for the volumetric component, where the price increases as successively higher blocks of water are consumed within a billing period. The first block tends to be set at or below LRMC, and second or third blocks above LRMC.

This type of pricing has a long history in Australia as a measure to:

• provide an amount of essential water (such as for drinking and cooking) at a low cost to assist low-income households

• provide incentives for water conservation

• reduce water use for the benefit of the environment (ESC 2007).

Inclining block tariff arrangements currently exist in some areas of all states and territories, except the Northern Territory. However, the size, number and price of blocks vary significantly (chapter 2). In 2008, Sydney moved from an IBT to a uniform volumetric rate.

In some regions, including Brisbane, South Australia and Western Australia, IBTs have also been applied to the volumetric charges paid by commercial water users, including an initial block of low priced water (ESC 2007).

Metering

Not all consumers in Australia are charged a volumetric price for the water they consume. In these cases, consumers have no incentives to manage the amount of water they consume.

In some areas water is not charged on a metered basis (Infrastructure Australia, sub. 62). Rather, it is charged as a fixed rate based on property values or, in other places such as in remote housing in Indigenous communities in the Northern Territory, there is no charge at all.

Tenants in most states do not face a volumetric (nor a fixed) charge for the water they consume. It is paid by landlords on their behalf. There are some exceptions:

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• In Victoria, tenants must pay the volumetric component of water bills if their dwelling is separately metered. Landlords pay fixed charges.

• According to the New South Wales Government (sub. 65), recent changes to the Residential Tenancies Act 2010 (NSW) allow landlords to charge tenants for water use if the premises has water efficient appliances and is separately metered.

• In Queensland, changes introduced in 2008 to the Residential Tenancies Act 1994 (Qld) mean that landlords can now pass on bills to tenants provided that the premises is individually metered and fitted with water efficient devices, and the tenancy agreement states that the tenant must pay for water consumption (RTA 2010).

Consumption in most multi-unit dwellings across the country is not separately metered. In this case, the volumetric component of bills is evenly distributed among residents. As a result, these households do not pay volumetric charges that reflect the cost of the quantity of water they have consumed, and there is cross-subsidisation among unit owners. In some places, unit owners get charged directly by utilities (Melbourne). In others, such as Sydney, utilities bill the strata corporation for the total water usage and this is recovered from owners through strata fees.

Postage stamp pricing

Under current pricing arrangements, all water utilities apply uniform tariffs to geographic areas of varying sizes, to some degree, regardless of the actual costs of serving individual customers within those areas. This is known as ‘postage stamp pricing’ (or ‘uniform pricing’).

Postage stamp pricing is applied at a range of levels, from the very large, such as an entire state or territory (South Australia and the Northern Territory), to areas that cover a single system (some regional urban areas in Victoria and New South Wales) (chapter 2).

In Western Australia, there has been some movement away from statewide pricing. Commercial and high use residential customers (those consuming more than 550 kL per year in the south and 750 kL per year in the north) are now being transitioned towards cost reflective prices, up to a cap of $5.94 per kL (2010-11 prices). A statewide tariff cap policy applies to country residential customers with lower consumption, where charges are capped at metropolitan residential rates (Department of Water (WA), sub. 38). The Western Australian Government pays a

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Community Service Obligation to the Water Corporation for low volume residential consumption and for customers where the cost of the services is above the tariff cap.

Scope for efficiency gains in changes to retail pricing

This section separately identifies some of the gains to be achieved even if flexible pricing is not adopted, in recognition of the possibility that flexible pricing might not be implemented, or might be implemented in a staged way.

More widespread consumption-based pricing

The move away from fixed charges for water to two-part tariffs with a metered volumetric component has been an important one. Having a volumetric component in pricing that varies according to the amount of water used sends signals to consumers about the cost of their consumption decisions.

The benefits of consumption-based pricing are widely recognised. IPART (sub. 58) quotes international results showing that the installation of meters resulted in annual reductions in water consumption of between 12 and 35 per cent, and significantly larger reductions during peak summer months. According to the Water Services Association of Australia (WSAA): WSAA recognises that pricing is necessarily part of an efficient and effective overall strategy for managing water usage, and clearly moves to consumption-based pricing have been significant in reinforcing to customers the ‘value’ of water services. (sub. 29, p. 17).

Similarly, a report by AECOM prepared for Infrastructure Australia stated: Metering is important as a tool to enable demand management, measure efficiency of supply and consumption, and importantly, to ensure customers are aware of the volume of water they are using. (AECOM 2010, p. 30)

However, as outlined above, there are still areas of Australia where water consumers do not face a price that is related to the amount of water they consume.

Where there is no metering currently in place, the costs of installing meters need to be weighed against the benefits of doing so in terms of sending better signals to consumers about their consumption decisions. In some regional urban areas, there might not be a net benefit. According to the Local Government Association of Queensland ‘the cost and ongoing maintenance of introducing metering may be problematic especially in areas where inappropriate economies of scale exist’ (sub. 20, p. 16). Where a net benefit is identified, however, meters should be installed.

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Similarly, where water is not separately metered in multi-unit dwellings, the costs and benefits of retro-fitting existing buildings, and fitting new dwellings with separate meters, need to be assessed. Although it might be too costly to retro-fit existing multi-unit dwellings with separate meters, it is the Commission’s view that the case for installing separate meters in new developments is strong. This is especially so given the trend towards high density housing which will result in an increasing number of households not receiving a price signal for the water they consume.

There is evidence that some jurisdictions are already examining the case for separate metering. With about 40 per cent of households in the greater Sydney area not paying water usage charges due to shared metering, the New South Wales Government stated: Recognising that sending direct price signals to as many water customers as possible will help promote more efficient water use and reduce pressure on supplies, Sydney Water has undertaken a trial to examine the costs and benefits of individual metering in multi-unit apartment buildings. … Non-metropolitan local water utilities are encouraged by the Best Practice Management Guidelines to mandate separate metering in all new multi-unit residential developments (both strata and non-strata) approved after 1 July 2004. In addition, all free standing residential premises are required to be separately metered since 1 July 2007. The Guidelines also state that local water utilities should encourage separate metering of existing multi-unit residential developments, where cost-effective. (sub. 65, p. 20)

There is no clear justification for landlords, rather than tenants, paying for water usage in those states and territories where water is separately metered. Tenants pay bills for other utilities such as electricity, gas and telecommunications, and it is difficult to see a case for treating water any differently. In any event, where tenants do not pay for water directly, they generally pay for it through higher rents. It would be more economically efficient for tenants in separately metered properties to face consumption charges directly, and more administratively simple for them to also pay for the fixed charges directly, rather than pay through rents.

Where utilities currently bill strata corporations of multi-unit buildings rather than owners (such as in Sydney) there is a case for changing this arrangement so that residents (be they tenants or owner occupiers) are billed directly by utilities.

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Charging tenants of separately metered properties for water and wastewater does not detract from the importance of affordability issues for low-income earners. On balance it is the Commission’s view that tenants will be at least no worse off, as rents should be reduced to reflect the change. It is also quite likely that tenants will be better off from being charged directly where water to their property is separately metered, as they will have the opportunity to benefit from any savings associated with reducing water consumption.

However, where this does not already occur, it might be necessary for State and Territory Governments to put in place transitional arrangements to ensure that savings to landlords are passed through to tenants.

To the extent that affordability concerns remain, it is the Commission’s view that these are best dealt with directly through the general taxation and transfer system (chapter 9).

Two-part tariffs with flat rather than inclining block structures

It is efficient for retail prices to comprise a two-part tariff to reflect those costs that vary with greater quantities consumed (the volumetric price) and those costs which are fixed with respect to quantities consumed (the fixed price component). The proportion of volumetric and fixed retail charges will depend on the way that these have been determined for each element along the supply chain, as discussed above.

To preserve the efficient pricing of the various components of water according to the costs involved, the costs need to be passed on to consumers in the same way. For example, if priced efficiently, bulk water will have a volumetric component that reflects the availability of water, transmission charges will also be related to volumes, and distribution, stormwater and wastewater would all be priced as a fixed charge.

The retail-specific costs would then be added to these charges. Retail costs are those associated with administering customer accounts, including billing, meter reading and responding to customer complaints (IPART 2007). These costs tend to vary by customer rather than by the quantity of water consumed. As such, it is not appropriate to include them in the volumetric price. These should be levied as a

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fixed charge set equal to the marginal cost per customer served (Baumann, Boland and Hanemann 1998).

The volumetric component

The use of IBTs for the volumetric component of final retail prices means that if one tier reflects the marginal cost of supplying water, then water consumed in other tiers is being priced above or below marginal cost (O’Dea and Cooper 2008). This violates the basic principle that consumers should face the costs of the water and wastewater services they consume.

In times of scarcity, IBTs insulate consumers from facing the cost of decreased water availability, and therefore lead to over-consumption (Sibly 2006b). By underpricing water, they also send distorted signals to water utilities, which can delay potentially efficient investment in supply augmentation, and to consumers in making their investment decisions. IBTs might encourage:

• large water users to incur considerable expense investing in costly water saving devices such as water efficient appliances, rainwater tanks or garden bores, whose dollar per unit of water saved might exceed the cost to water utilities of providing an equivalent amount of water

• businesses that are intensive water users to favour the development of smaller commercial enterprises, regardless of whether there might be efficiencies associated with large sizes.

As such, IBTs invariably result in efficiency losses compared with flat volumetric pricing and this is well understood by economic regulators. In its 2007 review of tariff structures in Victoria, the ESC noted: Generally, IBTs set the first tier price below marginal cost and prices for subsequent tiers above marginal costs — IBTs may not, therefore, provide accurate signals to customers about supply costs. Households with consumption falling within the first block may have little incentive to use water efficiently because the volumetric charge is lower than marginal cost. Conversely, households with consumption falling within the final block will be facing a volumetric charge that may be significantly above marginal cost (ESC 2007, p. 35).

IPART (sub. 58) also expressed this view, and moved from a two-tier IBT to a uniform volumetric price for Sydney in 2008.

In theory, IBTs could be used as a way of distributing the rents that can accrue on cheaper sources of water, like dam water, while maintaining an efficient price signal for consumption at the margin. However, this relies on all users facing an efficient

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marginal price, which is impractical since water users have different levels of demand for water.

Using IBTs to achieve affordability objectives is problematic. If all households had the same level of non-discretionary water use, a two-tier IBT could be designed such that an initial block of a size equal to the essential water requirement could be set below marginal cost, and all discretionary water use would fall into a subsequent block priced at marginal cost, without distorting consumption or reducing economic efficiency.

However, it is very difficult to define what essential water requirements are (chapter 9). Even if it were possible to clearly define essential water needs, the essential water requirements of households vary greatly as a result of their size and other factors. For example, a house with six occupants can reasonably be expected to have a higher essential water requirement than a single occupant household.

Given the impracticalities associated with adjusting IBTs for household size, IBTs disadvantage large households that face a higher marginal price even though on average they are likely to consumer less water per person than smaller families due to economies of scale in water consumption. The Economic Regulation Authority in its review of tariffs in Western Australia stated: Households with a large number of occupants are more likely to have higher water usage and would be more adversely impacted by inclining block tariffs than households with fewer occupants (all else being equal). (ERA 2009, p. 38)

It is the Commission’s view that consumers are best placed to determine their uses of water. An efficient flat volumetric rate allows them to do so, rather than an ‘essential’ level of demand being prescribed for them (Sibly 2006b). Declaring on behalf of consumers what is and is not essential usage distorts their consumption decisions and leads to inefficiencies.

The size of the efficiency gains that can be achieved through moving to flat volumetric charging for urban water will depend on the design of the inclining block tariff structure currently in place. Generally, the gains to be achieved will be greater:

• the larger the number of consumers facing marginal prices that are not equal to marginal cost

• the larger the difference between the marginal price paid by consumers and the marginal cost.

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Not only do flat volumetric rates enhance economic efficiency, but they are also more equitable. Flat volumetric rates also simplify the tariff rate structure and can be more administratively simple to implement.

Where there are concerns about affordability of water for low-income earners, it is the Commission’s view that these are best dealt with through the general taxation and transfer system (chapter 9).

Impediments to adopting flat volumetric rates

One of the primary reasons cited in support of an IBT structure is that it can provide an essential amount of water at a low or affordable price. In New South Wales, an IPART survey found that 63 per cent of respondents believed IBTs were fairer than the (then) current two-part tariff (quoted in Sibly 2006b). Some submissions to this inquiry expressed support for IBTs on this basis:

• Anglicare supports the following pricing principles: … an inclining block tariff, with the first tariff block kept at an at-cost or below-cost price (or even free) to ensure a minimum level of service is available for everyone at a minimal price’. (Anglicare Tasmania, sub. 44, p. 4)

• It is considered that inclining block tariffs are the most equitable method for applying water prices to ensure that the higher consumers are meeting a higher proportion of the costs to deliver and plan for the service. (Rockhampton Regional Council, sub. 33, p. 9)

This support for using IBTs to address affordability issues could be an impediment to moving to a flat volumetric rate.

However, as noted above, it is the Commission’s view that affordability issues are best dealt with directly through the taxation and transfer system, rather than by altering the tariff structure.

Moving away from postage stamp pricing

Over some geographic range, the cost for a water utility of servicing water and wastewater customers will differ. For example, the marginal cost of supplying water

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in systems that rely on a dam might be lower than systems that use groundwater, due to the pumping costs involved. A water utility might incur additional costs in pumping water against gravity to serve residents of a suburb situated on a hill as opposed to those in a neighbouring suburb who live in a lower lying area. Users located further away from treatment plants will also be more costly to service.

Postage stamp pricing ignores these cost differences. As a result, some consumers face prices greater than the costs they incur, and these users subsidise the rest. Where postage stamp pricing results in prices that differ significantly from marginal costs, it will result in efficiency costs (Frontier Economics 2008a). These efficiency losses are likely to be greater the larger the area and number of systems covered by the uniform tariff.

The alternative to postage stamp pricing is to implement location-specific pricing, where prices reflect the differences in marginal costs of supplying different users.

The efficiency benefits from location-specific pricing need to be weighed against the cost of determining and implementing more cost-reflective prices. This has been recognised in the NWI pricing principles: Water charges should be differentiated by the cost of servicing different customers (for example, on the basis of location and service standards) where there are benefits in doing so and where it can be shown that these benefits outweigh the costs of identifying differences and the equity advantages of alternatives. Differential pricing may be achieved by upfront contributions, including developer charges. (COAG 2010, p. 11)

The costs of location-based pricing will increase as the number of unique prices charged increases. Maintaining a single price for all customers of a utility might be appropriate if the costs of moving to location-specific pricing outweigh the benefits, for example, because the cost differences across locations are small or difficult to quantify.

To the extent that postage stamp pricing remains in place, the level of cross-subsidisation needs to be minimised. This can be achieved by:

• reducing the coverage of a postage stamp price to geographical areas containing less variation in costs of supply

• setting the level of the postage stamp price at the cost of servicing the majority of users within the postage stamp boundary — for example, metropolitan areas — and funding provision to more remote areas with direct and transparent government subsidies (Community Service Obligations) (chapter 13).

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Impediments to adopting more location-specific pricing

A key obstacle to moving away from postage stamp pricing is the perception that it is more equitable to share costs of water and wastewater services across a large number of users. This point was highlighted by some participants:

• … ‘postage stamp’ pricing is contrary to efficient pricing, but is widely practised because many consumers would view it as unfair if they were to pay a higher volumetric price than another consumer for what appears to be an identical product delivered by the same supplier. (Grafton, sub. 22, p. 9)

• Consumers expressed the view that water is a basic social right and strongly supported postage stamp pricing — even in areas where prices would decrease under area-based differential pricing. (Sydney Water, sub. 21, p. 20)

However, others consider that postage stamp pricing is inequitable because of the cross-subsidisation of high-cost customers by lower-cost customers. This view was expressed by the Australian Water Association: Postage stamp pricing is likely to be inefficient (as at least some will be paying more than the cost of supply) and to promote unjustifiable cross-subsidies (as it is not clear that those who benefit from postage stamp pricing are those least able to pay …). (sub. 42, p. 19)

In addition, Rockhampton Regional Council said: Postage stamp pricing is not equitable as it provides the opportunity for cross-subsidisation with the consumers in the more urbanised schemes assisting in maintaining a lower price for the smaller scheme consumers despite, quite often, the costs per unit being far higher in the smaller schemes. (sub. 33, p. 9)

Concerns have also been raised about the impact of removing postage stamp pricing on low-income customers. For example, CUAC said: CUAC … has some concerns about the social equity implications of removing postage stamp pricing in areas where it currently exists. The difficulty here is that water is often more expensive to supply in areas that also have a concentration of people on low incomes. In Victoria, for example, consumers in non-metropolitan areas (and in some of the state’s most socio-economically disadvantaged regions, such as Gippsland) tend to pay higher prices for water and sewerage services. When postage stamp pricing is removed, measures should be put in place to ensure continuing universal access where prices rise significantly. (sub. 46, p. 8)

Although postage stamp pricing can be thought of as equitable since everyone in the same geographic area pays the same price, it is in fact quite inequitable from the perspective that those living in low-cost areas are subsidising those in high-cost areas.

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Postage stamp pricing will not always necessarily translate to metropolitan users subsidising regional urban users. With the growing costs of sourcing water in metropolitan areas due to the drought and the need to seek more expensive sources of water such as desalination, a prospect that is becoming more realistic is that relatively sparsely populated regions might now be at a relative cost advantage in sourcing water and this might result in regional urban users subsidising metropolitan users.

Nor will postage stamp pricing necessarily translate to high-income earners subsidising the provision of water and wastewater to low-income earners. A person’s geographical location does not necessarily reflect their ability to pay for water and wastewater services. For example, postage stamp pricing can disadvantage low-income earners living in low-cost metropolitan cities or suburbs, who subsidise wealthy residents living in more remote or high-cost locations. For example, low-income residents of the inner-city suburb of Redfern subsidise the provision of water and wastewater services to high-income residents of the upper north shore suburb of St Ives where the cost of provision is likely to be higher.

It is the Commission’s view that prices — particularly volumetric prices — should be set efficiently according to the cost of provision where there is a net benefit from doing so. Any concerns regarding affordability are best dealt with directly, outside of the pricing system (chapter 9).

Moving toward more flexible pricing

Flexible retail pricing refers to the pass through of a flexible bulk water price to consumers.

Several different ideas have been put forward for operationalising flexible pricing at the retail level, each of which attempts to deal with some of the concerns raised with flexible pricing, such as price volatility and distributional impacts (see below).

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But the underlying principles are the same — flexible retail pricing aims to price in a way that reflects the scarcity value of water resources.

The benefits of moving to flexible bulk water pricing were outlined in section 7.1. These benefits are associated with making better supply augmentation decisions. Flexible pricing on the retail side would have the added benefit of better managing demand.

The Commission modelled a comparison between flexible pricing, and LRMC pricing. In the model, LRMC pricing was approximated as a ‘smoothed’ pricing policy that applied to prices paid by consumers that is set every four years. This approach captures the key cost of a smoothed pricing regime within a regulatory price setting period — consumers do not face higher prices for water during times of scarcity or lower prices when there is abundance of supply. In the modelling, the smoothed pricing regime is assumed to constrain only consumer prices. Investment decisions and supply are optimally determined, subject to the distortion in consumption induced by imposing smoothed prices.

The modelling results show that smoothed pricing in Melbourne and Perth reduces net social welfare by about $110 million over a 10 year period. This occurs because prices are on average higher than under flexible pricing, and this makes consumers worse off. Prices are higher because suppliers have to cope with variable inflows without the assistance of consumers, who do not change consumption. Suppliers might see that in some possible future drier scenarios, supply augmentation needs to occur to supply enough water. However, the price that is required to make the supply augmentation viable must also be applied in the case that rather than being dry, it rains. This leads to a higher than necessary average price for consumers.

The modelling results also show that investment is more risky under the smoothed pricing scenario because, while consumers face a relatively predictable pricing environment with prices being set in advance, water suppliers need to deal with variable inflows without any assistance from consumers.

The gains from flexible pricing have also been estimated by Grafton and Ward (2010) for Sydney. Their results indicate that: … the welfare costs of supply-inflexible volumetric water pricing generates large welfare losses in excess of a billion dollars due to on-going water restrictions and premature supply augmentation. However, these losses could be avoided if dynamically efficient volumetric pricing were to be adopted by price regulators or water utilities in response to variability in water availability. (Grafton and Ward 2010, p. 1)

Their results are significantly higher than the Commission’s results as they combine the losses from fixing prices, forcing investment in desalination (chapter 6) and

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imposing restrictions (chapter 8). The Commission, on the other hand, models these aspects separately.

The Commission’s modelling shows that moving from rigid to flexible retail pricing leads to welfare gains. However, these are not as large as the gains from other reforms such as removing policy bans and introducing a real options approach to supply augmentation decisions (chapter 6).

Impediments to flexible retail pricing

Responsiveness of demand

A commonly cited impediment to introducing flexible pricing is that consumers are not very responsive to changes in price and that, therefore, the signal sent through flexible pricing will not be an effective means of managing demand in times of scarcity (see, for example, Schott, Wilson and Walkom 2008; IPART sub. 58).

The degree of impact that a change in price has on demand is measured by the price elasticity of demand — the percentage reduction in demand resulting from a one per cent increase in price. If demand is inelastic, then the percentage decrease in the quantity demanded will be less than the percentage increase in price and the elasticity will have an absolute value between one and zero. If demand is elastic, then the absolute value will be greater than one.

There have been some studies to estimate the elasticity of water demand in Australia, and estimates vary quite widely. Some examples are included in box 7.1. These generally show that demand for water is relatively inelastic. However, it is difficult to draw conclusions about the price elasticity of demand for water, not only because estimates to date vary widely, but also because the price mechanism in Australia has been suppressed due to the widespread use of restrictions and campaigns promoting water use efficiency and conservation. According to WSAA, ‘significant step changes in consumption behaviours means that previously observed relationships — price elasticity — are now untested and unreliable’ (sub. 29, p. 15).

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Box 7.1 Estimates of the price elasticity of demand for water

Australian studies

Sydney

• Abrams et al. (2011) estimated a short-run price elasticity of demand of -0.09 at a nominal price of $2.00 per kL, and a long-run elasticity of -0.18.

• Warner (1996, cited in Abram et al. 2011) estimated a nominal price elasticity of -0.127.

• Grafton and Kompas (2007) estimated a nominal short-run price elasticity for Sydney of -0.352, and real short-run elasticity of -0.418.

ACT A study by Graham and Scott (1997, cited in Hughes et al. 2008) estimated the price elasticity of residential water demand in the ACT region to be in the range of -0.15 to -0.39.

Brisbane Hoffman, Worthington and Higgs (2006) estimated the elasticity in Brisbane to be between -0.55 and -0.67.

Perth

• Thomas and Syme (1988) estimated a price elasticity for Perth of about -0.2.

• A panel data study by Xayavong, Burton and White (2008) for Perth estimated an indoor elasticity of between -0.70 and -0.94, and an outdoor elasticity of between -1.30 and -1.45. International studies

• Dalhuisen et al. (2003) present a comprehensive meta-analysis of 64 US econometric studies, to derive an overall mean price elasticity of -0.41.

• Espey et al. (1997, cited in Grafton sub. 22) used 124 elasticity estimates to obtain a median short-run price elasticity of demand of -0.38 and a median long-run price elasticity of demand of -0.64.

Furthermore, there is no unique elasticity of demand for water. The elasticity varies across the uses of water, users of water and over time. It can also vary with the level and structure of prices. For example:

• household demand for outdoor water use is more elastic than demand for indoor use, because outdoor water use tends to be more discretionary (Brennan 2006)

• demand in the long run is more elastic than in the short run because over longer periods of time, consumers are able to modify their behaviour, install water

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saving technologies and change to less water-intensive gardens in response to higher water prices (PC 2008d; Abrams et al. 2011).

• investment in water efficient appliances reduces the responsiveness of demand to a change in price because it limits the scope for further reductions in water use (Abrams et al. 2011)

• as price rises and water becomes a larger share of the total budget, the price elasticity will increase (PC 2008d; Abrams et al. 2011)

• price is more elastic the easier it is to understand and the more clearly communicated it is to consumers (Bonbright, Danielsen and Kamerschen 1988).

Therefore, although demand for water is relatively inelastic overall, there is at least some scope to use prices to affect demand for some classes of urban water users and for some urban uses (PC 2008d). There are also several reforms to pricing that could take place to enhance the responsiveness of demand (box 7.2). In all cases, the costs of doing so would need to be weighed against the benefits in terms of using price to manage demand.

In addition, to the extent that the demand for water is inelastic and results in a relatively small change in demand for a given change in price, this does not mean that some other method of managing demand necessarily needs to be utilised during times of drought. Prices contain valuable information about the willingness of consumers to pay for water, so an inelastic demand indicates that consumers are willing to pay high prices to consume additional amounts of water. This suggests that the welfare of society would be larger if supply were augmented to satisfy demand (provided the consumer price reflected the marginal cost of supply), rather than restrict demand. Indeed, the more inelastic demand is, the greater the costs to the community of restricting demand (chapter 8).

Support for restrictions

Community support for restrictions and other water saving activities presents a barrier to relying more on prices to manage demand. However, it is important to recognise that there is evidence that many consumers would be willing to pay a higher water bill to avoid restrictions (chapter 8).

It is also important to note that the benefits of using prices rather than restrictions to manage demand are greater the more inelastic demand is with respect to price. This is because, as explained above, an inelastic demand indicates that consumers value water consumption, and so the benefits to the community will be enhanced by expanding supply capacity.

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This highlights the importance of providing consumers with objective information on the costs and benefits of using price versus non-price measures to manage demand (chapter 8).

Box 7.2 Measures to increase the price responsiveness of demand

More frequent billing One relatively low cost way to increase the responsiveness of demand to changes in price is to increase the frequency with which households are billed. Currently, residential bills are issued quarterly in most jurisdictions, so households pay for the water they use up to three or four months after the time of consumption. A more contemporaneous relationship between usage and billing could make households more aware of how their usage affects the amount they pay for water. On the other hand, it could weaken the price signal by lowering the amount of the individual bill. Rolling out smart meters would be another way of monitoring usage and allowing consumers to respond in real time. Although they have the advantage of preventing the cost of more frequent manual meter readings, a comprehensive roll out of smart meters would be very costly and unlikely to outweigh the benefits. Future advances in technology might, however, one day render this efficient (WSAA, sub. 29).

More comprehensive charging across the user base Another way to increase the aggregate response to changes in price is to move to more comprehensive consumption-based pricing, as discussed above. This ensures that more customers face a volumetric price for the water they consume.

Educating consumers on water prices Consumers will be more responsive to price changes if they understand the tariff structure. Educating them on how water is charged and how prices relate to consumption is, therefore, another way of increasing responsiveness. This also points to the importance of implementing a form of pricing that is transparent and simple to understand.

Removing permanent restrictions and mandatory conservation measures To the extent that users have already reduced their consumption in response to ongoing restrictions and conservation campaigns, there might be little scope left to reduce demand further if scarcity re-emerges. This suggests that, even if restrictions are removed and conservation campaigns phased out (chapter 8), it might take some time for this behavioural pattern to be unwound, and for pricing signals to work their way through to encouraging more consumption when water is in abundance.

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More volatile and higher residential prices

Flexible pricing, by definition, results in more variation in retail prices than prices based on LRMC. In times of scarcity, it can also lead to prices above LRMC. Concerns have been expressed with these potential outcomes on both efficiency and equity grounds.

On efficiency grounds, the concern is that variability in prices will send the wrong signals to consumers about what to invest in with respect to water using devices over time. Indeed, this was acknowledged by a report from the Industry Commission, which noted that smoother pricing paths might send clearer signals to consumers about the costs of providing the service, particularly if long periods of low prices encourage inefficient investments (such as inappropriate location decisions) by users who expect low prices to continue indefinitely (IC 1992).

On equity grounds, participants have expressed concerns regarding low-income households facing higher water prices in times of scarcity (see, for example, PIAC sub. 61 and CUAC sub. 46). It has been argued that a free essential block of water would be appropriate.

In addition, many view as undesirable the idea that users would face higher, and more volatile and unpredictable prices. For example, Sydney Water’s research indicates that consumers value stability in water pricing (sub. 21). Sydney Water also notes that ‘while water makes up only a small part of household income, low-income households and large families need to be considered from an equity perspective’ (Schott, Wilson and Walkom 2008, p. 416).

The modelling conducted by the Commission indicates that under flexible pricing in Melbourne and Perth:

• the price of water on average across all modelled rainfall scenarios is $1.35 per kL in Melbourne and $0.87 per kL in Perth

• in 90 per cent of scenarios the price of water always stays below $1.70 per kL in both Melbourne and Perth

• prices are on average lower under flexible pricing than they are when prices are fixed over several years (PC 2011a).

In terms of price volatility, there is already a range of frequencies in price setting arrangements, ranging from annual in some regional urban areas to up to four years in metropolitan areas, and it is not clear that any one frequency is favoured over another. It is also not clear that flexible pricing would lead to outcomes that are any more volatile or uncertain than those that currently exist. This point was made by ACTEW Corporation:

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While price certainty may be valued by some users, the uncertainty created by drought will inevitably emerge somewhere in the system. Under the current approach to drought (temporary water use restrictions), this uncertainty arises through the triggering and duration of quantitative restrictions. This is in turn a form of price uncertainty, as water use restrictions increase the effective cost of water to users. (sub. 45, p. 3)

In any event, if high, volatile and unpredictable prices at the consumer level are of concern to the community and to policy makers, flexible retail pricing could be introduced in a way that accounts for these concerns. For example, price movements could be limited to annual events. Alternatively, prices could move in the direction dictated by the relative scarcity of water, but move within pre-determined parameters, to ensure price stability and predictability.

ABARE (in Hughes et al. 2008) suggested that pricing could be implemented using a system of stages similar to that used for water restrictions. A number of price stages could be defined, each corresponding to a different level of scarcity. ABARE’s model results illustrated that a staged price system would result in a minimal loss of efficiency relative to a more flexible price system. According to ABARE, determining a price that achieves a given change in quantity is not necessarily a more difficult problem than developing a list of restrictions that achieves the same result. In addition, scarcity pricing has the advantage of more flexibility regarding the number of scarcity stages chosen.

To deal with the difficulties low-income users might face, Sibly (2006b) suggested: While efficiency requires a volumetric rate equal to the opportunity cost of water, it does not require that the fixed charge be equal across consumers. Thus, equity issues can be addressed by varying the fixed charge levied on different classes of consumers. Disadvantaged consumers (as determined by government social policy) could pay a lower fixed charge, with water authorities receiving commensurate compensation from the government either in direct payments, or by the government (as owner) accepting a lower than market rate of return from the authority. (Sibly 2006b, p. 22)

Furthermore, Quentin Grafton proposed: … receipts in excess of supply costs when supply availability is low during droughts provides an opportunity to return excess revenues back to households in a progressive way. By contrast, under the current fixed price system when costly supply augmentation occurs consumers can be faced with a much higher water bill to recover the capital costs of the supply augmentation. (sub. 22, p. 10)

The key point is that flexible pricing does not need to be introduced in a mandatory or prescribed way. Doing so would prevent consumers having access to more choice in their pricing options. The introduction of flexible pricing would bring with it the opportunity for utilities to offer consumers a range of different tariff structures. This

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would allow consumers to express their preferences regarding aspects such as security of supply, water restrictions and price volatility.

Some examples of tariff options include:

• A simple default tariff for those who prefer stable prices and guaranteed supply — the volumetric charge would be fixed over the contracted period (this could be several years) and they would have guaranteed supply (without any risk of restrictions) at this price. There could still be a fixed ‘access’ charge component to the tariff designed to recover the cost of fixed charges.

• A flexible tariff for those responsive to price, with guaranteed supply — the volumetric charge would vary from year to year to reflect the scarcity value of water. Consumers would have the opportunity to take advantage of using more water when prices are low, and cutting back consumption when prices are higher.

• Tariffs for different levels of security of supply — these would have a fixed security of supply charge that guarantees a certain contracted amount of water, and a discounted volumetric charge for all units within this limit. Once the limit is reached, the consumer might face a higher volumetric price for every additional unit.

In offering a range of products, retailers would no longer simply pass through costs to consumers. Rather, they would need to match the risk characteristics of their customer portfolio with their supply portfolio. In order to do so, they might need to build expertise in this area.

DRAFT RECOMMENDATION 7.3 More consumer choice in urban water tariff offerings should be available. This would:

• allow consumers to express their preferences on security of supply and price stability

If there is concern about the impact that introducing more choice will have on consumers, the change could be introduced gradually or, at the very least, trials could be conducted.

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7.5 Assessment of NWI pricing principles

Under the NWI, governments have made commitments to best practice water pricing including to:

• promote economically efficient and sustainable use of: – water resources – water infrastructure assets – government resources devoted to the management of water.

• ensure sufficient revenue streams to allow efficient delivery of the required services

• facilitate the efficient functioning of water markets, including inter-jurisdictional water markets, in both rural and urban settings

• give effect to the principle of user-pays and achieve pricing transparency in respect of water storage and delivery in irrigation systems and cost recovery for water planning and management

• avoid perverse or unintended pricing outcomes.

A stocktake on approaches to water charging was prepared by the Steering Group on Water Charges in 2007 and this identified that differences in pricing approaches across jurisdictions were most marked in approaches to recovering capital expenditure, approaches to setting urban water tariffs, and approaches to recovering the costs of water planning and management.

A set of refreshed pricing principles were agreed by all jurisdictions to assist states and territories to achieve consistency in water charges as required by the NWI. These took effect in 2010, and cover the following:

• Principles for the recovery of capital expenditure to provide guidance to water service providers on asset valuation and cost recovery for urban and rural capital expenditure.

• Principles for urban water tariffs to provide guidance for price setting in situations where there are monopoly providers and the absence of competitive pressures.

• Principles for water planning and management to provide guidance, for urban and rural water service providers, in identifying and allocating the costs of water planning and management activities between government and water users.

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• Principles for recycled water and stormwater reuse to provide broad policy guidance to stimulate efficient water use, in urban and rural settings, no matter what the water source.

The NWI pricing principles do not limit the ability of governments to address equity issues related to the provision of water services (COAG 2010). This allows the states and territories the flexibility to depart from efficient pricing principles. For example, the principles state that on economic efficiency grounds water usage charges should comprise only a single (flat) charge but that: … governments may decide on more than one tier for the water usage charge for policy reasons, e.g. sending a strong pricing signal to encourage efficient water use; and having regard to equity objectives. (COAG 2010, p. 10)

In addition, the principles support a LRMC approach to setting volumetric charges, and make no reference to pricing water according to its relative scarcity, or to providing more consumer choice in the tariff structures offered by utilities.

Commitment to implementing the agreed pricing principles has been variable across jurisdictions.

INFORMATION REQUEST

The Commission is seeking views about pricing principles. What should be included in these principles so that they provide sufficient guidance for utilities?

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8 Non-price demand management

Key points

• Restrictions generate costs to households, businesses and the community. They do so by denying consumers the opportunity to choose how to use water in the ways that are most valuable to them. – Quantitative estimates indicate that the costs of restrictions are significant and can amount to several hundred million dollars per jurisdiction per year where they have been in place.

• Similarly, policies that mandate water use efficiency and conservation, or encourage consumers to save water through education campaigns and moral suasion, lead to some consumers behaving in ways that do not align with their preferences.

• Although there has been strong community support for restrictions and water use efficiency and conservation measures, not all consumers share the same preferences for using less water. There is evidence to suggest that many consumers would be willing to pay a higher water bill to avoid being subject to restrictions on their water use.

• Allowing consumers to exercise choice in their water consumption behaviour will ensure that water resources are allocated in such a way that maximises the benefits to the community. – The use of restrictions should be limited to times of emergency water shortages, or in regional urban areas where there are no viable new water sources available to augment supply. – Governments should not mandate water use efficiency and conservation activities, unless there is a market failure present and it is clearly established that the social benefits of intervention exceed the social costs. – Policies that target reductions in per capita water use should be abolished. – Government education and information campaigns should be refocused to provide more balanced information on the costs and benefits of water savings activities, as well as the relative merits of using prices, restrictions and water use efficiency and conservation measures to manage demand.

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Demand management in the urban water sector refers to the modification of the level and timing of water usage through various methods, including price and non- price tools. Pricing was discussed in chapter 7. This chapter focuses on the use of non-price demand management tools, and the efficiency gains that can be achieved by changing the way that these tools are utilised. Non-price demand management tools include water restrictions, and water efficiency and conservation measures.

Section 8.1 examines the economic costs of water restrictions, and outlines the scope for efficiency gains in not using restrictions except in limited circumstances only. Section 8.2 discusses the scope for efficiency gains in refocusing the way that measures are implemented by governments to promote water use efficiency and conservation. The impediments to achieving these efficiency gains are outlined in section 8.3. The chapter concludes with a summary of the superiority of price, rather than non-price, measures in managing demand.

8.1 Water restrictions

As outlined in chapter 2, restrictions have been the approach preferred by governments, regulators and utilities for managing demand in times of scarcity due to drought/climate change. Although restrictions began as a voluntary measure in most places, they were made mandatory as the severity of drought increased. They were also intended to be a temporary measure, but many jurisdictions have implemented permanent low level restrictions as part of an ongoing water conservation strategy (section 8.2). This approach is encouraged in the National Water Initiative (NWI) which provides that the State and Territory Governments should: review the effectiveness of temporary water restrictions and associated public education strategies, and assess the scope for extending low level restrictions as standard practice (COAG 2004, p. 20).

Rather than restrict the absolute quantity of water that can be consumed, restrictions usually constrain certain methods of watering and/or the timing of the use of water (Brennan, Tapsuwan and Ingram 2007). (Chapter 2 and appendix B provide an overview of the use of restrictions across the country.)

At the household level, restrictions tend to focus on outdoor use, which is easier to enforce than restrictions within the home. Restricting outdoor use is also seen as more equitable since it is believed to represent the more discretionary component of demand. Indoor use, on the other hand, is believed to represent the more ‘essential’ uses of water (chapter 9).

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It is estimated that in 2007, 80 per cent of Australian urban residents were subject to temporary restrictions (ACG 2007). This figure is likely to have decreased in the past year since restrictions have been eased in most regions, and in most cases they have been replaced with permanent ‘low level’ restrictions (chapter 2).

According to a recent report by Infrastructure Australia (sub. 62), 69 per cent of 101 surveyed regional towns were under some form of water restrictions in 2009, with level 3 water restrictions the most common.

Restrictions have also been placed on non-residential users in most states and territories, with the notable exception of Perth (chapter 2) (Institute for Sustainable Futures and ACIL Tasman 2009).

There is variation in the extent to which sanctions for violating mandated restrictions have been put in place and called upon.1 Nevertheless, moral suasion through government-initiated appeals and education campaigns has played a major role in encouraging households to comply with restrictions (Cooper, Crase and Burton, sub. 28) (section 8.3). This was highlighted by Lin Crase: In most jurisdictions some dispensation [from water restrictions] is made for the elderly although many are reluctant to seek relief for fear of the community backlash and a determination to share in the community’s ‘pain’. (Crase and O’Keefe, sub. 5, attachment, p. 5)

Restrictions, combined with water use efficiency and conservation measures (section 8.2), have been very effective in reducing demand for water. Total household consumption in Australia has decreased by 22 per cent since 2000-01 (chapter 2). Indeed, Sydney Water has found that restrictions not only reduced outdoor water use, but also usage within the home by about the same amount (after controlling for the effect of water conservation activities) (Beatty 2011).

Scope for efficiency gains

The success of restrictions in reducing demand has entailed many economic costs.

1 No breach of urban water restrictions has led to a fine in Victoria (Cooper 2010 quoted in Crase and O’Keefe sub. 5) but numerous fines have been applied in New South Wales, Queensland and Perth (Institute for Sustainable Futures and ACIL Tasman 2009).

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Costs of restrictions

Any policy that restricts consumption in a mandatory way imposes real economic costs on households, businesses and the community. This was highlighted by many participants. For example, WSAA stated that: … many restrictions impose a significant cost on customers and the community – examples include customer inconvenience, degradation of sporting facilities, creation of a bias for high-cost self supply options such as rainwater tanks – and therefore, are not in WSAA’s view an appropriate permanent or long term solution. (sub. 29, p. 19)

Costs to households

Many of the costs of restrictions are borne by denying households the opportunity to choose how to use water in the ways that are most valuable to them. Restrictions force all consumers to confine outdoor water demand in the same way even though some, such as avid gardeners, might value outdoor water use more than others, such as those living in high rise apartments. This leads to significant costs for those users who would be willing to pay for additional water and, therefore, an inefficient allocation of water resources.

Comments along these lines were made in a submission by Lin Crase: The notion that urban water customers have differing demands should of itself not be particularly remarkable. However, the current policy setting runs contrary to this view. Outdoor water restrictions are equally stringent on residents in high-rise apartments with no outdoor space and suburban dwellers with the demands of a vegetable patch, all in the name of equity. Watering times are also rostered with no consideration of the hours available to different householders to hand-water portions of their garden. (Crase and O’Keefe, sub. 5, attachment, p. 5)

More specifically, the requirement to reduce outdoor water demand in prescribed ways leads to the following financial and non-financial costs:

• time and inconvenience costs associated with having to water gardens at permitted times (ACG 2007)

• the sacrifice of water-based de-stressing activities such as long showers, playing in the pool or having a spa (Colmar Brunton Social Research 2008)

• carrying ‘greywater’ in buckets from showers to outdoor plants, which is not only time consuming but can also cause physical injury

• time and cost of having to drive cars to a car wash to clean them

• loss of amenity from private gardens and pools and degradation of those assets (Colmar Brunton Social Research 2008)

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– for example, Dr Terence Dwyer (sub. 74, p. 1) stated that: ‘as a result of water restrictions we have lost 3 trees, the garden has been trashed and its value severely diminished (both in terms of use and thousands of dollars in restoration costs).’

• private property damage from dry soil causing cracking and movement of houses

• loss of real estate value of homes due to dead or dying gardens, or the decreased aesthetic value of neighbourhoods (Colmar Brunton Social Research 2008).

Restrictions can induce inefficient and costly investment in private water storages as an alternative water source (ACG 2009). As outlined in chapter 6, this is a very expensive augmentation option. For instance, a common 2000 litre household rainwater tank costing about $1500 to $2000, holds about $4 worth of water at current mains water prices.

Restrictions also impose costs associated with purchasing and installing new watering systems as changes occur in allowed methods of watering. These costs of adjusting to different levels of restrictions are exacerbated when there is uncertainty about the triggers for implementing different levels of restrictions, the nature of different levels of restrictions and the likely frequency with which they are expected to be implemented (Irrigation Australia, sub. 14).

Altered incentives for water use

Restrictions can result in perverse incentives for deliberate excessive use of drinking-quality water through showers, baths and water tanks to generate additional ‘greywater’ for use on lawns and gardens (ACG 2009).

They can also lead to ‘over watering’ of gardens during the allowable watering times to compensate for restricted times of use (Brennan, Tapsuwan and Ingram 2007).

Costs to businesses

Businesses that are intensive users of water and are subject to water restrictions can experience an increase in production costs as they seek alternative sources of water (Institute for Sustainable Futures and ACIL Tasman 2009).

Those businesses that sell water-intensive products might experience a reduction in sales. Industries that could be particularly negatively affected include the nurseries, turf, pool and spa, and commercial car wash industries. These losses will not, however, necessarily represent a net loss as consumers spending less on water

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intensive products might spend more money on other goods and services (including water-saving products) (CIE 2008).

Costs to the community

Restrictions can reduce community welfare through a loss of amenity associated with less green open space, including unwatered council parks and a lack of access to community sport and recreational facilities.2 This loss of amenity can lead to other social problems including increased health issues such as depression and obesity (Irrigation Australia, sub. 14). Poorer quality sporting fields can also lead to risk of injury from sporting activities (Colmar Brunton Social Research 2008).

Restrictions, through a loss of green open space, can also have environmental impacts, including:

• reduced cooling effects on buildings, requiring greater energy consumption

• diminished urban stormwater management, whereby green open spaces cannot assist with reducing peak flows and runoff pollutants

• distorted soil structure and soil erosion (CRCIF technical report, quoted in Irrigation Australia, sub. 14).

A lack of green open space can also reduce property values, and cause damage to buildings, other structures and pipes through cracking.

Furthermore, restrictions can lead to a reduction in social cohesion arising from households being encouraged to report neighbours that do not comply (Institute for Sustainable Futures and ACIL Tasman 2009).

A study by Cooper (2010, quoted in Crase and O’Keefe, sub. 5) found that about 20 per cent of customers would actually pay an additional water charge to prevent other water users accessing the water market in order to alleviate the burden of water restrictions.

Costs to utilities and State and Territory Governments

Restrictions can be financially costly for governments and utilities to administer. Restrictions require advertising campaigns to communicate the rules under different levels of restrictions. Where mandatory, costs of monitoring and enforcement can also be incurred (CIE 2008).

2 Alternatively, households can pay through their council rates for high-cost recycled water to keep them green.

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Using restrictions rather than prices also limits the volume of water that can be sold by utilities and, over time, constrains the revenue to pursue future supply augmentation (Crase and O’Keefe, sub. 5).

Restrictions can also cause confusion over the complexity of the arrangements, such as which days of the week and times of the day watering is allowed, and when odd/even house numbers are permitted to use water.

Quantifying the costs

There have been some attempts to quantify the costs of restrictions put in place in Australia in recent years. Some examples include the following:

• The CIE (2008) found that the total annual cost of restrictions in the ACT ranges from $5.2 million for stage 1 restrictions, to $209 million for stage 4 restrictions. – the total cost of restrictions to households ranged from $4.5 million for stage 1 restrictions, to $115 million – the cost to ACTEW and the ACT Government of lost profits, reduced revenue and administrative costs from advertising, monitoring and enforcing restrictions ranges from between $0.7 million to $23.8 million.

• Grafton and Ward 2008 (quoted in Grafton and Ward 2010) found that restrictions resulted in aggregate welfare losses in Sydney equal to about $275 million (2010 dollars) in 2004-05 relative to a volumetric price that would have ensured the same level of demand and remitted revenues, in excess of supply costs, back to consumers in the form of lower access fees. – In its 2008 research paper, the Commission used this figure to estimate that the aggregate welfare cost of water restrictions to Australian households then subject to restrictions was about $900 million.

• In a study on restrictions in Perth, Brennan, Tapsuwan and Ingram (2007) estimated that the household welfare costs of a sprinkler restriction appear to be less than $100 per season when mild sprinkler restrictions are in place (two days per week), and might range between $347 and $870 per season when a complete sprinkler ban is in place, depending on the opportunity cost of time assumed.

The economic modelling conducted by the Commission for this inquiry estimates that the equivalent of level 3a restrictions in Melbourne would cost that city between $400 million and $1.5 billion over a 10 year period (PC 2011a). This welfare loss is likely to be a lower bound on the actual costs of restrictions since it does not capture the differential effect across individual households — for example,

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some households that are prepared to pay a lot for additional water might have to forego consumption due to restrictions.

When are restrictions appropriate?

The main advantage of water restrictions is that they can be imposed quickly in the face of an unexpected water shortfall (Grafton and Ward 2010). By contrast, due to lags in the billing cycle, price changes might take several months to be fully implemented.

Restrictions are most appropriate when there is a need to respond to an emergency situation, such as a technical failure somewhere along the supply chain, involving an unpredictable shortage of water. In these cases, it will not be possible to wait for the price mechanism to take effect on demand, since prices are usually set for a given period (rather than adjusted instantaneously) (Sibly 2006). At such times, restrictions would be in place for a short period only. They would be removed once the emergency situation has been resolved.

There might also be some regional urban areas where there is no economically viable supply augmentation option available during times of water shortage. In these areas, restrictions might be the only alternative.

Outside of these circumstances, restrictions are costly, and these costs are greater the more inelastic demand is with respect to price. This is because an inelastic demand indicates that consumers place a high value on consuming water, suggesting that the correct policy response to a water shortage is for investment in supply capacity to take place, not to restrict valued water consumption.

Therefore, although strong support for restrictions by the community (section 8.3) helped to manage scarce water supplies during the drought, consumers should not be called upon year after year to restrict their demand. The need to comply with restrictions for so long only materialised because supply capacity was not augmented due to the suddenness and severity of the reduction in inflows and the poor investment decisions (chapter 6).

Consumer choice is economically superior to restrictions. Those with a preference to restrict their water usage should be able to do so, but this should be voluntary. Those preferring to use more water should not have to put aside their preference for greater water consumption. Allowing consumers to exercise choice in their water consumption behaviour through an efficient price mechanism will ensure that water resources are allocated in such a way that maximises the benefits to the community.

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8.2 Water use efficiency and conservation measures

Water use efficiency measures aim to reduce water consumption while at the same time maintaining or increasing the level of useful output or outcome delivered. For example, if two dishwashers do an equally good job of cleaning dishes, the one that uses less water has a higher water use efficiency.

The term water conservation can be used to mean much the same as water use efficiency (chapter 3). Where it is used differently, it can be defined as a reduction in water use that also causes a reduction in the level of useful output or outcome delivered.

Chapter 2 outlines the range of water use efficiency and conservation measures initiated across the country, some of which are mandatory (such as the Basix scheme in New South Wales and the Queensland Development Code), and others which are aimed at influencing behaviour, often supported by moral suasion, to encourage voluntary conservation (such as the Target 155 campaign in Melbourne (which was recently abolished), and education campaigns like Sydney’s Every Drop Counts campaign). Many of these initiatives have come about because of State and Territory Government-set targets for utilities to reduce per capita water usage (for example, the Victorian Government’s conservation target of reducing total per capita water usage by 25 per cent by 2015, increasing to 30 per cent by 2020) (DSE 2006).

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As with restrictions, there is evidence that water use efficiency and conservation programs have been very effective in reducing demand during recent droughts. For example, Sydney Water estimates that water conservation activities over the past 10 years have reduced total residential water use by about 30 gigalitres or about 9 per cent of demand (Abrams et al. 2011).

It is thought that there is now little scope left for these programs to further reduce demand, as discretionary demand has decreased to such low levels (see, for example, Sydney Water, sub. 21).

Scope for efficiency gains from refocusing water use efficiency and conservation measures

Reducing water consumption through water use efficiency and conservation is not always advantageous. The benefits from improving water use efficiency and conservation will differ according to the share of total (household or business) expenditure that is accounted for by water. The costs will differ depending on the value that a consumer places on water versus other resources.

Whether a water use efficiency or conservation measure is worth pursuing or not requires an assessment of the costs and the benefits involved.

In some cases, achieving greater water use efficiency can provide a net benefit for both water utilities and consumers. For example, water use efficiency programs can be commercially attractive for a utility because they reduce supply costs — the reduction in revenue from selling less water is more than offset by the savings induced by avoiding the need to upgrade or expand capacity. For households, they can be beneficial when paying a lower water bill outweighs the cost to them of implementing water use efficiency and conservation measures.

The costs of water use efficiency and conservation measures can, however, be substantial. These include not only the direct financial costs of investing in water saving appliances, but also the costs resulting from using more of other valuable resources, such as energy, materials or labour to achieve a given reduction in water. Tradeoffs need to be made in using available resources to reduce water use, and using them to undertake other activities. Whether such tradeoffs are worth making depends on the value of the water saved relative to the value of the extra resources used.

Mandatory water use efficiency and conservation measures prescribe how these tradeoffs should take place instead of leaving it in the hands of water users. For example, mandatory use of water efficient appliances in buildings obliges all

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consumers to use water efficient appliances. However, for some consumers it will be more cost effective to buy a cheap but not very water efficient appliance as they use it so little that the cost savings from the smaller amount of water used will never outweigh the upfront capital costs.

Although not mandating water savings, government initiated education campaigns use moral suasion to encourage consumers to make choices that they otherwise would not. They do this by sending a very strong message to consumers that using less water is always a good thing. This point was made by Lin Crase: ... the heavy emphasis on narrow concepts such as WUE [water use efficiency] has already created within government and community circles a view that less water use by the urban sector constitutes a superior state under any circumstance. … The expansive effort to promote WUE as dogma has resulted in urban water use being almost demonised. (Crase and O’Keefe, sub. 5, attachment, pp. 6, 9)

By restricting consumer choice, policies that either mandate or encourage water savings lead to inefficiencies because users will value water differently. Lin Crase observed the following: Water is usually only one of many inputs in the production of outputs, including in household settings. Complementary inputs are also a requirement (e.g. the labour required to hand-water plants). Thus, to target only one input will inevitably result in poor input selection. … To simply assume that WUE [water use efficiency] is superior to the efficient use of all inputs belies the expansive economic literature in this field. Moreover, to place WUE above overall economic efficiency seems an even greater misjudgement. Some outputs produced at the household and commercial level will be water-intensive and have few options for input substitution. Moreover, these same outputs may also be highly valued and in that context households and commercial enterprises will accept the necessity for increased water use and willingly carry the related costs. (Crase and O’Keefe, sub. 5, attachment, p. 2)

Mandatory and subsidised measures also entail the government ‘picking winners’ as to which water saving technologies are utilised, and unless this decision is based on a rigorous cost–benefit analysis, inefficiencies will arise. For example, Crase and Dollery (2005) examined subsidies paid in Melbourne on water-saving investments for households and found the cost per megalitre of water saved ranged from $770 for AAA shower roses, to $9069 for rainwater tanks, and to $33 395 for AAA dishwashers. This compares with a price of between $750 and $1300 per megalitre at the time. In addition, the Department of Water (WA) said in its submission: Other non-price demand management measures implemented by the Western Australian Government include a water efficiency rebate program which ran from February 2003 to June 2009. An assessment of costs per kilolitre of water saved during the program indicated that most rebate products were more expensive than the alternative of producing more potable water. (sub. 38, p. 8)

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Water use efficiency measures might also have the potential to actually increase water consumption through a ‘rebound effect’ although the evidence is not conclusive. According to Quentin Grafton: While it seems intuitive that water-saving devices should reduce household consumption, this may not necessarily be true in all cases. This is because an increase in water efficiency of a device effectively reduces the unit cost of the produced service and, thus, could theoretically cause an increase in consumption. Olmstead and Stavins (2009) provide a review and summary of studies on water savings devices. The empirical evidence is mixed. (sub. 22, p. 8)

In the Commission’s view, water conservation for its own sake deprives the community of valued water use. If individuals have a preference to engage in water conservation activities and it is cost effective for them to do so, then they should be allowed to act upon their preference. But those who do not share such a preference for conservation should not be made to engage in the same behaviour — for them, the benefit derived from consuming water will be greater than the prevailing price. As long as water use efficiency and conservation measures are voluntary, individuals can decide for themselves.

However, following the strong public advocacy of water saving behaviour through information and education campaigns, it will be very difficult to reverse the message that saving water is always in the interests of the community. Lin Crase suggested that: At the national level (i.e. NWI) the WUE [water use efficiency] mantra needs to be reconsidered and recrafted. This will be a formidable task given the momentum developed around the notion of ‘saving every last drop’. Nevertheless, unless this is tackled the objective of optimising supply in the longer term will be unattainable. It is difficult to see this being accomplished in less than 10 years. ... much needs to be done to re-shape community thinking about urban water use. (Crase and O’Keefe, sub. 5, attachment, pp. 8–9)

In the Commission’s view, there is a strong case for governments to provide more balanced information on the costs and benefits of water savings activities, as well as the relative merits of using prices, restrictions and water use efficiency and conservation measures to manage demand. Presenting consumers with the facts would enable them to make objective choices that are aligned with their individual preferences.

Market failures could give rise to the need for government intervention

Producers and consumers might not always seek greater water use efficiency, even when it is of net benefit to do so. This can be due to market failures associated with imperfect information and split incentives.

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Imperfect information

Markets work best when consumers and producers have sufficient information about technologies and services to make choices that will maximise their welfare and profit respectively.

However, consumers might not be able to access the necessary information on the relative water use efficiency of a product because of deficiencies in available information. Similarly, producers might not have sufficient information about the water use efficiency of the products of their competitors, or their consumers’ preferences to reduce water consumption. Consequently, consumers and producers might make sub-optimal decisions based on limited information.

The market might fail to provide sufficient information due to the high costs of obtaining it, its public good characteristics and differences in the information held by buyers and sellers (box 8.1).

Box 8.1 Causes of market failure in information provision There are three reasons why market information might be imperfect. 1. Information can be costly to obtain — the costs are not just financial; they might include the opportunity costs of devoting time and effort that could be spent elsewhere. For consumers, this might mean less leisure time, and for firms it might mean less attention is given to other business activities and obligations. This will be a particular barrier where water represents a small proportion of a business’s total costs or a household’s total expenditure. 2. Information can have public good characteristics — information can be used many times over without reducing what is available to others, and it can be difficult to exclude its use by others, even if they do not pay for it. This decreases the incentives for private providers to supply such information, especially where that information is not product specific and, therefore, is unlikely to give them a marketing advantage over their competitors. 3. Information is not available equally to all participants in the market — this typically occurs where producers have more information about the water use efficiency of their products than their consumers. This information asymmetry could persist because sellers have an incentive to promote products as water efficient even when they are not. If consumers think this is the case, then they will be unwilling to pay a premium for actual higher water efficiency. This will in turn lead to only poorer quality products being supplied to the market. As a result, markets might undersupply cost-effective water-efficient technologies.

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Split incentives

Split incentives arise when the person purchasing a water-efficient product is different from the person who benefits from it, and the incentives facing the purchaser differ from those of users.

This problem can occur in real estate markets, where it is sometimes called the landlord–tenant problem. Landlords, it is argued, will not have strong incentives to install more water-efficient appliances if they cannot get sufficient benefit, in the form of higher rents, to recoup the costs involved.

This is currently unlikely to be much of a problem for water as landlords currently pay water bills on behalf of their tenants in most states and territories with some exceptions in Victoria, New South Wales and Queensland (chapter 7) and, therefore, do have scope to benefit over time from a reduced water bill. If, however, the situation changes to one where tenants pay their water bills, as recommended by the Commission (chapter 7), split incentives would become more of an issue. Not only would landlords have limited incentives to invest in water-efficient appliances, but so would tenants. Tenants might be prohibited from replacing appliances, or they might not be confident that they will be able to recoup the savings (through lower water bills) over the lifetime of their tenancy, especially if they live in a multi-unit dwelling where water is not separately metered.

Owner occupiers could also have a reduced incentive to invest in water conserving features if these features are unlikely to be recognised when the building is sold — that is, if the improvements are not capitalised into the value of the building. In this case, an owner will only invest in those features that are likely to repay themselves over the remaining duration of their occupancy. Even then, if they live in a multi- unit dwelling where water is not separately metered, the incentives will be diminished further as owner occupiers will be unable to accrue the full savings from their reduction in water consumption due to cross subsidisation among units.

Split incentives can occur where there is an information asymmetry, but this is not essential. Even where the buyer and seller have the same access to information, the transaction costs of overcoming their different incentives might result in the non- adoption of what would otherwise have been a worthwhile investment.

Government intervention to deal with market failures

The market failures associated with information provision and, to a lesser extent, split incentives, might provide some rationale for government intervention. However, the presence of market failure does not of itself warrant government

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intervention. Such intervention can be costly and introduces its own distortions, especially if the intervention is poorly targeted (chapter 4). Intervention is only warranted when it produces net benefits to the community (including economic, social or environmental benefits and the public and private costs).

The method and extent to which governments actually intervene will depend in part on the material nature of the problem and the relative cost effectiveness of the various policy options. Intervention is best achieved by targeting the market failure as directly as possible. For example, some information asymmetries might be virtually insurmountable for most consumers at any reasonable cost. Government intervention that provided such information directly or that required it to be provided could reduce the search costs of obtaining information.

The Water Efficiency Labelling Scheme (WELS) is an example of an intervention aimed at addressing the information gap by providing information on the water use efficiency of specific appliances. WELS was initially a voluntary scheme but was made mandatory in 2006 (Australian Government 2011). It is a joint Commonwealth and State and Territory Government initiative.

A 2009 survey of the WELS scheme undertaken on behalf of the Department of Environment, Water, Heritage and Arts found that 56 per cent of household and non-household consumers were aware of WELS. Of this 56 per cent:

• 78 per cent claimed that WELS was credible

• 92 per cent said WELS helped to a ‘moderate’ or ‘great extent’ in purchase decisions of water-using appliances (only 8 per cent said it did not help)

• 80 per cent said it helped compare water consumption

• 72 per cent said it helped compare water efficiency

• 46 and 47 per cent said it helped compare running costs and environmental impact, respectively (George Wilkenfeld and Associates 2010).

DRAFT FINDING 8.2 The WELS scheme has been successful at providing the public with an objective set of information with which to make informed decisions, and should continue.

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8.3 Impediments to achieving efficiency gains

The above sections identify scope for significant efficiency gains from reducing the reliance on restrictions and water use efficiency and conservation programs to manage demand. There are, however, several impediments to achieving these gains. These include strong community support for such measures, as well as the absence of an alternative mechanism for managing demand.

Community support

Restrictions and other measures to reduce water use appear to have been very strongly supported by the community, with a strong change in behaviour and a high level of compliance even during periods of very stringent restrictions.

According to Sydney Water: … 36% of customers place a high value on water efficiency – either through active water conservation on an individual level, or through the take-up of Sydney Water products such as water efficiency rebates. (sub. 21, p. 21)

Furthermore, according to the Consumer Utilities Advocacy Centre (CUAC): Community attitude surveys typically show popular acceptance of water restrictions. For example, a survey by IPART in 2003 found that around 63 per cent of people were willing to have water restrictions once each year. A later survey in 2007 found that 80 per cent of participants were in ‘total support’ of the restrictions in place in Sydney at that time, and nearly 70 per cent ‘were in total support of restrictions remaining in place for the foreseeable future’. … Given their effectiveness and the community backing they enjoy, CUAC supports the use of restrictions (temporary and permanent) where these are carefully planned and implemented. (sub. 46, p. 6)

One reason behind strong community support is that it gives individuals a sense of community spirit and solidarity by working together to achieve a common purpose. According to a report by the Institute for Sustainable Futures and ACIL Tasman (2009), anecdotal evidence suggests that the experience of drought and drought response has been a unifying force in communities, and acted as a common cultural reference and talking point.

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The strong community support for saving water could be an impediment to removing the focus on non-price demand management. According to Lin Crase: … the near ecumenical enthusiasm of state agencies to promote urban water saving at any cost has resulted in an environment where a shift to more rational investment decisions is likely to attract criticism from some parts of the citizenry. The negative response of some Melbournians to the relaxation of water restrictions as a result of recent widespread rains is a case in point. … Thus, while there is scope for more diverse responses to supply augmentation these are only likely to be realised if accompanied by a successful ‘re-education’ campaign on the part of water agencies. (Crase and O’Keefe, sub. 5, attachment, p. 6)

Clearly some individuals derive utility from restricting their water consumption to benefit the wider community. There is, however, evidence to suggest that parts of the community do not share this preference and would be willing to pay a higher water bill to avoid restricting their water consumption (box 8.2). For example, according to results from one study: Contrary to the implied value of ‘saving water’ that dominates popular thinking, these results reveal that particular segments within society actually value not being subject to water restrictions. (Cooper, Crase and Burton, sub. 28, p. 25)

In addition, a report by Colmar Brunton Social Research (2008) conducted in the ACT indicates that 56 per cent of respondents preferred that individual households were able to choose water plans to suit their needs and budgets, rather than the same blanket restrictions applying to all households at all times.

The measures are seen as equitable

A main reason for strong community support of restrictions and other measures is that they are seen as an equitable tool for dealing with water shortages. This is because everybody is seen to share in the losses from having to ration a shortage of supply according to a set of rules or mandated water reduction measures that are applied equally to all households. This, it is argued, compares to using price to manage demand, where those that can afford to buy more have access to larger amounts of water than poorer households (Colmar Brunton Social Research 2008).

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Box 8.2 Studies on the willingness to pay to avoid restrictions Examples of studies that have estimated the willingness of consumers to pay to avoid restrictions include the following:

• Allen Consulting Group (2007, quoted in CIE 2010b) found that households in south-east Queensland were willing to pay an additional $132 per annum to reduce the frequency of level 4 restrictions from 50 per cent of the time to 20 per cent of the time, and an additional $190 per annum to remove the need for level 2 (or worse) restrictions.

• Cooper, Crase and Burton (sub. 28) found that respondents in New South Wales and Victoria with a lawn were willing to pay $152 to avoid restrictions compared to those without who were willing to pay $98. Respondents from water rich cities generally had a lower willingness to pay range. Those with a higher income had a higher willingness to pay to avoid water restrictions. Notably, participants with a higher income indicated a willingness to pay value of $181 from the conservative perspective, with the upper bound estimating a willingness to pay value of $291.

• Gordon et al. (2001, quoted in Brennan Tapsuwan and Ingram 2007), using a choice modelling exercise, found that consumers were willing to pay an extra $150 per year on their water bill for a more ‘voluntary based’ demand management approach (including incentive schemes for grey water recycling and efficiency regulations on new buildings) rather than mandatory restrictions aimed at achieving the same demand reduction.

• In another choice modelling study, Hensher, Shore and Train (2006) found that households in Canberra were on average willing to pay up to $239 extra on their water bill to move from stage 3 restrictions (complete sprinkler bans) that apply every day and last all year to a situation where there are no restrictions at all. Households were not willing to pay to avoid level 1 and 2 restrictions. At the time of the study, level 1 restrictions were in place.

However, there are many ways in which these measures do not affect all water users equally and, therefore, embody inequities:

• Restrictions disadvantage those that value outdoor use most and benefit those that value it least. Those that are disadvantaged include gardeners; families with children that play under sprinklers; users of outdoor sports venues; and businesses that sell water intensive goods and services. In contrast, those who value indoor use more are hardly affected. This includes those living in apartments with no outdoor demand.

• There are large costs to circumventing restrictions, such as installing rainwater tanks, installing bores or grey water reuse systems, or having to go to the carwash or local pool. These costs might be insurmountable for low-income households. This means that the rich can more readily circumvent restrictions, in

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a similar way that the rich have a greater financial capacity to buy more water than the poor when prices are high.

• Some mandated building requirements (such as Basix in New South Wales) apply only to new residential developments, and these increase the costs for purchasers of new homes, while purchasers of existing homes do not incur these same costs.

Environmental benefits

Some argue that conservation and water use efficiency is good for the environment because, for example, less water is taken out of rivers, or less energy is used manufacturing water from desalinisation plants. The New South Wales Government said in its submission: In addition to reducing pressure on potable supplies, DM [demand management] can also deliver positive environmental benefits, such as reducing the amount of energy used by hot water systems and for pumping water to deliver it to customers and reducing wastewater volumes and associated pumping and treatment costs. (sub. 65, p. 13)

As explained in chapter 3, it is the Commission’s view that environmental objectives are best pursued directly, outside of the urban water sector.

Absence of other demand management alternatives

To date, regulated wholesale and retail prices have meant that price as a demand management tool has been suppressed and there has been no choice but to resort to restrictions and water use efficiency and conservation measures. The gains from removing restrictions and reducing the emphasis on water use efficiency and conservation would only be attainable if price were used instead as a tool to manage demand (chapter 7). According to Quentin Grafton: Fixed volumetric pricing specified years in advance and independent of water availability is the major cause of water restrictions in Australia. Dynamically efficient water pricing would eliminate the need for water restrictions, except in unanticipated emergencies. (sub. 22, p. 3)

As explained in chapter 7, prices send the right signal to consumers and producers about the opportunity cost of the consumption, production and investment decisions. In doing so, allocating scarce water resources via the price mechanism, rather than through non-price demand measures, ensures that the benefits to the community are maximised.

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9 Achieving affordability and consumer protection objectives

Key points

• Water consumption per capita in Australia is well above generally agreed subsistence requirements. There is no need for an ‘essential’ volume of water to be determined by governments.

• Expenditure on water and wastewater services generally represents a small proportion of income, including for low income groups, and relatively few households have difficulty paying water and wastewater bills.

• Price increases for water and wastewater services, although contributing to rising costs of living, are likely to have had less detrimental effect on consumers than price increases of other essential goods and services such as energy and housing, on which expenditure represents a greater share of incomes.

• Current state and territory concession arrangements for water and wastewater services are inefficient and inequitable. Efficiency gains can be made by replacing or amending concessions with direct payments to targeted households or rebates on the fixed component of water and wastewater service bills.

• The affordability of water and wastewater services for low income and disadvantaged households, in addition to the affordability of other essential goods and services, is most efficiently achieved through non-concession elements of Australia’s tax and transfer system.

• If water and wastewater concessions are necessary, they should be funded by governments through transparent Community Service Obligations.

• Properly designed hardship policies, that outline the obligations of water utilities when dealing with customers facing payment difficulties, are in the interests of consumers. Other measures to alleviate hardship for low income and disadvantaged consumers in exceptional circumstances, such as utility grant schemes, also have merit.

• Consumer advocacy and research plays an important role in ensuring that policy makers and regulators are informed about consumer preferences. Consumer policy advocacy and research in the urban water sector is poorly resourced and regulatory and policy decision making would benefit from greater resources in this area. It is important that advocacy represents the views of the majority of consumers.

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As noted in chapter 3, the Commission accepts that universal and affordable access to water and wastewater services should be a government objective for both equity and efficiency reasons, because a failure to have an adequate level of access and use can have considerable detrimental affects on individual consumers and public health.

As such, it is important that:

• an adequate level of consumption of these services be affordable for all individuals and households

• consumers be protected from poor levels of service

• service delivery meets consumer preferences at least cost.

This chapter explains how affordability and consumer protection objectives can be achieved effectively and efficiently.

9.1 Affordability of water and wastewater services

The affordability of water and wastewater services relates to their cost and the ability of individuals and households to pay for them.

There is general acceptance that those that benefit from the consumption of a good or service should have to pay for it. However, there is also acceptance that all people should have the means to achieve a minimum acceptable standard of living regardless of their ability to pay for it (the social safety net).

The benefits of achieving universal and affordable access to water are likely to include:

• a higher standard of living

• better sanitation, prevention of disease and improved public health outcomes

• greater social inclusion and cohesion, greater upward social mobility and self-sufficiency.

What level of access and use is required?

Given that universal access and use of some level of water and wastewater services is necessary, how much access and use is required? On the whole, participants in the inquiry expressed the view that the basic right or essential requirement did not extend to an unlimited amount of water (and, by extension, wastewater services).

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The Consumer Utilities Advocacy Centre (CUAC) stated: In discussion of access to water, reference is often made to a ‘minimum acceptable’ or ‘essential’ level of access. This distinction recognises that consumers are not entitled to an unlimited or excessive supply of water. (sub. 46, p. 2)

Anglicare Tasmania addressed the issue in terms of discretionary and non-discretionary use: Put simply, use of water and sewerage services in Australia is not discretionary, although some components of usage (such as using water for long showers or hosing down driveways) may be discretionary. (sub. 44, p. 2)

The Environmental Defenders Office (SA) argued that water should be priced with both affordability and conservation objectives in mind: Pricing for water should be structured so that the most disadvantaged in the community are not inappropriately charged for the provision of basic water services. Above a basic level of access however, water should be charged at a premium in order to discourage abuse. (sub. 39, p. 1)

CUAC noted that, ‘individuals’ different circumstances (such as family size, medical needs, and climate) mean that the amount of water necessary to meet basic needs varies’ (sub. 46. p. 2). In addition CUAC stated, ‘in a highly developed country like Australia, a level of water use beyond that needed to meet basic survival needs is necessary to social participation and inclusion’ (sub. 46, p. 2), and ‘we don’t want a society where entire groups of people can’t, say, have a modest garden’ (trans., p. 236).

In highlighting the potential inequities of inclining block tariffs, the Public Interest Advocacy Centre (PIAC) stated that: … households with residents that need water for medical purposes, such as kidney dialysis; households with a large number of members, including families with children; and households that accommodate transitory populations, such as Indigenous Australians … would reasonably be expected to consume large quantities of water to secure an adequate standard of living. (sub. 61, p. 7)

As such, a person’s view of what constitutes essential water use is likely to depend on what type of water using activities and their frequency they believe are required. However, there is a stronger case for a definition of essential water use that includes the amount of water sufficient for survival and maintenance of adequate hygiene, as opposed to one that includes other uses, such as gardening, which are regarded by many as amenity uses of water.

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Evidence on minimum acceptable access and use

Although there is significant information on the average amount of water consumed by Australian households, relatively little information is available about how much water constitutes essential or non-discretionary use. The distinction between water consumed and non-discretionary use is important, as water has many amenity uses in addition to its essential uses. In relation to essential water requirements, CUAC stated that ‘there needs to be a lot more work done to establish what that might be’ (trans., p. 236).

Much of the published research on essential water requirements is aimed at informing service provision by relief organisations following natural disasters, or in developing countries. These estimates are small relative to Australia’s average level of household consumption (in 2008-09) of about 220 litres per person per day (80 kilolitres (kL) per year) (NWC 2011b).

In a study of water access, use and health outcomes prepared for the World Health Organization, Howard and Bartram (2003) found that access to 100 litres of water per person per day (36.5 kL per year) or more provided continuously to a dwelling through multiple taps is an optimum level of access allowing all consumption and hygiene needs to be met (table 9.1). This includes water for drinking, preparing food, bathing, laundering and sanitation.

Table 9.1 Estimates of water service requirements to promote health

Service level Needs met Level of health concern

No access (below 5 litres per day) Consumption – cannot be assured Very high Hygiene – no needs met Basic access (average quantity Consumption – should be assured High unlikely to exceed 20 litres per Hygiene – hand washing and basic food day) hygiene possible; laundry and bathing difficult to assure Intermediate access (average Consumption – assured Low quantity about 50 litres per day) Hygiene – all basic personal and food hygiene assured; laundry and bathing should also be assured Optimal access (average quantity Consumption – all needs met Very Low 100 litres per day and above) Hygiene – all needs should be met Source: Howard and Bartram (2003).

Gleick (2006) found that 80 litres of water per person per day (30 kL per year), was sufficient to satisfy basic water needs using water piped directly to a house

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including the toilet. Falkenmark (1991, in Gleick 2006) cited 100 litres per person per day as the typical household water demand in water scarce regions.

Although much less than Australia’s average per capita use, these estimates are not much less than the average consumption level in some other developed countries such as the Netherlands, in which consumption averages 127.5 litres per person per day (Vewin 2010) or consumption in some areas of Australia during water restrictions — the average water consumption for residents of Melbourne under level 3a water restrictions was 148 litres per person per day in 2009-10 (Melbourne Water 2010).

Water consumption in Australia generally exceeds all definitions of essential water use — the Commission’s own analysis of per capita water consumption indicates that although some sections of metropolitan Melbourne and Sydney consumed about the level of consumption identified by Howard and Bartram as the minimum optimal amount (100 litres per person per day) in 2009-10, the vast majority consumed much more (PC 2011b).

In the context of a developed country like Australia, in which accepted levels of consumption exceed all definitions of subsistence or minimum acceptable amounts of water use, there does not appear to be a need for governments to define a minimum essential requirement for water.

In addition, the amount of essential water use required at the household level (relevant for metering purposes) is correlated with the number of persons in a household and this would make it administratively difficult to extend an essential water requirement to the household level.

Also, although for most individuals the amount of water required for essential uses in Australia is small relative to actual use, there are some specific health conditions for which outpatient treatment requires considerable amounts of water to be used, such as haemodialysis treatment for renal failure.

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How affordable are water and wastewater services?

As discussed in chapter 2, prices for water and wastewater services have increased significantly in recent years and are forecast to rise further in the next few years to finance investment in infrastructure.

In the course of this inquiry, the Commission has heard that some Australian households find it difficult to pay for water and wastewater services, and to make ends meet more generally. This is consistent with wider community commentary on growing cost of living pressures (box 9.1).

The Tasmanian Council of Social Service (TasCOSS) stated: Our members report that people living on low incomes are finding it increasingly difficult to meet the basic costs of living as housing, energy, food, transport and other costs rise. (sub. 13, p. 2)

Anglicare Tasmania, commenting on the effect of expected price increases for water and wastewater services in Tasmania submitted: Anglicare is extremely concerned about the effect these price increases will have on people on low incomes, particularly as the cost of living more generally is increasing and people are coming under sustained pressure from rising electricity prices, rising food prices and an ongoing shortage of affordable housing. (sub. 44, p. 2)

CUAC, commenting on the potential effect of scarcity pricing, stated: … there are already consumers who are struggling with affordability, so if prices went up further then there will be more and I think you only need to look at Victorian media to see that cost of living concerns are a major issue for a lot of people and water, as one thing, may not be a huge part of the household budget, although I also note that our most recent data on that isn’t that recent or that fantastic. But when you consider it in concert with rising electricity prices and other cost of living pressures, it’s a concern. (trans., p. 239)

Water and wastewater are essential services, and as such, households do not generally require encouragement to consume an adequate amount of these services if they are affordable.

The affordability of water and wastewater services will depend on four factors:

• the cost of purchasing access to and use of water and wastewater services

• the cost of other essential goods and services required to be purchased

• the ability to budget for water and wastewater service bills and pay for them when they become due

• incomes.

220 AUSTRALIA'S URBAN WATER SECTOR

The question then, is whether the source of an inability to afford water and wastewater services is due to the cost of these services in particular, the general level of prices of other essential goods, or if bills are infrequent and large, in relation to incomes.

Box 9.1 Commentary on cost of living pressures A number of community service and other organisations have commented on the rising cost of living and its impact on low income and disadvantaged groups. The Energy and Water Ombudsman Victoria (EWOV 2010, p. 33): Our case trends point to increasing financial hardship. In 2009-10, customers raised 28% more issues about payment difficulties than in 2008-09. We helped negotiate 2,473 payment plans, 31% more than in 2008-09 and 143% more than four years ago, when we first began to collate this information. The Energy and Water Ombudsman NSW (EWON 2010, p. 2): At our outreach events, community workers reported that utility price increases continued to be a great concern for low-income households and customers living on a fixed income. Some community workers were also experiencing increased demand for their services from a new group of clients who were employed but struggling to meet their housing costs and utility bills. The Wesley Mission (2010, p. 5): … increasing numbers of people in NSW, particularly single parents, are struggling to make ends meet. Many are still struggling to recover from the job losses or reduced working hours caused by the GFC. Rising rents and mortgage costs add to the problem as does the relentless increase in utility costs. The Essential Services Commission of South Australia (ESCOSA 2010, p. 48): To the extent that utility prices continue to increase, there is the potential for more customers to experience financial difficulties from time to time. The South Australian Council of Social Service (SACOSS 2010, p. 3): Recent price rises for electricity – and now water and rates – are combining with rapid increases in the cost of housing to make a decent standard of living simply unaffordable for many low income South Australians. Energy represents a significant expenditure item and a point of financial stress. Lower income households spend a much greater proportion of income on energy expenses than other people, even when the government concessions are taken into account. Water costs in SA are set to continue rising well above the CPI (20% per year for the next five years).

Expenditure on water and wastewater

Information on household expenditure on water and wastewater services and other consumption items is collected by the Australian Bureau of Statistics (ABS) and

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shows that expenditure on water and wastewater services represents a small proportion of income on average.

Table 9.2 shows the average weekly expenditure on water and wastewater services in each Australian jurisdiction in 2007-08 by quintile of disposable income.

Table 9.2 Average weekly expenditure on water and wastewater services by jurisdiction and weekly household income, 2007-08

Jurisdiction Disposable income quintilea All households

lowest middle highest Australia a) Water and sewerage ($) 7.26 10.50 14.11 10.84 b) per cent of disposable income 2.11 1.01 0.52 0.81 New South Wales a) Water and sewerage ($) 6.05 10.26 13.75 10.24 b) per cent of disposable income 1.96 1.01 0.50 0.78 Victoria a) Water and sewerage ($) 7.64 9.67 12.22 9.83 b) per cent of disposable income 2.25 0.94 0.46 0.77 Queensland a) Water and sewerage ($) 5.04 5.83 6.91 6.01 b) per cent of disposable income 1.59 0.54 0.28 0.47 South Australia a) Water and sewerage ($) 8.29 11.93 17.11 12.48 b) per cent of disposable income 2.78 1.32 0.68 1.01 Western Australia a) Water and sewerage ($) 7.65 10.90 13.13 10.56 b) per cent of disposable income 2.29 0.95 0.45 0.74 Tasmaniab a) Water and sewerage ($) 5.30 3.37 3.15 3.84 b) per cent of disposable income 1.74 0.38 0.16 0.40 Northern Territoryb a) Water and sewerage ($) 15.45 15.92 19.37 16.52 b) per cent of disposable income 3.36 1.15 0.67 0.94 ACTb a) Water and sewerage ($) 14.19 17.44 17.70 16.62 b) per cent of disposable income 3.19 1.27 0.52 0.92 a Quintiles of disposable income are estimated by ranking all households from lowest disposable income to highest disposable income, and then dividing the households into five equal or nearly equal sized groups. Disposable income is defined as gross income less income tax. b Estimates for Tasmania, the Northern Territory and the ACT are based on small survey samples and might be unreliable. Source: ABS (Survey of Income and Housing 2007-08, Expanded CURF, Cat. no. 6541.0, RADL).

For the whole of Australia, average expenditure on water and wastewater services by households with the lowest 20 per cent of disposable incomes was $7.26 per

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week or 2.11 per cent of household incomes. Average weekly expenditure by households with the highest 20 per cent of disposable incomes was higher ($14.11), but represented a smaller proportion of income (0.52 per cent).

Across Australia, the proportion of disposable income spent on water and wastewater services by households in the lowest 20 per cent of incomes was consistently low, ranging from 3.36 per cent in the Northern Territory to 1.59 per cent in Queensland.

The Commission has heard evidence that ABS surveys might understate expenditure on water and wastewater services as tenants or apartment dwellers often only pay for water usage directly, or do not pay for any water and wastewater costs at all. These costs are then recovered through body corporate fees or rent (ACOSS, trans., p. 43).

As part of its inquiry, the Commission undertook its own analysis of consumption patterns and expenditure on water and wastewater services of different consumer groups utilising data from water utilities matched with ABS census data (PC 2011b).

The Commission found that, in low income areas of Sydney and Melbourne (those in the lowest quintile of median household income), average household expenditure on water and wastewater services — assuming all volumetric and fixed costs were borne by the household and before concessions were deducted — averaged just over 1 per cent of income, and ranged between 0.3 per cent and 4.9 per cent of income in 2005-06 (box 9.2). This is broadly consistent with the quantum of estimates obtained from ABS survey data.

In addition to representing a small proportion of income, recent increases in the price of water and wastewater services (to finance investment in infrastructure (chapter 2)), have had a relatively minor impact on household budgets. In comparison, price increases of other essential goods and services, that represent a larger proportion of household expenditure, have had a more significant impact on household budgets (figure 9.1).

From 2005-06 to 2009-10, average prices for water and wastewater services in Australian capital cities increased by 48 per cent on average, but ranged from 60 per cent in Sydney to 22 per cent in Hobart. On the whole, this was more than the increase in average capital city prices for electricity (39 per cent) or housing (21 per cent), and significantly more than the increase in the Consumer Price Index (CPI) (13 per cent).

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Box 9.2 The effect of income on consumption of water and wastewater services As part of its inquiry, the Commission analysed consumption of, and expenditure on, water and wastewater services of different consumer groups utilising data from water utilities matched with ABS census data. The Commission found:

• water consumption increases with income on average

• very high income households consume much more water than moderate and low income households

• water and wastewater service bills represent a small proportion of household income for all income groups

• expenditure on water and wastewater services represents a smaller proportion of income for high income households than low income households.

Average annual water and wastewater service bills for Census Collection Districts, by income quintilea, Sydney and Melbourne, 2005-06

Quintile of median household income

Units 1 2 3 4 5 Total

Melbourne Median household incomeb $’000 37.24 50.91 57.42 65.21 86.23 57.44 Average annual consumption kL 174.10 181.30 191.59 206.86 254.54 493.74 Exp. as prop. of incomec % 1.27 0.93 0.84 0.76 0.64 0.89 range – low % 0.79 0.61 0.56 0.42 0.28 0.28 range – high % 3.00 1.37 1.45 1.15 1.11 3.00

Sydney Median household incomeb $’000 37.7 53.4 62.8 77.8 102.2 62.8 Average annual consumption kL 211.51 217.29 226.73 228.84 262.56 229.64 Exp. as prop. of incomec % 1.75 1.26 1.10 0.89 0.71 1.10 range - low % 0.94 0.91 0.70 0.55 0.30 0.30 range - high % 4.88 2.20 1.78 1.52 1.19 4.88

a Quintiles of median household income are estimated by ranking all collection districts (approximately 250 households) according to median household income, and then dividing the total number of collection districts into five equal or nearly equal sized groups. b The median of 2006 Census Collection District median household incomes within the quintile. c Does not include deductions attributable to concessions.

Source: PC (2011b).

However, in the same period, the increase in expenditure on water and wastewater services as a proportion of total household expenditure (0.2 per cent), was less than the increase for energy (0.3 per cent) (of which electricity forms the major

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component) or housing (2.1 per cent). This is because water and wastewater represents a smaller share of household expenditure than energy or housing and greater relative price rises for water and wastewater services have less impact on total expenditure than smaller price increases in these other goods and services.

Figure 9.1 Prices and household expenditurea for selected essential services, 2005-06 to 2009-10

25 175

20 150 15

125 10

100 5 Prices (index, 2005-06 = 100)

Per cent of household expenditure of household cent Per 0 75 2005-06 2006-07 2007-08 2008-09 2009-10 Water & sew. (RHS) Electricity (RHS) Housing (RHS) CPI (RHS) Water & sew. (LHS) Energy (LHS) Housing (LHS) a Household expenditure is defined as household final consumption expenditure. Expenditure on housing includes imputed rent from owner occupied dwellings. Sources: ABS (Consumer Price Index, Australia Dec. 2010, Cat. no. 6401.0); ABS (Australian System of National Accounts 2009-10, Cat. no. 5204.0).

From 2005-06 to 2009-10, expenditure on water and wastewater services as a proportion of total household expenditure increased from 0.8 to 1.0 per cent. By comparison, expenditure on energy and housing as a proportion of total household expenditure increased from 2.0 to 2.3 per cent, and from 16.2 to 18.3 per cent respectively.

Number of households experiencing payment difficulties

The available evidence indicates that relatively few households experience payment difficulties for water and wastewater services, with larger numbers experiencing difficulty meeting other costs (particularly electricity).

In Victoria, a survey conducted from 2007 to 2008 by the Victorian Council of Social Service and Emergency Relief Victoria revealed that electricity or gas costs were the most commonly nominated contributor to financial hardship for those

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seeking emergency relief assistance (12 per cent), followed by phone costs (10 per cent), petrol (10 per cent), food (9 per cent) and rent (8 per cent). Water and wastewater was equal sixth most cited cause of financial hardship with car maintenance at 7 per cent (VCOSS and ERV 2009).

Anglicare Victoria’s Hardship Survey 2010 (Anglicare Victoria 2010) found that water was the fifth most commonly cited payment for which clients of emergency relief centres stated they were seriously behind, with 27 per cent of respondents indicating this. Other costs more commonly cited as being behind payment were rent and electricity (47 per cent), telephone (44 per cent) and gas (40 per cent).

The number of restrictions and disconnections for non-payment of water reported by the National Water Commission and Water Services Association of Australia in their 2008-09 National Performance Report (NWC and WSAA 2010a), indicate that only a small proportion of consumers have their water flow restricted or disconnected for non-payment of water bills. Of the major water utilities in Australia (those with more than 100 000 connections), the Hunter Valley Water Corporation in New South Wales restricted the greatest proportion of its customers (0.5 per cent) in 2008-09. The other major Australian water utilities restricted the flow of 0–0.2 per cent of their customers due to non-payment. Of all utilities, Goulburn Valley Water in Victoria restricted the largest proportion of its customers in 2008-09 for non-payment (1.6 per cent).

In comparison, average rates of disconnection reported for non-payment of electricity bills in 2008-09 were higher, with state wide rates recorded in New South Wales (0.6 per cent), Victoria (0.43 per cent), South Australia (0.87 per cent), Western Australia (0.55 per cent) and Tasmania (0.45 per cent) (ERA 2011a), exceeding the rates of restriction of all but one major water utility.

However, there is some evidence that recent price increases have increased the number of households seeking assistance, though the relative numbers still remain small.

In New South Wales, a study of people who had their utility service disconnected or restricted because of non-payment of bills found that the share of total respondents who had their water flow restricted increased from 9 per cent to 14 per cent between 2004 and 2008. However, in 2008 the proportion of respondents disconnected for non-payment of electricity (84 per cent) and gas bills (16 per cent) remained higher than that for water (PIAC 2009).

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Sydney Water Corporation stated ‘the number of Sydney Water customers seeking financial assistance has grown by more than 20% in the past two years’ (sub. 21, p. 20). However, at public hearings, Sydney Water Corporation clarified: It’s quite small. I would have to check the number, but it is in the thousands, compared to a population of 4.3 million. … I don’t actually think it is directly connected to the price of water, though that doesn’t help. But more recently what we have noticed in Sydney is that the impact of rising power prices seems to have had quite an impact and people’s power bills have gone up rather a lot. (trans., pp. 98–99)

A survey conducted by the Independent Pricing and Regulatory Tribunal (IPART) of utility users in Sydney, the Blue Mountains and Illawarra showed that the number of users who had approached water utilities in the past three years about payment difficulties was very low, about 1 per cent for all surveyed income groups in 2010 (figure 9.2). In contrast, a larger proportion of electricity users of all income groups approached their retailer because of payment difficulties (3–10 per cent). This might be due to the larger size of electricity bills or a greater preparedness of electricity utilities to disconnect services.

Figure 9.2 Per cent of households that approached supplier in the past three years because of inability to pay, by income group — Sydney, the Blue Mountains and Illawarra, 2010

12 < $33,000 $33,800 to $62,400

10 $62,400 to $130,000 > $130,000

0 Electricity Water

Source: IPART (2010).

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What will be the impact of forecast price increases and pricing reforms?

A concern raised by community organisations to the inquiry is that future price increases and pricing reforms, such as flat volumetric or scarcity pricing, could have detrimental effects on low income and disadvantaged consumers.

Forecast price increases

As noted in chapter 2, recent pricing decisions by economic regulators and governments will result in retail prices for water and wastewater services increasing significantly in Australia in the next few years in order to finance investment in infrastructure.

As discussed previously, low income households consume less water on average than high income households but expenditure on water and wastewater services by low income households represents a larger proportion of income. Low income households might have less discretionary water use, and so might not be able to reduce consumption in the event of higher prices, to the same extent as households with higher incomes. As such, low income households might be more affected by increasing water and wastewater costs than other groups of consumers.

However, as the total cost of water and wastewater services represents a small proportion of income (even for low income households), forecast price increases in water and wastewater services — although contributing to increasing living costs — are unlikely to significantly impact on affordability. To illustrate, a 50 per cent increase in the cost of a good or service, that comprises just five per cent of income would increase costs as a proportion of income by only 2.5 per cent.

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Pricing reforms

A number of pricing reforms are proposed in chapter 7 to improve economic efficiency and increase the welfare of society of a whole. These reforms would result in the unwinding of complex cross-subsidies between households with different consumption patterns. As a consequence, there might be winners and losers from pricing reforms.

• The adoption of flexible pricing, in the place of long-run marginal cost pricing, would result in lower prices on average, benefitting all consumers. However, prices would be more variable, rising gradually in periods of short supply when storage levels decrease and falling sharply when storages fill. If flexible pricing is revenue neutral, for example if revenue from higher prices is passed back to consumers in the form of lower fixed charges, in periods of reduced supply, volumetric prices would be higher and service charges lower, benefitting smaller water users. In periods of increased supply, volumetric prices would be lower and service charges higher, benefitting larger water users.

• Postage stamp pricing results in cross-subsidies from areas that are low-cost to service, to areas that are high-cost to service. Moving to location-specific pricing would result in an unwinding of these cross-subsidies with higher prices for those in high-cost areas and lower prices for those in low-cost areas.

• Depending on how inclining block tariffs are designed, replacing them with flat volumetric tariffs that reflect the variable costs of water provision might increase total costs for moderate water users and decrease prices for small and large water users.

• Moving away from pricing services based on rateable land values would increase costs for those living in areas with low property values and decrease costs for those in high property value areas.

Given the complex (and often inequitable) cross-subsidies that exist within prevailing regulated pricing arrangements, and the many factors affecting household water consumption (box 9.3), the distributional impacts of pricing reforms will also be complicated and depend on the specific pricing arrangements in place, the reforms implemented and consumption characteristics of individual households.

However, implementing reforms that reduce total costs of supplying water and wastewater services will increase consumer welfare in total. If governments wish to pursue distributional objectives, such as supporting low income and disadvantaged consumers, they should do so at least cost. In contrast to the perverse inefficiencies and inequities generated by indirect price measures (and consequential non-price demand management measures) aimed at improving affordability outcomes,

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governments have other measures available to them that are more efficient, flexibly targeted and transparent.

Box 9.3 Factors affecting water consumption As part of its inquiry, the Commission undertook econometric analysis of the socio-economic factors affecting water consumption using data provided by water utilities matched with ABS census data aggregated to the Census Collection District level. The Commission found that household size and income are the most influential determinants of household water consumption:

• Water consumption increases with household size and income.

• In periods of water restrictions, income has a weaker positive effect on water consumption than during other times.

• Per capita consumption decreases on average with household size, indicating there are economies of scale in water consumption within households. Other factors that might also contribute to household water consumption include climate, household composition, housing tenure, and educational attainment, occupation and skills levels.

Source: PC (2011b).

Achieving affordability objectives at least cost to efficiency

The tax and transfer system is the primary instrument governments use to ensure that all people have the means to achieve a minimum acceptable standard of living and are able to afford all the necessities of life. The main features of the tax and transfer system include:

• concessions and rebates on the consumption of a wide range of goods and services for low income and disadvantaged individuals and families

• income support payments for those who are unable to support themselves financially

• family assistance, to assist families with the cost of raising children

• the direct provision of services below cost, for example, education, health and public housing

• a progressive taxation system.

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Concessions and rebate policy

All levels of government offer concessions or rebates to particular groups of low income or disadvantaged consumers on consumption of a variety of goods and services, including water and wastewater, electricity, medicines, public transport and local council rates. Eligibility for these concessions is typically based on holding one or more of a number of Australian government concession cards targeted towards low income and disadvantaged groups.

State, Territory and Local Governments administer concessions and rebates on water and wastewater services and provide most of the funding. The Australian Government provides some funding to states and territories through a National Partnership Agreement to make concessions on certain services, including water and wastewater, available to all Pensioner Card holders. The concessions on water and wastewater services and value of rebates offered, the method in which they are applied and their eligibility requirements vary considerably between jurisdictions (table 9.3).

Concession and rebate arrangements can have beneficial characteristics, particularly in comparison to pricing measures, to address affordability issues in that they can:

• be targeted towards particular groups assessed as being in need, for example, low income earners or people with certain medical conditions

• be designed so as not to affect the prices paid by consumers, resulting in less cost to economic efficiency

• encourage the consumption of water and wastewater services, at the expense of goods that can be harmful, for instance, alcohol and tobacco.

However, in practice concession arrangements can have a number of weaknesses (Australia’s Future Tax System Review Panel 2009, p. 622–25).

First, concessions and rebates can only address the affordability of one good or service at a time but households have many essential goods and services that need to be purchased. As such, different levels of government have developed concessions and rebate arrangements for a number of different consumption items. This results in a complex arrangement, in that:

• consumers can be confused about what assistance is available and from whom

• the administrative costs can be higher than otherwise might be the case

• governments can find it difficult to ascertain the impact of particular concessions, in isolation from other concessions and assistance measures, and therefore the value for money of each concession.

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Table 9.3 Concessions and rebates for water and wastewater services, by jurisdiction, 2010-11

Jurisdiction Eligibility Concession

NSW Pensioner Concession • 100% of water service charge to a maximum of $31.33 metropolitan Card, DVA Gold Card per quarter and 84% of wastewater service charge • 33% of usage charges to a maximum of 100kL per

year NSW regional Pensioner Concession • Owner-occupiers receive rebate of up to $87.50 on Card, DVA Gold Card their water rates or charges and the same again on wastewater rates or charges Vic Pensioner Concession • Customers billed for both water and sewerage Card, Health Care services, 50% discount on the total bill capped at $245 Card, DVA Gold Card • Customers billed for a single service, 50% discount on the total bill capped at $122.50 Qld (SEQ) Pensioner Concession • Owner-occupiers receive $100 subsidy on the cost of Card, DVA Gold Card water service and usage charges Qld other Pensioner Concession • Owner-occupiers receive subsidy of 20% on gross Card, DVA Gold Card local government rates and charges including water and sewerage charges capped at $180 per year SA Pensioner Concession • Owner-occupiers receive 20% concession on total Card, DVA Gold Card, water bills capped at $210 per year with a minimum of Health Care Card, or $100, plus up to $100 off their sewerage rates meet low income • Tenants receive a concession of 20% of the total water provisions bill with a maximum of $168 and a minimum of $58 WA Pensioner Concession • Pensioner Concession and State Concession Card Card, State Concession holders eligible for 50% discount on annual service Card, State Seniors charges and water usage up to a maximum of 150kL in Card, Commonwealth Perth, 400kL in the south of the state and 600kL in the Seniors Card north • State Seniors Card holders receive 25% discount on annual service charges capped at $46.65 for water charges and $159.55 for sewerage charges • Holders of both a State Seniors Card and Commonwealth Seniors Health Card eligible to receive 50% discount on annual service charges Tas Pensioner Concession • Concession of up to $68.25 for water bills and the Card, Healthcare Card, same again for sewerage bills DVA Gold Card NT Northern Territory • $0.725 per day on water service charge and $0.407 Pensioner and per kilolitre of water used Concession Card • $0.754 per day on wastewater service charge ACT Pensioner Concession • 68% of total water and wastewater charges Card, Low Income Health Care Card, DVA Gold Card, asylum seekers Sources: Sydney Water (2011b), DPC (2011), DHS (2011b), Department of Communities (Qld) (2010), DFC (2011), Water Corporation (2011a), Tasmanian Government (2010), DHCS (2011), Department of Health (NT) (2011).

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Second, concessions for water and wastewater may apply to the volumetric component of the bill, in addition to the fixed component, such that consumers might not face an efficient price signal, resulting in efficiency costs.

Third, concessions can also be regressive. If they are paid on the volumetric component, concession holders with higher incomes might receive a larger benefit, because other things equal, they are likely to consume more than those with lower incomes. This is particularly relevant in jurisdictions such as Western Australia where concessions have relatively relaxed eligibility requirements for older people (State Seniors Cards and Commonwealth Seniors Health Cards have more generous means testing).

Concessions can also be regressive if they are targeted towards particular low income groups and not others. Specifically, the treatment of pensioners and the unemployed contrasts greatly. In all jurisdictions except South Australia, Tasmania and the ACT, holders of Centrelink Health Care Cards (which include the unemployed) are ineligible for concessions although holders of Pensioner Concession Cards (such as aged pensioners) are eligible. This is despite the maximum pay rates for the aged pension being significantly higher than maximum pay rates for unemployment benefits.

Fourth, eligibility for concession cards is often based on an income threshold, and this can create a strong incentive to reduce incomes. Concession holders who earn an income around the cut-off for a concession card can face a significant marginal tax rate if earning more means they lose all their entitlements to a concession card and this can reduce incentives to increase paid work.

Fifth, because it is administratively difficult to provide concessions tailored to individual household characteristics, water and wastewater concessions can result in inequitable outcomes:

• Concession arrangements do not take account of the number of occupants in a household so the arrangements are relatively more generous for small households than larger households.

• Tenants or owner-occupiers of units in multi-dwelling buildings that do not have individual meters and who pay for their water and wastewater services through rent or body corporate fees are not typically eligible for concessions, though they might have a similar level of need to those paying for bills directly and receiving concessions.

In 2008, the Henry Review of Australia’s taxation system identified a number of potential shortcomings with the current complex concession arrangements and recommended that the Commission be tasked with undertaking a review of

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concessions across all levels of government and provide recommendations for consideration by the Council of Australian Governments (COAG) (Recommendation 107) (Australia’s Future Tax System Review Panel 2009, p. 624–25).

Other elements of the tax and transfer system

Income support payments are the principal source of government assistance for those who are unable to support themselves financially. There are a variety of different payments targeted to those who are not expected to work, those unable to work and those who are unemployed or studying. In addition, family assistance is based on the number of children or dependants in a household.

Both income support payments and family assistance are provided to recipients as direct cash payments and have a number of beneficial characteristics over both pricing and concession affordability measures.

First, eligibility and rates of payment for income support and family assistance are means tested against recipients income and assets, and take into account the specific circumstances of an individual or family including income from other sources such as a spouse, or number of dependent children. People in similar circumstances are treated the same and people in different circumstances are treated differently. For example, an unemployed single person is treated the same as other unemployed singles, but differently from low income families with children. These payments can therefore achieve more equitable outcomes.

Second, direct cash transfers empower recipients to maximise the utility from their available resources according to their individual needs and preferences. For example, recipients of cash transfers are able to use their income to pay for water for their garden if they wish, go to the movies with friends, or spend it in any other way that maximises their personal benefit.

Third, although any transfer will reduce incentives to work, direct cash transfers are typically reduced on a sliding scale as incomes increase, avoiding the high marginal tax rates that can be created by concessions linked to concession cards.

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In addition, the rates of payment for different types of benefits are set to encourage workforce participation. Allowances which are paid to the unemployed and students, are paid at lower rates and have lower income and assets tests than pensions, which are paid to those who are not expected or are unable to work such as the aged or persons with a disability. This is intended to provide greater encouragement for those that can work to seek employment, without unnecessarily constraining the living standards of those that cannot, or are not expected to work.

Fourth, cash transfers do not change the prices faced by consumers, so pricing signals are maintained and efficiency losses are not as high as when prices are distorted or concessions are tied to consumption.

Improving the effectiveness and efficiency of assistance measures

In principle, cash transfers are a better way of providing assistance to low income and disadvantaged groups than pricing measures and concessions, as they:

• empower individuals to make consumption choices that maximise their individual utility

• are more flexibly tailored to an individuals’ and family’s circumstances, resulting in more equitable outcomes

• have fewer efficiency costs than concessions and pricing measures.

Moving away from the provision of assistance to low income and disadvantaged consumers through State, Territory and Local Government concession arrangements would require coordination across all levels of government and would be most appropriately considered by COAG, informed by a thorough review.

Given that affordability issues for low income and disadvantaged consumers appear to be the result of general cost of living pressures rather than being urban water specific, there is a strong argument that a review of concessions should be broader than just the urban water sector. As utilities, particularly electricity and gas, are cited as a principle cause of hardship by those seeking emergency relief, a review of all utilities concessions appears warranted.

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DRAFT RECOMMENDATION 9.1 COAG should commission a review of concessions on utility services across all levels of government. The review should assess:

• the appropriateness of existing arrangements for providing concessions, including eligibility criteria

• the merit of and scope for abolishing concessions and providing relevant assistance to all low income households via other elements of the tax and transfer payments system.

Although there are clear benefits of relying on income support payments and family assistance to meet affordability objectives, additional assistance measures may be warranted if there is a clear and sizable burden on a specific group that is disadvantaged.

In the urban water sector, these situations might exist in a limited number of circumstances:

• Postage stamp pricing reform, as discussed in section 7.4, might lead to significant hardship in some country towns. The Commission is aware that the costs of supplying water and wastewater services vary considerably between country towns, in some extreme cases exceeding $30 per kL for water and $5000 per connection per year for wastewater services (ERA 2006). A transition to cost reflective prices in these circumstances would expose some communities to a significant burden. In these situations, the most efficient way of providing assistance would be to provide a lump sum payment to affected households, or for the service to be subsidised through a Community Service Obligation payment to water utilities. In order to maximise efficiency, whether subsidies are provided directly to households or to utilities, they should be independent of the actual level of consumption — the price of water should reflect the marginal cost of provision. In this way, it will not affect users incentives to conserve water. Addressing affordability issues in this way might not be feasible if high costs reflect high marginal, rather than high fixed costs.

• Individuals that have medical conditions that require significant amounts of water use such as patients requiring haemodialysis treatment at home, might be exposed to high costs. Many State, Territory and Local Governments have recognised the special requirements of patients undergoing haemodialysis at home and provide concessions of varying value and eligibility. For instance, Victoria’s concession is equal to the value of 168kL of water per year and

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eligibility is restricted to certain concession card holders. In Queensland, the concession is for 200kL per year and is not means tested. The Commission considers that such cases should be dealt with through the health system. A rebate offsetting water costs may be appropriate if these costs represent a significant burden on disadvantaged haemodialysis patients.

Alleviating financial hardship

Even when access to water and wastewater services is universal and affordable, there will be situations, when, for one reason or another, some customers find themselves in financial hardship and find it difficult or impossible to pay their bills. SA Water’s Customer Assist Program states: Financial hardship can occur due to a number of circumstances including unemployment, low or reduced income, ill health, domestic violence, addiction, unexpected large or multiple bills and relationship breakdown. (SA Water 2011d, p. 1)

In addition, the nature of billing for household utilities — the separation of payment from consumption and infrequent and consequently large bills — might also increase payment difficulties for some households. Below ground leaks or taps accidentally left running for long periods can also subject households to unexpectedly large bills.

Hardship policies

A hardship policy outlines a company’s actions regarding customers who fail to pay their bills and commonly include:

• the facility to negotiate an agreed payment plan outside of normal payment timeframes and debt recovery processes

• referral to community financial counselling services

• a commitment to provide customers with information about available concession or rebate arrangements and dispute resolution processes.

Hardship policies serve as an intermediate measure to avoid disconnecting consumers and have obvious benefits for those customers who have a strong desire to pay their bills but, for whatever reason, have difficulty doing so.

Hardship policies also enjoy strong support from community organisations. The Tasmanian Council of Social Service stated: We also support the requirement that water and sewerage service providers establish and implement approved hardship policies that ensure that no household is

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disconnected from supply for inability to pay. Hardship policies should deal proactively with consumers experiencing financial hardship by offering such options as payment plans with instalments tailored to individual consumer circumstances; referral to financial counselling and support services; and occasional and negotiated payment or total bill waivers. (sub. 13, p. 2)

Similarly, PIAC stated: As I’ve indicated, we’ve previously called for the development of a comprehensive statewide framework to address hardship issues in relation to water and wastewater usage. Such a framework should provide that all water utilities provide a hardship program for people in financial hardship and provide for the mandatory minimum elements for such hardship schemes. (trans., p. 62).

In addition to benefits for affected consumers, in a 2008 review of Australia’s consumer policy framework, the Commission argued that there can be benefits to utilities themselves in maintaining hardship policies: As well as helping consumers facing hardship, there are incentives for suppliers to run these programs. In particular, they help suppliers to:

• recoup some payment in situations where a customer is simply unable to pay immediately rather than unwilling to pay, thus reducing costs of debt collection; and

• identify potential problem customers and apply preventative measures before substantial debts arise. (PC 2008c, p. 481)

Reflecting this view, Yarra Valley Water stated: Yarra Valley Water has in place a hardship policy and programs that are recognised as best practice for Australian utilities. … We have established this program based on a business case and this basis has been recognised by the Essential Services Commission in its price reviews. (sub. 19, p. 24)

Although residential water supplies are not commonly disconnected in Australia due to non-payment of bills, water utilities are often permitted to limit the flow of water to a minimal level. This is intended to provide sufficient water to allow only basic water uses such as drinking, cooking, hygiene and sanitation — 2 litres per minute is a commonly cited flow rate for restrictions. Given the importance of water to personal and public health, disconnection or restriction of water services should be avoided where possible. However, if a user does not follow payment plans or other conditions of hardship provisions, then flow restrictions appear to provide a reasonable compromise between protecting an individuals right to water and creating an incentive through inconvenience, to contribute to the cost of providing the service.

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Other assistance measures

Exceptional circumstances grants

In addition to concessions and rebates, State and Territory Governments sometimes provide grants to assist disadvantaged households experiencing exceptional circumstances such as an uncharacteristically large bill or other financial crises, with their utility bills.

• The Water Payment Assistance Scheme (PAS) in New South Wales provides $25 vouchers (multiples can be provided) that are issued by community welfare organisations to customers experiencing hardship including a loss of income, high water bills, illness, family crisis or unexpected bills or expenses (EWON 2011b).

• The Utility Relief Grant Scheme in Victoria provides assistance to utility customers who have experienced a temporary financial crisis within the last 12 months, and hold an eligible concession card, or are registered with a utility hardship program (DHS 2011a).

• The Hardship Utility Grant Scheme in Western Australia pays 85 per cent of the outstanding bill for applicants who are unable to pay their utility bills and are at risk of disconnection up to a limit of $450 or $750 depending on their location (DCP 2011).

The availability of exceptional circumstances grants are more tightly controlled than concessions, and eligibility conditions typically require that claimants circumstances be assessed by a financial counsellor and that the receipt of a grant precludes receipt of additional assistance for a period of time. These measures provide encouragement for potential applicants not to ‘game the system’ by engaging in behaviour that could lead to a financial crisis and eligibility for grants.

Alternative payment methods

Some of the problems attributable to the payment of water and wastewater bills might be due to the infrequent and consequently large size of these bills. Alternative

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payment arrangements can assist low income and disadvantaged households to budget for large regular payments or reduce the size of bills.

Centrepay is a free bill payment facility for recipients of Centrelink payments. It allows payment recipients to pay bills by having a regular amount deducted from their Centrelink payments.

The majority of water utilities in Australia currently accept Centrepay as a method of payment and this is likely to have a positive effect on the ability of low income and disadvantaged customers to meet their obligations in relation to water bills.

Another payment method aimed at increasing customer control of their expenditure on utilities is prepayment meters. Although prepayment meters are an established means of payment for electricity in South Australia, Tasmania, the Northern Territory and the ACT, the Commission is not aware of any instances in Australia where prepayment meters for household water use have been implemented, although the technology has been implemented overseas, primarily in developing countries.

Prepayment meters can assist customers to manage credit issues stemming from the payment of utility services after they are consumed, by allowing them to pay for water services in advance. However, there are also costs involved in establishing and maintaining prepayment meter systems. Although conceivably being of benefit to some consumers, the lower aggregate cost of water and wastewater services and fewer payment difficulties compared to electricity are two factors that might limit the demand for prepayment meters in the urban water sector and work against a business case for these devices.

9.2 Consumer policy framework

The consumer policy framework in the urban water sector refers to the government policies that seek to directly promote better outcomes for consumers of water and wastewater services. It is of particular importance, as:

• the services are essential, and failure to provide an adequate level of service can have significant harmful effects on consumers

• the monopoly provision of services by government-owned utilities means that consumers cannot change their provider in response to poor service.

Consumer policy in the urban water sector should aim to ensure that there is an acceptable level of access for all consumers, disputes are dealt with effectively and the industry serves the interests and preferences of consumers.

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Consistent best practice consumer protection

Beyond generic national consumer legislation, such as the Competition and Consumer Act 2010 (Cwlth), the responsibility for consumer protection arrangements in the urban water sector lies with State and Territory Governments. There are considerable variations between and within jurisdictions (table 9.4). Common consumer protection arrangements include:

• independent economic regulators to monitor compliance with legislation and regulatory instruments

• licensing of urban water utilities

• industry or customer codes defining service standards and consumer protections

• independent dispute resolution.

Table 9.4 Jurisdictional comparison of urban water consumer protection arrangements

Independent Licensing of Industry Independent economic water utilities customer code dispute regulator resolution NSW (metropolitan) • • • NSW (other) • Victoria (metropolitan) • • • • Victoria (other) • • • • Queensland (south-east) • • • • Queensland (other) • Western Australiaa • • • South Australiaa • Tasmania • • • • Northern Territory • • ACT • • • • a Western Australia and South Australia are currently reviewing their customer protection arrangements for water and wastewater services.

Licensing and/or customer codes are the primary industry specific means of implementing protection provisions for consumers in the urban water sector. Common consumer protections outlined in either industry codes or water utility licenses include:

• standard contractual terms and conditions

• minimum standards of service

• conditions for disconnection or restriction

• provisions for customers having difficulty making payments (hardship policies)

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• provision of pricing and service information to customers.

Although licensing itself can provide a mechanism with which to apply consumer protection arrangements to individual water utilities, industry codes can be made as a separate regulatory instrument and applied to all utilities in a jurisdiction as a condition of licensing. The benefit of this approach is that it allows for the application of consistent customer protection provisions across a number of water utilities.

Industry codes currently exist for water utilities in Victoria, Queensland, Tasmania and the ACT, although they do not apply to Local Government water utilities in Queensland. Industry codes have also been proposed for introduction in South Australia and Western Australia.

Another area of inconsistency between and within jurisdictions is the form of independent dispute resolution. Together with suppliers’ own dispute resolution processes, ombudsman schemes are the main avenue through which customers can seek redress in the event of a dispute with a water utility. Examples of disputes dealt with by ombudsmen include disagreements over service quality, billing and disconnections or restrictions.

Ombudsmen schemes provide a low cost alternative to the court system for small value disputes that would otherwise be unlikely to be resolved because of the high cost of legal action.

In New South Wales, Victoria and Queensland, specialist industry-based energy and water ombudsmen operate under memoranda of understanding with State Government ombudsmen to resolve disputes between water utilities and their customers. However, in New South Wales and Queensland, the coverage of industry-based ombudsmen schemes does not extend to water services provided by Local Governments. Instead, as also occurs for customers of major water utilities in South Australia, Tasmania and the Northern Territory, customers can make complaints to State Government ombudsmen. In Western Australia, customers of water utilities are able to make complaints to the Department of Water, and in the ACT, customers can complain to the Civil and Administrative Tribunal.

There are significant differences in the powers and resources of State Government ombudsmen compared to industry-based energy and water ombudsmen. State Government ombudsmen are typically empowered to investigate the administrative acts of a range of government departments and authorities, and concentrate on ensuring that the processes undertaken by the water utility are correct. They can make recommendations to government-owned water utilities but cannot make binding decisions. In contrast, specialist energy and water ombudsmen have a much

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narrower focus and greater expertise for dealing with complaints from energy and water consumers. They also have dependable funding through levies on their member utilities and are empowered to make binding decisions.

The inconsistency in protection arrangements has the potential to result in very different outcomes for consumers, particularly in New South Wales and Queensland, where the regulatory arrangements for metropolitan water utilities and local councils contrast greatly.

For example, in New South Wales the metropolitan utilities (Sydney Water, Hunter Water Corporation) are licensed by IPART to provide retail water services. As part of this licensing, the metropolitan utilities are subject to a number of customer protection provisions including meeting specific service standards, providing information to customers about their contract and maintaining a hardship policy. In contrast, water services provided by local councils are not required to be licensed and are not covered by these arrangements.

PIAC stated: ... the lack of a consistent approach to hardship across the 106 local water utilities in NSW results in an inequity and inconsistency in the availability of hardship programs for disadvantaged consumers across NSW. (sub. 61, p. 10)

An inquiry into water supply and sewerage services in non-metropolitan New South Wales recommended that ‘the Energy and Water Ombudsman NSW scheme be adopted by local water utilities as a mandatory requirement, provided it can be demonstrated that there are net benefits in doing so’ (Armstrong and Gellatly 2008, p. 6).

Given the most prominent issues surrounding consumer protection in the urban water sector are likely to be the same across and within jurisdictions — such as the negative consequences of disconnection and greater payment difficulties due to infrequent billing and the prevalence of credit as a purchase method — a large proportion of best practice consumer policy framework principles, such as the existence of provisions for customers facing hardship and independent dispute resolution, are likely to be equally applicable in most areas of Australia.

However, prescriptive consumer protection requirements can have significant costs and different arrangements will be appropriate in different circumstances. For example, industry-based ombudsmen are generally accepted to have many benefits over relying on State Government ombudsmen in terms of expertise and funding, however the cost of maintaining these organisations, particularly for small jurisdictions could be considerable. There are likely to be some scale economies in incorporating water and energy ombudsmen, but even with these it seems unlikely

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that there is a sufficiently strong case for industry-based ombudsman in smaller jurisdictions, such as the Northern Territory and the ACT. It should also be kept in mind that proposals to introduce national dispute resolution arrangements for energy in the National Electricity Market (PC 2008c) could affect the feasibility of industry-based ombudsman for water in the future.

• access to an independent dispute resolution process, preferably by a specialist utilities industry ombudsman

• the establishment of an industry code defining service standards and provisions to assist consumers facing hardship.

Consumer policy advocacy

Individuals often lack the means — time, money and know-how — to represent their views as consumers in policy and regulatory forums. Consumer policy advocates can overcome this problem by alerting governments to problems for consumers that require action and making sure that the interests of consumers are served by new and existing government policies.

Strong consumer policy advocates can ensure that consumer interests are represented in both policy and regulator decision making. Having effective consumer involvement in these forums will reduce the risk of regulators and ministers making poor decisions based on poor information on consumer preferences.

In the consultations for this inquiry, there was generally less input from individuals and organisations representing the interests of consumers than from those representing government or industry. In addition, policy advocates that were able to contribute to the inquiry who generally represented disadvantaged groups, noted that limited resources had not allowed them to participate fully and the resources available contrasted with those in the energy sector (box 9.4) .

The Australian Council of Social Service stated: … ACOSS certainly welcomes the Commission's interest and particularly the encouragement that we have had to participate, but I will say unambiguously that there are no resources available to community customer advocates in this sphere, in stark contrast with the at least reasonable attempt to support demand-side engagement in the

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market for electricity and gas through the Consumer Advocacy Panel, which is funded by a levy on customers. (ACOSS, trans., p. 43)

The Consumer Utilities Advocacy Centre argued: There is an immediate need for a stronger consumer voice in national water reform processes. Effective professional consumer advocacy is an important means through which this can be achieved. Unfortunately, consumer advocacy in this area is currently constrained by a lack of resources. Compared to the energy sector, consumer advocacy in water is less vigorous and under-resourced. (CUAC, sub. 46, p. 11)

In this respect, the experience of the Commission in this inquiry mirrored that in it’s 2008 Review of Australia’s Consumer Policy Framework, in that ‘a number of consumer advocacy groups argued that they, or the consumer movement generally, lack sufficient resources to adequately represent consumer interests in policy reform.’ (PC 2008c, p. 279).

Box 9.4 The Consumer Advocacy Panel for energy The Consumer Advocacy Panel (the Panel) commenced operation in 2008 (it replaced the National Electricity Consumer Advocacy Panel operating since 2001 upon the incorporation of natural gas into the national energy market arrangements). The Panel is an independent body charged with funding grants for electricity and natural gas consumer advocacy and research with a focus on issues affecting small and medium users. In 2008-09, the Panel approved 44 projects for funding to 24 organisations at a value of $2.4 million. Recipients of funding included organisations with a specific energy focus as well as community organisations such as Australian and state council of social service organisations, the Public Interest Advisory Centre, Consumer Utility Advocacy Centre and Consumer Action Law Centre. In 2009-10, the Panel trialled a new funding model in place of the existing contestable grant funding program:

• Established organisations that have capacity and expertise to participate in regulatory and policy decision making fora, but require support for advocacy, are eligible to apply for annual budget funding against an agreed set of outcomes.

• Capacity building grants are available for organisations that would not otherwise be able to participate in national energy market regulatory and decision making fora. The Panel comprises a chairperson and four other members appointed by the Ministerial Council on Energy, and is assisted by a full time Executive Director and a part-time administrative assistant. Revenue for the Panel is supplied by the Australian Energy Market Commission — funding for electricity projects is derived from a levy on consumers, and for natural gas projects, from participating states and territories.

Sources: Consumer Advocacy Panel (2009; 2011)

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The case for government involvement

In its 2008 review, the Commission found that consumer advocacy organisations had difficulty attracting funding for a number of reasons:

• Individual consumers have an incentive to ‘free ride’ on the advocacy efforts of others. This situation is not as pervasive for company advocacy where interests are more focussed and organisation is easier.

• Consumers might not see representation as an important issue or believe (perhaps falsely) that that their interests are already being represented.

• Consumer organisations are sometimes perceived as not representing the interests of all consumers equally. For instance, there is a common perception that consumer groups are particularly focussed on the interests of a relatively small group of disadvantaged users (PC 2008c, p. 279–80).

Specifically in the urban water sector, it is also possible that the limited resources available for consumer policy advocacy might suffer from competition from other utility areas in which price and regulatory developments, such as electricity, are seen as having a greater impact on consumers.

In its 2008 report, the Commission also accepted that ‘there is a general case for governments help to ensure that consumer representatives have the financial wherewithal to make an effective input into policy’ (PC 2008c, p. 280) and: … there would potentially be net benefits from the provision of additional taxpayer resources for consumer advocacy provided there are means of ensuring that it generates advocacy that is appropriately representative and that benefits significant numbers of consumers. (PC 2008c, p. 281).

In addition, in the urban water sector the case for government involvement is particularly significant as:

• equity and consumer interest issues are often cited as reasons for implementing inefficient pricing and non-price demand management policies

• the scope for reform in the urban water sector outlined in this report is significant and implementation of the recommended reforms might have distributional impacts.

Which consumers’ views should be represented?

Consumers are diverse and sometimes have conflicting interests. For example, as noted in chapter 8, some consumers prefer to face restrictions in periods of short

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supply in exchange for a lower price, while others are willing to pay a premium to avoid reducing their water use.

Consumer advocacy organisations often have a particular focus on disadvantaged groups. For example, CUAC states that it was ‘established to ensure the representation of Victorian consumers in policy and regulatory debates on electricity, gas and water. In particular, CUAC represents the interests of low income, disadvantaged, rural and regional, and Indigenous consumers’ (CUAC 2011a).

Although representing the interests of disadvantaged consumers is important, it is also important that the interests of the vast majority of users of water and wastewater services who are not disadvantaged are also represented. To the extent that consumer interests conflict, consumer policy advocacy that provides an informed and impartial account of each consumer groups specific interests would provide policy makers and regulators with the best basis for making informed decisions. As such, any consumer and advocacy arrangements funded by government should include governance arrangements that ensure that the interests of all consumers are represented in a balanced way.

Institutional arrangements for funding consumer policy advocacy and research in the urban water sector

In its 2008 report, the Commission recommended (Recommendation 11.3) public funding be provided to:

• support the basic operating costs of a representative national peak consumer body

• assist the networking and policy functions of general consumer advocacy groups

• enable and expansion in policy related research, including the establishment of a dedicated National Consumer Policy Research Centre and contestable research grants for specific consumer policy issues (PC 2008c, p. 291–92).

The Commission understands that arrangements to support consumer policy advocacy and research are still being pursued by COAG. It is the Commission’s view that these reforms remain an important outstanding opportunity to improve outcomes in regulatory and policy decision making.

Support for consumer advocacy and research in the urban water sector would be best assisted through general consumer arrangements consistent with those the Commission recommended in 2008. This approach would enable the needs of consumer advocacy in the urban water sector and in other sectors of the economy,

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both now and in the future, to be assessed in the context of pressing issues for consumers more generally.

In addition to increased support for generic consumer advocacy and research, in its discussion of institutional arrangements in chapter 11, the Commission has sought stakeholder views on whether a consumer representative body should play a formal role in supply augmentation, pricing and setting service standards.

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10 Framework for reform

Key points

• There is a compelling case for reform of the urban water sector.

• The overall objectives for urban water reform should be to ensure the delivery of water, wastewater and stormwater services in an economically efficient manner so as to maximise net benefits to the community.

• Analysis of the scope to achieve efficiency gains suggests that the lower-level objectives for reform should be to: – achieve water security at least expected cost – give water users greater choice – directly target environmental outcomes – promote affordability and consumer protection efficiently – reduce the cost of regulation – remove impediments to integration of the water cycle – introduce greater competition where cost effective – exploit economies of scale more fully, particularly in non-metropolitan New South Wales and Queensland.

• The policy and other recommendations made earlier in this report, if implemented, would go some way to achieving some of the above reform objectives.

• Beyond this there is a need to consider integrated reform options that contain institutional, governance, regulatory and structural elements. This is done in subsequent chapters.

In the Commission’s view the analysis of the scope for efficiency gains presented in chapters 5 to 9 of this report makes a compelling case for reform of the urban water sector. To realise these gains governments should firstly:

• set clear objectives for the sector

• ensure that government policies are consistent with these objectives in the following areas that significantly impact on service provision and resource allocation: – public health

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– environment – service delivery of potable water, non-potable water, wastewater and stormwater services – water property rights across the water cycle.

Recommendations and guidance for this are contained in earlier chapters. The remainder of this report focuses on:

• identifying specific reform objectives

• putting in place best practice institutional, regulatory and governance arrangements for: – public health regulation – environmental regulation – economic regulation – service delivery of potable water, non potable water, wastewater and stormwater services

• assessing the case for structural reforms to achieve benefits through increased competition and other means

• reform implementation and monitoring.

10.1 Objectives for reform

The overall objectives for urban water reform should be to provide water, wastewater and stormwater services in an economically efficient manner so as to maximise net benefits to the community (chapter 3). The analysis in chapters 5 to 9 of this report identifies the types of efficiency gains that are possible, and where feasible quantifies them. The following summarises the most important types of gains. These can be thought of as lower-level objectives for reform.

Achieving water security at least expected cost

The largest efficiency gains are likely to be from achieving water security at lower expected cost, particularly through making better supply augmentation decisions and more efficient allocation of water resources. This requires:

• considering supply augmentation and demand management options (including more flexible pricing) together

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• considering the costs and benefits of all supply augmentation options and removing any policy bans and subsidies that distort decisions

• taking a real options (or adaptive management) approach.

Given community sensitivities about the health, environmental and cost characteristics of some augmentation options, it is critical that adequate information (including costs, benefits and risks) be provided to consumers and that consumers be consulted prior to major decisions being made.

In addition, many urban water systems are becoming more complex and this increases the importance of decisions about which supply sources to operate at any one time.

Giving water users greater choice

Consumers frequently face restrictions governing when they can use water and what they can use it for. In many areas water restrictions have been in place for most of the last decade. More recently, as dam levels have risen, temporary restrictions have often given way to permanent restrictions. The community’s willingness to accept restrictions has been admirable, but reliance on this goodwill has deprived many households of their preferred choices.

With restrictions in place, hundreds of thousands of households have sought to maintain outdoor watering by installing their own rainwater tanks and/or greywater systems. Many gardens have been substantially modified to require less water. In many cases, the cost to the community of these responses greatly exceeds the cost that would have been incurred if alternate approaches to maintaining water security had been used (such as more flexible pricing, and timely and appropriately scaled augmentation of the reticulated water supply system). Many of those without tanks (perhaps because they could not afford the large capital cost of installation) have had to do without water they would have willingly paid for.

Consumer choices are constrained in the name of water efficiency/conservation in various other ways as well. Appliances that fully informed people may have chosen to buy have been banned because they have been deemed to be not sufficiently water efficient. Those wanting to fill their swimming pool with around $100 worth of water may find that they are required to firstly purchase a pool cover and obtain a permit. Information provided to consumers can also overstate the benefits of water efficiency and conservation and lead to poorly informed choices.

As demonstrated in chapter 8, restrictions and other constraints place unnecessary costs on the community that are substantial.

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There is more to giving consumers greater choice than removing restrictions and mandatory water efficiency measures. Urban water services are generally provided by regional monopolies and so currently consumers have no choice but to live with the decisions made by their provider. Because of this there may be a case for consumer representatives to have a formal role in policy/regulatory decisions, and the pricing and procurement decisions of utilities. Allowing water utilities to develop multiple service offerings is a further means for allowing greater consumer choice.

Directly targeting environmental outcomes

Measures to increase water conservation, reuse and recycling are often implemented on the premise that they will improve environmental outcomes. In reality, the relationship between these measures and environmental outcomes is indirect and uncertain. What are needed instead are policies that directly target identified environmental problems in an efficient way. Changing focus in this way would allow the objectives of the National Strategy for Ecologically Sustainable Development to be more fully realised.

For example, subsidising water recycling so as to reduce river extractions and improve the health of riverine ecosystems may or may not produce an environmental benefit. It may simply result in dam levels being a bit higher than otherwise or reduce the amount of rural–urban trade. A preferable approach would be for governments to ensure that environmental flows, wastewater discharge standards and standards for stormwater management are calibrated to maintain valued ecosystems in a healthy state in a cost effective manner.

In some cases doing this will make water recycling projects viable and so they become part of the solution. The message is that rather than mandating water recycling in the hope that this will improve environmental outcomes, these outcomes should be directly targeted and recycling schemes be allowed to emerge where they can contribute cost effectively.

Promoting affordability and consumer protection efficiently

There are various arrangements in place in the urban water sector that are at least partly motivated by the desire to promote affordability and protect consumers, particularly those on low incomes. These include:

• using a pricing structure that includes an initial allocation of water at a low volumetric price

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• ‘postage stamp’ pricing across large geographic areas

• using water restrictions and other non-price demand management measures in lieu of higher prices during times of high water scarcity

• providing concessions on water bills to concession card holders

• hardship policies.

Chapters 7 and 9 demonstrate that while some of these arrangements have merit, many of them, particularly those that relate to pricing, are poorly targeted and inefficient. Reform should seek to find more efficient ways of achieving affordability for low income groups, including by relying more heavily on the social security and taxation systems.

It is also apparent from chapter 6 that the costs of providing water, wastewater and stormwater services are higher than they need to be in some places due to various inefficiencies. Reforms that increase efficiency can lower these costs, thereby increasing affordability for everyone, including those on low incomes.

Reducing the cost of regulation

Health, environmental and economic regulation has costs as well as benefits and it is important that regulatory approaches are calibrated to maximise net benefits. Regulatory costs include the direct costs of funding regulatory agencies and the compliance costs they impose on regulated entities. The Commission’s analysis indicates that there are several areas where current arrangements appear to fall short of maximising net benefits. These include:

• economic regulation (particularly price determination by regulators) that may be imposing higher costs than alternative governance and monitoring arrangements

• wastewater discharge standards that in some cases have been increased without analysis of costs and benefits

• regulation of distributed water systems, such as greywater systems, that are inconsistent and impose unnecessarily high compliance costs

• mandatory requirements that new dwellings be designed to use less potable water that override consumer preferences.

It is clear, therefore, that regulatory reform should form part of any integrated reform option.

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Removing impediments to integration of the water cycle

There are two main conceptual models for integrated water cycle management. The first assumes that water conservation, reuse and recycling are objectives in their own right, and that the reliance of urban areas on external water sources should be minimised. Analysis in chapter 6 demonstrates that this model is flawed and that it is influencing current arrangements in ways that cause substantial inefficiencies.

The second model, which the Commission advocates, is to treat integrated water cycle management as a coordination issue. Arrangements are needed to ensure that the interrelationships between water, wastewater and stormwater services, and between these services and the environment and urban development, are factored into decision making in a coordinated way. There is a range of impediments, such as unclear property right arrangements for stormwater and wastewater, that need to be addressed in order to achieve this. Where this is done, water recycling and reuse will be undertaken wherever it provides net benefits to the community.

Introducing greater competition where cost effective

Reforms that introduce greater levels of competition have achieved significant efficiency gains in other utility sectors, such as electricity and gas. The potential gains in urban water are likely to be more modest because:

• limited forms of competition have already been introduced through contracting out and build, own and operate arrangements

• compared with other utility sectors, a greater proportion of costs are in natural monopoly elements of the supply chain (for which competition in the market would be inefficient).

Even so, the gains from increased competition (in various forms, including competition for the market and yardstick competition) could be substantial, particularly for bulk water supply. It is difficult to estimate these gains because they often come in the form of innovations that are inherently unpredictable. What is needed is to weigh up the costs and risks of increasing competitive pressures against the plausible benefits. Taking a phased approach, as advocated by Ruff and Sweir (sub. 47), may also be beneficial.

Exploiting economies of scale more fully

The available literature on economies of scale and scope, and views expressed by many inquiry participants, suggest that significant efficiency gains could be

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achieved by increasing the effective size of small utilities, particularly in New South Wales and Queensland. Many of them, however, are operated by local governments and it is possible that in some cases their remaining functions would become less efficient if water were separated out into larger regional entities. The reform challenge, therefore, is to more fully exploit available economies of scale, while recognising possible impacts on the efficiency of local government and the benefits that local provision can have for consumers. Success in doing this could result in various benefits, including improved asset management and higher service standards (for example, fewer ‘boil water’ notices).

At the other end of the spectrum, the vast majority of Western Australia, South Australia and the Northern Territory are each serviced by one water utility. In these cases, disaggregation could bring benefits without the loss of economies of scale.

10.2 Reform options

The recommendations made earlier in this report, if implemented, would go some way to achieving the reform objectives discussed above. Beyond this there is a need to consider institutional, governance, regulatory and structural reform tools and to assess how they fit in with one another, so as to arrive at integrated reform options. This is the task of the remainder of this report.

Chapter 11 considers reforms that centre on institutional arrangements. It examines the roles and responsibilities for government ministers, departments, water utilities, regulators and the private sector. It recommends changes that would improve transparency and accountability in the urban water sector. In essence, the chapter looks at improvements that could be made regardless of the structure of the supply chain. It concludes with an illustration of how the ideas discussed in the chapter could be applied to the traditional vertically-integrated structure in an integrated way (option 1). This option can be thought of as the minimum high priority set of reforms (in concert with the reforms from earlier in the report) that the Commission considers would be appropriate for urban water systems.

Chapter 12 builds on chapter 11 by introducing structural reforms to increase competitive pressures and achieve other benefits. Four reform options are presented (options 2, 3, 4 and 5), with the degree of structural change and the role of markets progressively increasing with each successive option. Options 2, 3 and 4 are likely to be most suited to the larger capital cities and the costs and benefits of each are discussed. Option 5, involving decentralised competition, is less fully fleshed out than the others, reflecting an assessment that such an option should be viewed more as a longer-term possibility.

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Chapter 13 specifically addresses reform in regional areas. The problems that reform should seek to address are somewhat different for regional areas than for major metropolitan areas. In particular, there are many smaller water utilities that face major challenges to meet desired service standards, manage assets, attract suitably skilled staff and remain financially viable. A range of options for addressing these challenges is put forward in this chapter.

Chapter 14 identifies the priorities for reform, discusses how reforms should be implemented, and deals with transitional issues. In doing so, it outlines a timetable for reform. The chapter also presents a monitoring and review framework for assessing the efficiency gains from reform.

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11 Institution-centred reform

Key points

• Reforming existing institutional arrangements for urban water provision is central to achieving the efficiency gains discussed in earlier chapters. Many of the most beneficial potential improvements can be achieved without the need for major structural reform.

• There is a need for better definition and separation of the roles and responsibilities of participants in the urban water sector. In particular, there is a need for clear delineation between decisions most appropriately made by elected representatives (those regarding ‘public interest’ considerations), commercial decisions typically best made by water utilities, those decisions most appropriately made by regulatory agencies, and those decisions most appropriately made by consumers.

• In particular, the role of procurement of supply augmentation should be assigned to retailer–distributors to appropriately align risks and incentives.

• Although governments have made considerable progress in this regard, there is scope to further improve governance arrangements for publicly owned urban water providers. Under the Commission’s preferred arrangements, governments (as owners) would create a charter providing guidance to the utilities on: – obligations to serve (security of supply and obligation to procure) – processes and procedures for choosing supply augmentation (transparent, tenders for supply, public consultation, public reporting of the decision, which includes a review of the decision by an independent body) – principles for pricing and service offerings – process and procedures for setting prices that are transparent, involve public consultation and public reporting of decisions (including a periodic review by an independent body) – borrowings and dividends policies – customer service standard/hardship policies – risk allocation (consumers, government shareholder, private suppliers) – nature and funding of Community Service Obligations.

• Establishing good governance procedures would render much of the current price regulation of government-owned water utilities unnecessary, and would be likely to provide greater net public benefits when compared to price regulation.

(Continued next page)

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Key points (continued)

• State and Territory Governments should move away from current regulatory price setting, initially to a price monitoring regime. Subsequently, all States and Territory Governments should initiate independent reviews (not by regulatory agencies) to determine whether there is an issue of misuse of market power, and if it cannot be demonstrated, price regulation should be abolished and replaced by a self-reporting regime against the proposed charter subject to periodic independent review.

• Transparency and accountability of health and environmental regulation need to be treated in the same way as economic regulation.

• To ensure consumer preferences are considered in utility decisions, a representative consumer body with a formal charter should be established and funded by a surcharge on water bills.

11.1 Introduction

To achieve the potential efficiency gains discussed in earlier chapters, existing institutional arrangements for water provision need to be reformed. Many of the potential improvements can be achieved without the need for major structural reform. This chapter focuses on these more basic reform options that are expected to have a significant pay-off at relatively little cost. It effectively underpins all of the Commission’s suggested reform models that were discussed in chapter 10. Discussion of the potential for further gains from more significant structural reform is in chapter 12, while chapter 13 looks at reform in a regional context.

Section 11.2 highlights the benefits of more clearly assigning roles and responsibilities to urban water sector participants. Section 11.3 discusses potential improvements to the governance of water utilities. Section 11.4 looks at whether better governance arrangements would reduce the need for price regulation of the urban water sector. Section 11.5 discusses potential improvements to institutional and governance arrangements for regulators. Section 11.6 looks at what institutional changes might be required to facilitate increased water trading, and section 11.7 introduces the Commission’s reform ‘option 1’.

11.2 Assigning roles and responsibilities

Earlier chapters have highlighted the areas where the Commission considers the greatest efficiency gains can be made in the urban water sector. These have included better clarification of objectives, mechanisms for improved supply

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augmentation decisions, more appropriate measures to deal with affordability issues, and better decisions about demand management (in particular, with an increased role for pricing and less reliance on water restrictions).

The Commission considers that clearer definition of the roles and responsibilities of participants in the urban water sector is needed to best achieve the overarching objective of maximising benefits to society. In particular there is a need for clear delineation between decisions for elected representatives (those regarding ‘public interest’ considerations), commercial and operating decisions (typically best made by water utilities), those decisions most appropriately made by regulatory agencies and, importantly, those best made by consumers.

It has long been established that ministers and other elected representatives (for example, local councillors) are uniquely placed, and indeed obliged, to make decisions that have a strong public interest component, as they have the authority of a democratic mandate (whereas other players in the urban water sector do not). Ministers are best placed to resolve the inevitable tradeoffs between the public interest objectives of utilities.

However, once ministers have made the key decisions regarding the public interest, it is most appropriate that ‘day to day’ decisions about the running of water utilities are left to the board and management of the utilities. For example, while it is appropriate for governments to make decisions about supply targets, subsequent investment decisions about augmentation are best left to utilities.

Utilities should be focused on servicing their customers, and not be seen as policy making bodies. In the area of planning, water utilities (particularly prior to the era of commercialisation) have often been given a broad role and, at times, have played a major role in determining urban growth boundaries. The Commission does not consider this to be a suitable role for utilities. They do have a legitimate advisory role in this area (for example, providing information to governments about the likely cost of infrastructure provision, or about the effects of development on water quality) but they should not be given (even de facto) planning powers.

Nor should utilities be heavily involved in setting environmental and health standards, or making judgments about environmental and health tradeoffs. These should be determined by government and independently monitored by specialist regulators in each jurisdiction. If these roles are performed by the water utilities, the potential for conflict between objectives is too great. For example, there is a conflict between commercial objectives and setting water treatment standards (IC 1992).

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The Commission considers better governance arrangements for water utilities would avoid the need for the current heavy handed price regulation of the sector, which comes with heavy costs. This will be discussed later in the chapter.

11.3 Governance of water utilities

Following concerns about the performance of government controlled urban water providers (IC 1992) — and government infrastructure providers more generally — in the 1980s, providers (especially those under State Government control) were subjected to a number of reforms to make them more commercially oriented and, in many cases, they have been corporatised. (Significantly less reform of this nature occurred in urban water providers controlled by Local Government.) These reforms notwithstanding, there are good reasons to believe that urban water utilities would benefit from further governance reform.

As the Commission has noted before (PC 2005a), there is an inherent tension in the corporatisation model (box 11.1). On the one hand, many government trading enterprises (GTEs) have been corporatised to enable them to operate as if they were private sector businesses. This is to bring to their operations efficiencies spurred by commercial imperatives, competition (where it exists), expert and accountable boards and management and, for the most part, the incentives and sanctions which apply to private sector organisations.

On the other hand, however, government ownership brings with it whole-of-government policies, the requirement to protect public funds and assets, protection from bankruptcy and potential for ministerial political and policy intervention. Ministers will potentially seek to influence decisions that could be politically ‘contentious’, and will typically take a whole-of-government perspective on what constitutes the public interest when making decisions on issues such as GTE dividend policies, Community Service Obligations (CSOs), terms of employment and industrial policies. To address the tension between commercial imperatives and the possibility of ministerial intervention, it is important to establish sound governance procedures.

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Box 11.1 Characteristics of corporatised entities Corporatised government trading enterprises (GTEs) exhibit a number of key characteristics, many of which distinguish them from private companies and government departments:

• Ownership and legal status — Ownership is non-contestable, with government retaining ownership (or part ownership) of the GTE on behalf of the public. The GTE is not part of a government department, but is established as a separate corporatised legal entity. Some are established as company GTEs, to which Corporations Law applies. Most are established as statutory GTEs, under (in the urban water sector, State or Territory Government) legislation that might be specific to a GTE, to the relevant industry, or to cover all GTEs in a jurisdiction.

• Functions — Although the corporatised GTE is commercially and competitively focused, it generally has other objectives that can conflict with that focus. The GTE has no regulatory functions — these, where they existed, have been transferred to separate agencies or government departments. Most policy functions were similarly moved. The GTE is required to abide by competitive neutrality principles.

• Ministerial authority and responsibilities — Ministers, often on the advice of specialist GTE units within their jurisdictional Treasury departments, undertake the role of owners on behalf of the community. The responsible minister(s) exercises external governance through broad strategic control over the GTE. There are varying legislative models among the jurisdictions, some of which also permit a measure of ministerial involvement in internal governance. Ministers specify the community service obligations they expect the GTE to meet and ideally, for the purposes of transparency, provide the GTE with separate budget funding to satisfy those CSOs. Ministers might, in some cases, also direct the GTE to adopt other public policy or whole-of-government practices. The establishing legislation generally provides for directions by the responsible minister(s) to a GTE’s board to be in writing and tabled in Parliament.

• Board authority — A board is established. It is presumed to be autonomous and accountable for internal governance. Directors are generally appointed because of their expertise and ability to contribute to the GTE’s overall corporate goals, rather than being representatives of particular constituent interest groups. The board normally prepares statements of corporate intent for approval by the responsible minister(s) — these specify objectives, undertakings, activities and financial and non-financial targets by which the performance of the board’s management of the GTE can be judged.

Source: PC 2005a.

Similar issues apply in Local Government controlled urban water providers, where councillors have many of the same incentives to intervene in decision making as do ministers in the State Government-owned entities. The ability for councillors to intervene is greatly lessened where water providers are separate entities from the

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council, and particularly if they are under the control of multiple councils, such as in south-east Queensland, and in the ‘county council’ model applied in parts of New South Wales.

A charter for water utilities

The Commission considers that the governance ‘tensions’ identified above would be best dealt with by governments, in their capacity as utility owners, creating a publicly available charter to provide water utilities with guidance. The charter would seek to ensure the practices of the utilities were consistent with the government’s overarching objective for the sector. The charter would have some elements which are common across all utilities, while others would be specific to the individual utility concerned (especially to retailer–distributors).

The charter, which the Commission anticipates would be a relatively brief document (approximately five to six pages), would set out the utility’s supply and reliability obligations, the arrangements for transparently making supply augmentation decisions and the risk sharing arrangements relating to supply augmentations.

Government policies with regard to dividends, borrowing policies and provision of CSOs would also be included in the charter, as would ‘hardship’ provisions for dealing with financially disadvantaged customers. The Commission considers the charter would, through a staged process over time, obviate the need for price regulation in the sector, and therefore anticipates the charter would also cover a number of areas currently determined by regulators, such as levels of return, asset valuations and pricing structures. (Issues relating to the appropriate pricing of infrastructure are discussed in chapter 7).

The Commission envisages that utilities would regularly report information on their performance against the charter and publish it on their websites. To provide customers with reassurance, the process could be overseen by the auditor-general’s office (or even an economic regulator). The auditor-general could also report on the efficacy and efficiency with which services are provided.

Responsibility for procurement and investment

Chapter 6 highlighted the significant costs associated with poor supply augmentation decisions. These poor decisions stem, in part, from (often short-term) political pressures on governments influencing their (long-term) supply augmentation decisions. Were government to only determine the supply obligations

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of water utilities and leave the investment and augmentation decisions to utilities, this would, in the Commission’s view, reduce the probability of poor investment decisions.

The Commission considers that as utilities — and particularly retailer–distributors — are ultimately responsible for water supply, and ultimately bear the consequences of their investment decisions, it is appropriate that they make supply augmentation decisions. The charter with the government would set out the processes to be followed by the utilities in making decisions, including procedures for public consultation.

As noted above, the charter would also set out risk sharing arrangements between the government and the utilities stemming from supply augmentation decisions. The risk sharing arrangements would be particularly important if augmentations were initiated by government and not based on commercial criteria.

Although the Commission considers providing retailers with the obligation to supply provides the best alignment of incentives with regard to augmentation, institutional arrangements in some areas might make implementing that more challenging. For example, in south-east Queensland, a water grid manager (WGM) has been set up to strategically manage the water grid. The WGM does not own or operate infrastructure but holds urban water entitlements, and acts as the single buyer of bulk water and the single seller of bulk water services for urban use.

• are best placed to understand the preferences of urban water consumers

• are in a position to facilitate contestability and competition for new water supplies and services from potential service providers

• have the incentives to, and are best placed to, manage the commercial risks of procurement, particularly those associated with long-term supply and service contracts.

One possible alternative for ‘de-politicisation’ of supply augmentation decisions is the formation of an independent procurement entity (IPE) to deal with matters relating to supply augmentation. The introduction of such a body has been proposed in Western Australia by that State’s water pricing regulator, the Economic Regulation Authority (ERA).

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The ERA proposed that the IPE be established as a statutory authority with the explicit objective of ensuring maintenance of supply security at least expected cost, within given policy and regulatory constraints. In broad terms, as envisaged by the ERA, the IPE would receive a supply security requirement determined by the Government and, subject to this, identify future supply shortfalls and seek ways to meet these shortfalls via supply augmentations and demand management options. It was also envisaged that the IPE would take over responsibility for all factors that influence supply and demand.

Major advantages of the IPE as envisaged by the ERA would be ‘de-politicisation’ of supply augmentation decisions and, in a Western Australian context, enhanced competitive neutrality with an organisation other than Western Australia’s Water Corporation making supply augmentation decisions (meaning rival suppliers would presumably be more likely to be successful) (ERA 2008).

For the IPE to ultimately be successful, its independence would have to be assured. This could be achieved by appointing IPE decision makers for fixed terms with few provisions for ministers to remove them. This could, however, raise accountability issues, particularly in view of the large sums of public expenditure for which the IPE would potentially be responsible.

Although the Commission sees benefits in ‘de-politicising’ decisions about supply augmentation, difficulties in holding the IPE truly accountable for its decisions mean it could not be assured that the IPE would be likely to make better investment decisions than are made under current arrangements. It is difficult to envisage how the IPE would be either ‘politically’ or ‘commercially’ accountable for its decisions, while measures to ensure its independence would presumably make its key decision makers difficult to dismiss.

The Commission therefore considers that — in the context of the proposed charter arrangement — supply augmentation decisions should be made by those water utilities given an obligation to supply customers under the charter. These utilities are likely to have information about the preferences of their customers (and the charter could contain mechanisms for further determining these), and ultimately bear the commercial consequences of their decisions. These outcomes might be further enhanced by pursuing the structural reforms set out in chapter 12.

DRAFT RECOMMENDATION 11.1 Retail–distribution utilities should be assigned responsibility for meeting security of supply standards and procuring water supply and services.

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Where water utilities are controlled by State or Territory Governments, implementation of charters should be relatively straightforward. Where water utilities are controlled by Local Government, the Commission still considers that charters are desirable. It is likely, however, that the development of a ‘common charter’ by State or Territory Governments would be preferable to a separate charter being developed for each Local Government. This would also deal with the problem of utilities owned by multiple councils where no one council could exercise control. There might need to be subtle differences in the content of charters depending on the nature of specific water businesses and their legal form.

• obligations to serve (security of supply and obligation to procure)

• transparent processes and procedures for choosing supply augmentations (public consultation, tenders for supply, public reporting of the decision, and monitoring by an independent body)

• principles for pricing and service offerings

• transparent processes and procedures for setting prices that involve public consultation, public reporting of decisions and periodic review by an independent body

• borrowing and dividend policies

• customer service standards/hardship policies

• risk allocation (between consumers, government shareholders and private suppliers)

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Further commercialisation of water utilities

There are a number of specific areas in which the Commission considers further application of commercial principles for government-owned water utilities would lead to better outcomes.

Conflicting objectives

Chapter 3 highlighted the gains to be made by setting, prioritising and allocating objectives appropriately. The Commission’s view is that the sector as a whole should have an overarching objective of maximising benefits to the community (that is, economic efficiency, with economic efficiency defined to encapsulate objectives relating to water security and reliability, cost control, health, the environment, flood mitigation and commercial viability).

Implementation of the overarching objective would ideally involve estimating the monetary value of changes in environmental and health outcomes, although other methods are available to support decision making. This is an area of ongoing policy development and different estimates and approaches could be considered prior to decisions being taken by the relevant regulator or Minister and subsequently implemented by the relevant utilities and other organisations.

A problem currently with GTEs is that they are typically given a number of conflicting (or even seemingly mutually exclusive) objectives, often with limited guidance provided by governments about the relative importance of the conflicting objectives. For example, two key roles of urban water utilities are to sell water and to discourage the use of water (PC 2008d). Without guidance about the relative importance of the objectives, it is difficult to establish how GTEs have performed overall. They are likely to have done well against some objectives, and less well against others. As discussed in chapter 3, GTEs are also sometimes given objectives (such as increasing water efficiency) that are inappropriate in their own right as pursuing them can reduce overall community welfare.

While many participants have been relatively sanguine about the ability of water authorities to balance conflicting objectives, they have typically acknowledged GTEs are forced to make difficult tradeoffs. Yarra Valley Water Managing Director Tony Kelly stated: Dealing with conflicting objectives is core business for a water utility. We’re owned by governments, so we inevitably share the conflicting objectives that governments have. … we have to balance the social needs against the cost of these projects against the environmental impacts, and the industry has developed a number of models in that regard … none of them are perfect, and all of them have some elements of subjectivity

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in them, because the science isn’t concrete. Particularly on the social side it’s difficult. It’s opinion based … so you have to tread a difficult course I think to balance those … elements and be accountable for the final decisions that are made in the end. (trans., p. 222)

DRAFT FINDING 11.2 Government-owned water utilities are typically given a number of conflicting objectives by governments. Some objectives are inefficient (for example, utilities being required to reduce per capita consumption) and some are more appropriately assigned to other agencies. Often, little guidance about the relative importance of objectives is provided.

Ministerial directions

Ministers responsible for GTEs usually have the power to direct GTE boards. Often there are restrictions on the directions that can be given (for example, they might be restricted to non-commercial objectives or based on public interest criteria). There are also sometimes requirements to consult with board members before issuing directions.

Research by the Commission in 2005 suggested that about 80 per cent of GTEs (not just those in the water sector) were publicly required to report ministerial directions, typically either in the government gazette, to parliament or in annual reports. For those GTEs with public disclosure of directions, the Commission found formal ministerial directions to be rare. It is unclear, however, whether this means there are few directions, or whether ministerial wishes are being relayed to boards in an informal, non-transparent manner (PC 2005a).

With GTE board members generally appointed by ministers, there is scope for governments to influence decisions of board members even in the absence of formal directions. There are many opportunities for informal communications (Whincop 2005). Departmental or ministerial staff could also potentially issue informal directions to boards or influence their decision making (even without ministerial knowledge or authority in some cases). In some circumstances, board members might believe that they are to pursue particular government objectives even in the absence of any formal or informal directives.

INFORMATION REQUEST

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Are there similar issues with instructions from councillors in those cases where utilities are council owned?

Would independence, responsibility and accountability be improved by constituting utilities under the Corporations Act 2001 (Cwlth), rather than state water industry or general GTE legislation?

Appointment of boards

Sound principles for the appointment of public sector boards were enunciated by the Nolan Committee in the UK (COSIPL 1995). The recommendations of the Committee (including the creation of an Office of the Commissioner for Public Appointments to monitor appointments to boards) were subsequently adopted in full by the UK Government and continue to guide board appointments in the UK to this day. Other major Nolan Committee recommendations included:

• ultimate responsibility for appointments should remain with ministers

• appointments should be guided by the overriding principle of appointment on merit

• merit selection procedures should take account of the balance of skills and backgrounds required, and these should be clearly specified

• the basis on which members are appointed and how they are expected to fulfil their role should be made explicit

• candidates for appointment should be required to declare any significant political activity which they have undertaken in the past five years

• codes of conduct should be developed, incorporating requirements to declare, and deal with, potential conflicts of interest.

The Commission considers the recommendations of the Nolan Committee potentially provide a sound basis for appointing board members.

To ensure the accountability of boards, there would be merit in incorporating periodic independent review of the performance of GTE boards in governance arrangements. For example, there could be annual internal reviews, with less frequent external reviews of board performance.

There might also be merit in governments further easing constraints on remuneration levels for GTE boards to ensure they are competitive with private sector remuneration. However, there are currently many worthwhile candidates offering their services at prevailing rates of remuneration, and there is great

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reluctance on the part of the public to the paying of private sector levels of remuneration to GTE board members.

As the Commission has noted before (PC 2005a), this appears to be an almost inherent contradiction in the GTE model — that between the government acting as owner of a commercial enterprise and as custodian of public funds. This is despite the high potential cost to taxpayers and the community in the event of poor GTE decision making.

Funding CSOs

Prior to the recent microeconomic reform era, governments typically recognised the broader public benefits of non-commercial functions undertaken by GTEs by funding their (almost inevitable) operating deficits. Today, it is generally considered more appropriate to calculate the costs of providing these broader benefits (or CSOs) and to make corresponding payments from the budget. For example, water providers would typically be ‘compensated’ for the need to provide concessional tariffs to disadvantaged customers.

The National Water Initiative (NWI) pricing principles highlight the importance of transparently reporting CSO payments when determining prices: In determining prices, transparency is required in the treatment of community service obligations, contributed assets, the opening value of assets, externalities including resource management costs, and tax equivalent regimes. (NRMMC 2010, p. 18)

Strict adherence to explicit on-budget funding for CSOs by governments improves external governance of GTEs by recognising and funding the economic and social benefits to the community provided by the GTEs over and above the direct benefits reflected in the prices paid by consumers. It also requires CSO payments to be subjected to annual scrutiny through the budget process (PC 2005a). The use of explicit CSO payments also reduces concerns about competitive neutrality where public providers are potentially subject to private sector competition.

Use of CSO payments appears widespread in the water sector. The Commission notes that the National Water Commission (NWC) concluded in its 2009 Biennial Assessment that: In most jurisdictions, community service obligation (CSO) payments to metropolitan water providers are largely transparent and are reported on publicly through annual reports and annual pricing reviews. This is consistent with the NWI. (NWC 2009a, p. 169)

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The Commission agrees with this assessment, and also notes that the NWC highlighted that use of transparent CSOs was widespread for non-urban utilities that had failed to achieve lower bound pricing (with CSOs accounting for the revenue shortfall).

The Commission considers it is desirable to regularly review the appropriateness of CSO payments to ensure they are truly cost reflective, and that they accurately reflect government priorities (as recommended by the NWC, consistent with the NWI principles).

Borrowing arrangements

The ability of water utilities to obtain capital in their own right will have implications for their independence. If governance arrangements allow utilities to be relatively free to obtain capital, they are less dependent on government. If their borrowings can only be done through central agencies, or if they require ministerial approval, their independence is reduced.

However, there are tradeoffs between independence and the need to protect taxpayers who potentially bear the risk of reckless GTE borrowing. Where GTEs are monopolies, water consumers also potentially bear the risk of poor investment decisions that could potentially flow through to increased water prices.

Arrangements for GTE borrowing are typically the same as for other government agencies, whereby the Treasurer approves broad borrowing limits and risk management processes.

Arrangements in New South Wales are typical. In that State, borrowings from the New South Wales Treasury Corporation (TCorp) are guaranteed, while borrowings obtained from other sources are only government guaranteed if the Treasurer has specified such a guarantee in writing. To ensure competitive neutrality, a fee is charged to expose Government businesses to the risk-related cost of debt they would face if they were required to borrow funds based on their stand-alone credit rating rather than the rating of the State of New South Wales.

All government businesses subject to the guarantee fee are required to obtain an annual credit rating on a stand-alone basis to assess a business’s level of competitive advantage from access to guaranteed borrowings. Government businesses pay for their individual rating assessments, using credit rating agencies selected by New South Wales Treasury on a competitive tender basis (NSW Treasury 2010).

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Evidence provided to the Commission during this inquiry suggests that GTEs are relatively comfortable with their current borrowing arrangements. As is discussed elsewhere in this report, of more concern to the Commission than the ability of GTEs to borrow money is the manner in which GTE investment decisions are made, particularly decisions relating to supply augmentation.

Determination of dividends

Ministers ultimately have the power to effectively determine the level of ordinary and special dividends paid by GTEs, often on the advice of the board of the GTE. This potentially limits the capacity of GTE boards to plan for the use of retained earnings for future investment and capital replacement needs (particularly if combined with restrictions on GTE borrowing). If this impedes the efficient management of GTE assets or leads to reduced investment, it could ultimately lead to inadequate service provision and, potentially, unnecessarily higher prices in the long run. (This issue is also relevant to local government controlled providers, where councils often have similar powers to declare dividends and, in some cases, where councils are subject to ‘rate capping’ by State Governments, it has been suggested they use funds obtained from providers as a source of revenue to offset the effects of rate capping).

The inclusion of future investment intentions in publicly available corporate plans enhances transparency and accountability by allowing the public to make better informed judgments about whether dividend payments to governments were consistent with each GTE’s previously stated investment intentions. Currently, investment intentions are typically foreshadowed in information provided to regulators, although the purpose of these documents means there might be an incentive to overstate investment intentions (to influence regulatory outcomes).

There are also strong arguments for making the initial recommendations regarding the size of dividends and assessment of the capacity to pay a responsibility of all GTE boards. This would be consistent with private sector practice, and that of a number of Australian Government GTEs such as Airservices Australia. In the event that ministers, as representatives of the owners, override this recommendation, they should be required to publicly provide reasons for doing so.

Although concern is often legitimately expressed about ‘excessive’ dividends (that is, concern that governments use GTEs as ‘cash cows’ and potentially distort future investment decisions), it should not be forgotten that shareholding ministers do ultimately have a role to ensure that, over time, dividends provide an appropriate return on public funds. This is also important from a competitive neutrality perspective. While large dividend payments might raise concerns about ‘excessive’

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rates of return or the viability of future service provision, tolerance of low rates of return, if sustained for an extended period of time, must at some point represent an implicit subsidy to urban water providers or their customers (PC 2006c). They would also represent a potential source of subsidy to public providers relative to any private providers that might participate in water markets.

Based on the dividend payments detailed in chapter 2, it is unlikely that dividend payments have affected the investment plans of urban water providers to any significant degree. (In fact, in many cases concerns have been expressed about dividend payments being too low). However, many jurisdictions appear to have a predetermined percentage of profits to be paid in the form of dividends, and some flexibility in this regard is likely to be desirable. It is important for dividend policies to be cognisant of the need for investment.

DRAFT RECOMMENDATION 11.3 Governments should further improve governance arrangements for publicly-owned urban water utilities. Areas for improvement include:

• governments setting overall water security and reliability objectives, and requirements for wastewater, stormwater and flood mitigation

• further separation between Ministerial and board governance

• greater definition and alignment of objectives and assignment to appropriate agencies

• implementing procedures to ensure independence of boards

• regular reviews of Community Service Obligation payments

• regular reviews of board performance

• greater flexibility regarding dividend payments to ensure they are consistent with investment intentions. Initial recommendations on payments should be made by boards.

11.4 Rethinking economic regulation of the urban water sector

For many years a view has emerged in favour of further independent economic regulation of the urban water sector. The use of independent price regulation was agreed by COAG under the NWI: 77. The Parties agree to use independent bodies to:

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i) set or review prices, or price setting processes, for water storage and delivery by government water service providers, on a case-by-case basis, consistent with the principles … above; and ii) publicly review and report on pricing in government and private water service providers to ensure that the principles … are met. (COAG 2004, p. 16)

A number of participants have suggested there is a greater role for independent regulation than is currently the case in many jurisdictions. For example, the Water Services Association of Australia (WSAA) said: WSAA supports independent economic regulation and the continued removal of (actual or perceived) political interference in pricing, particularly as prices are projected to rise to cover the costs of developing a diverse portfolio of water supply sources to mitigate climate risks. (sub. 29, p. 20)

The NWC expressed similar views in its 2009 Biennial Assessment: Independent economic regulation is promoting transparency, rigour, and at least broad consistency in price review and price setting processes in Victoria, New South Wales and the ACT. While the [NWC] acknowledges some progress in other jurisdictions, such as South Australia’s recent announcement that the role of the Essential Services Commission will be extended, South Australia, Tasmania, Western Australia and the Northern Territory do not yet benefit from fully independent economic regulation. (NWC 2009a, p. 159)

WSAA recommended extending the use of independent price regulation outside of metropolitan areas. In doing so, however, they pointed to the potential cost burden this would impose and the need to balance costs and benefits: Clearly, however, regulatory frameworks and their application need to be mindful of the particular institutional arrangements in non-metropolitan areas. Heavy handed price regulation, with its attendant information and resourcing requirements, would impose a significant burden on many regional urban water businesses. More light-handed regulatory models … would be less costly to implement and administer but still offer benefits in improving the discipline on regional urban water businesses to pursue efficient operating and capital strategies, and to reflect the costs of these in efficient pricing policies. (sub. 29, pp. 21–22)

Independent economic regulation of urban water utilities has been seen as important in the absence of competitive markets because the alternative has traditionally been high levels of political interference in pricing. This has meant prices have often been set at levels well below cost recovery levels, possibly leading to inefficiently high water consumption and probably resulting in underinvestment and deferred maintenance.

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The likelihood of political interference in the absence of independent regulation was highlighted by Sydney Water Managing Director Kerry Schott: I think the regulators have pretty much stopped the monopoly power abuse, but what they haven’t stopped in all jurisdictions is politicians telling them not to put prices up. So in Queensland you get huge infrastructure spends without anybody working out how to pay for it, and it not being reflected yet in water prices, and now it’s starting to be reflected and everyone is going, ‘Hey, what’s happening here?’ If your price rises too just before an election, the odds are that you’re going to have a minister saying, ‘You can’t put your prices up by that much.’ (trans., p. 113)

While a report prepared by former Australian Competition and Consumer Commission (ACCC) Commissioner David Cousins for the Council of Mayors (SEQ) expressed concern about State Government interference in Queensland pricing decisions: State government criticism of Councils for the pricing of the distributor-retailers seems contrary to the basis on which the Government established these entities as independent bodies, having a commercial focus and subject to independent prices oversight. State Government, or Council, suggestions to ignore the costs of providing water services, or to restrict the degree of efficient cost recovery through pricing intervention, will result in inefficient and possibly inequitable prices being set. Recent legislation, requiring the [Queensland Competition Authority] to consider the application of price paths when proposed price increases exceed the rate of inflation and giving the Minister power to make codes relating to price determinations, raises concerns that efficient pricing will be compromised. (Cousins 2010, p. 4)

The Tasmanian economic regulator recently highlighted the consequences of current government-determined price caps in that State: The fact that the corporations, under accounting requirements, have been required to adopt impaired asset values, much lower than the true replacement cost of those assets, is indicative that revenues under the current pricing arrangements are insufficient to ensure the sustainability of the corporations in the longer term. This outcome means that, without further revenue and price increases after the interim period, the corporations will not be able to fund sufficient levels of investment to maintain their assets. ... The unsustainability of the industry is also highlighted through the extent that expected revenues are below full cost recovery and, more importantly, the fact that all three corporations will require increases in debt to fund their cash obligations. At some point after the interim period, revenue and prices will need to rise at a rate greater than five per cent per annum for some customers for the corporations to achieve sustainability. The only alternative would be to sacrifice or defer dividends and/or capital expenditure at some point. (OTTER 2010a, p. 26)

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As discussed in chapter 5, the Commission does not consider it a proper role for regulation to prevent under-recovery of costs1. Rather, price regulation should be about preventing abuse of market power where such power can be shown to exist.

In any case, small rural areas where underrecovery is likely to be most significant are often not subject to price regulation, presumably because the compliance costs are considered too great for the relevant water authorities. Numerically, there are considerably more water providers not subject to independent price regulation than there are subject to it. Further, as demonstrated by the Victorian rural utilities discussed in chapter 13, even when smaller utilities are subject to price regulation, they can still persistently have negative rates of return. Governance arrangements are likely to be more effective than regulation in dealing with underrecovery.

Is abuse of market power likely to be a problem?

In the absence of structural reform (chapter 12), many urban water providers currently have legislated monopolies and, therefore, potentially have the power to extract monopoly rents. Therefore there is concern that water providers would increase prices above efficient levels and reduce water consumption (creating so called ‘deadweight losses’ of monopoly). If price regulation promotes efficient water pricing, in the absence of offsetting costs, it could therefore provide net benefits to the community.

However, despite Kerry Schott’s comment above about regulators having ‘pretty much stopped the monopoly power abuse’, the major concerns in the urban water sector have traditionally related to poor rates of return, underpricing and, at times, underinvestment.

There have, of course, also been significant concerns, particularly prior to the microeconomic reform era, about x-inefficiency (that is, of water utilities not achieving efficient cost of their operations). This might be the point of Kerry Schott’s comment. However, the Commission considers that the governance reforms undertaken over the last two decades or so would have been far more significant in reducing this x-inefficiency than has been regulation (and the structural reforms discussed in chapter 12 have the potential to further reduce any remaining x-inefficiency).

1 While price regulation might be used to set minimum prices where predatory pricing is a concern, this is not an issue of concern in the urban water sector. Moreover, water providers generally have a legislated monopoly.

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It cannot be said that Australian water utilities have a history of ‘gouging’ monopoly rents. As discussed in chapter 2 (and consistently demonstrated over the years in the Commission’s GTE monitoring reports), rates of return for government-owned water providers have generally been relatively poor and often below the risk-free rate of return benchmark (the Australian Government 10-year bond rate), let alone one that makes an allowance for risk. A recent draft report by the Queensland Competition Authority found with regard to water utilities in south-east Queensland: (a) [Queensland Urban Utilities] forecast total water and wastewater revenues of $718.9 million marginally exceed the [maximum allowable revenue] of $708.3 million; (b) Allconnex’s forecast total water and wastewater revenues of $591.7 million fall well below the [maximum allowable revenue] of $765.2 million; and (c) Unitywater’s forecast total water and wastewater revenues of $372.3 million fall below the [maximum allowable revenue] of $392.3 million. Overall, on the information available to date, the Authority has not found evidence of an exercise of monopoly power in 2010/11. (QCA 2011, p. ii)

Even where water providers have the power to earn monopoly rents, good governance, transparent arrangements, performance reporting and independent review should prevent this (assuming avoiding monopoly rents is consistent with government priorities). Therefore, there are strong reasons to question whether price regulation (and particularly, price setting) of the urban water sector is still needed.

WSAA suggested that, with significant price increases likely to be necessary for the next few years in many jurisdictions, independent price regulation would have a role in reassuring consumers: Recent regulatory price paths to 2011-12 and 2012-13 suggest typical residential bills will increase significantly in the coming years if current consumption levels are maintained or increase. Price increases are not a result of regulation. Rather, independent prices regulation provides customers with a level of reassurance that regulator-approved price increases are ‘appropriate’, whilst benefitting businesses by allowing sometimes complex and contentious pricing issues to be debated in an expert and objective forum. (sub. 29, p. 20)

The Commission does not consider the role of regulation to be providing customers with assurance that price rises are justified, or to protect water utilities from criticism when they put up prices. If governments wish to provide customers with reassurance, they can do so through the use of transparent governance arrangements (such as the Commission’s proposed charter), by employing regular performance reporting and through regular independent reviews of the utility’s performance.

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Governance is important

The Commission agrees that publicly owned urban water providers are likely to possess market power. However, heavy handed price regulation would only be justified if there was a strong likelihood of them using their market power in a way that damages economic efficiency. Given that their shareholder governments are committed to efficient pricing, and set the objectives of the providers, good governance arrangements should render price regulation unnecessary. The Commission’s proposed charter would be an example of such a governance arrangement.

Costs of regulation

Price regulation is not costless. For example, price regulation involves significant administration and compliance costs, potentially restricts the pricing strategies of providers, limits flexibility in terms of price–quality tradeoffs, potentially influences supply augmentation decisions and can deter investment.

Cousins (2010) discussed the impact of regulatory uncertainty on the investment intentions of some Queensland council-owned providers: The entities … pointed to the uncertainty surrounding their regulatory environment. Should they wait to be told what to do by the regulator, or do they just get on and do it and convince the regulator later, if necessary, that what they have done is not inappropriate? (Cousins 2010, p. 27)

ACTEW Corporation stated that regulatory arrangements represented a disincentive to innovate: A significant drawback of the governance structures typically applied in regulated natural monopoly markets, such as the urban water market, is the lack of reward to innovate. Whilst in the short term this may result in lower prices, it may also deprive water consumers of more significant price decreases or quality increases that may flow from research and development in the longer term (sub. 45, p. 5)

Given the poor rates of return in the sector historically, it is perhaps surprising that the sector is subject to price setting, the most heavy handed form of price regulation, when other more light handed options, such as price monitoring, are available. This is particularly so given that many proponents of regulation state that political interference has tended to keep prices charged artificially low, thereby leading to underinvestment. As noted, the Commission does not see this as an argument for price regulation. Rather, price regulation should be about preventing inefficiencies associated with use of market power.

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In the event of further structural reform of the urban water sector (chapter 12), ongoing price regulation would potentially inhibit the price flexibility required to achieve efficient resource allocation.

Regulatory options

Of course, the question of price regulation of the urban water sector is not simply one of ‘should it be in place or not?’. While most States and Territory Governments have moved towards price setting/revenue capping by regulators for urban water utilities, others have maintained the regulators for advisory purposes (meaning their recommendations are likely to be adopted by government, but that final decisions on pricing are still a government decision) with ministers making the final decisions. There are also other more ‘light handed’ regulatory options, such as self-reporting, price monitoring and price notification (the latter being an indirect form of price control in practice, and therefore still relatively ‘heavy handed’).

Price monitoring has replaced price setting at major Australian airports.2 Under the price monitoring regime, the ACCC monitors the prices, costs and profits relating to the supply of various services at those airports covered by the regime. The intention of the framework is that the ACCC does not draw conclusions as to whether the prices and profit levels for monitored services are evidence of ‘taking advantage of monopoly power’, but the information assembled, and the ACCC’s reporting of it, helps to inform judgments by the Government on the effectiveness of the price monitoring regime. If warranted, the Minister could direct the ACCC to conduct a public inquiry, possibly leading to stricter price controls (PC 2006b, PC 2011c).

Regulation of ports in Victoria has seen a similar trend. Over time there has been a reduction in the number of services subject to price regulation, and price monitoring has replaced potentially more heavy handed regulation for those still subject to price regulation (ESC 2010). Following a staged process with reviews, some ports are no longer subject to price regulation.

The Commission is of the view that, if price regulation is to continue in the long term, price monitoring should be adopted as a more light handed regulatory option

2 The price monitoring regime for airport services is currently the subject of a separate Commission inquiry and was the subject of previous inquiries in 2002 and 2006.

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compared with price setting or revenue capping. As such, the Commission recommends all states and territories where prices for the urban water sector are currently set by regulators should move to a price monitoring regime. The current price monitoring arrangements in Queensland should either continue beyond the interim period (or ended if they could not be shown to have net benefits). The current Queensland arrangements represent a good model for the regulatory regime that the Commission considers would be more suitable across jurisdictions than the current price setting regimes.

Within five years of moving to price monitoring, State and Territory Governments should complete an independent review of whether the benefits of price regulation are truly greater than the associated costs. If net benefits of price regulation cannot be demonstrated, it should be replaced by a self-reporting regime, which could be overseen by an auditor-general, an independent regulatory agency or an agency such as the NSW Office of Water.

• whether water utilities are abusing their market power and, if they are, what action should be taken to deal with this

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Would ending price regulation lead to under-recovery of costs?

Given that many proponents of ongoing independent price regulation argue it should be maintained to prevent under-recovery of costs, the question remains of whether an end to price regulation would result in greater under-recovery. The Commission considers this should not be the case, assuming governance arrangements are adequate.

The Commission envisages that, in an unregulated environment, utilities would be expected to earn a commercial return on assets, although not one that raised concerns about excessive use of market power. The utilities would report regularly on their commercial performance, with the process overseen by a suitable agency or a regulator to flag any issues relating to perceived under- or over-recovery of costs.

Although there would still be political incentives to keep water prices low, there would also be potential for performance reports to be politically embarrassing if they found evidence of poor commercial performance (not just perceived ‘excessive’ returns). Reports could also find evidence of inefficiency or poor investment decisions.

If governments wished to assist customers because of affordability concerns, as discussed in chapter 9, rather than setting prices below cost they would be better off doing so through the tax or welfare systems, or by provision of CSO payments.

Transitioning to a charter

While the Commission questions the need for price regulation where there is appropriate governance, this does not mean that there is no potential role for an economic regulator in this process. Given the prior experience of most economic regulators in determining regulatory parameters, they could provide useful advice to the government on issues such as rates of return and asset values. Many regulators have established processes that could also facilitate public consultation ahead of the drafting of the charter by government.

For example, the charter could require utilities to fully recover costs (incorporating an appropriate return on the shareholder government’s investment) but not to price in a manner that would allow a return above this or in some other way that damages economic efficiency. There would be merit in allowing utilities to achieve greater rates of return if they could demonstrate efficiency gains (to ensure there were incentives to avoid inefficiency).

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If urban water utilities did seek to exploit market power, assuming they charged based on a two part tariff, they would be likely to maximise revenue by increasing the fixed part of the charge rather than the volumetric component (as increasing the latter would provoke a supply response). Monitoring total revenue would be an appropriate form of regulation under these circumstances. Reporting on the utility’s performance against the charter could be based on total revenue to determine whether returns were potentially ‘excessive’.

Consumer involvement

As is the case with other utilities, there is no market based expression for the preferences of consumers across a wide range of product characteristics. This is particularly the case regarding service and reliability matters. Moreover, there is little or no information to inform decision makers about how much consumers are prepared to pay for increases in service quality (such as, fewer breakdowns).

If decision makers are risk averse (namely, they adopt the attitude there must never be a system failure) then consumers could be faced with higher prices for service quality they do not value. Much of the decision making in the urban water sector revolves around issues of reliability (for example, frequency of restrictions, pressure loss, likelihood of flood inundation) and, in the absence of such information, decision makers have to simply ‘make up’ consumer preferences as they have no other source of information.

Thus the Commission considers there is merit in looking at arrangements to give voice to consumer preferences independent of decision makers. One proposal that the Commission is interested in exploring is to create a formal representational role for a new consumer advocacy body. The consumer representative group would have a clearly specified formal role in making representations (but not being a decision maker) to utilities and other policy makers in matters such as:

• providing input on cost–benefit analyses conducted by regulators

• setting of quality and reliability standards

• determination of water related service offerings

• identifying and assessing supply augmentations.

Some commentators see a much greater role for the public in utility pricing although there is a range of institutional approaches that have been proposed and indeed implemented. For example, Littlechild (2008) has encouraged the use of ‘negotiated settlements’ between customers and utility companies as an alternative to current regulatory arrangements.

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Such arrangements involve customers, customer groups and appointed customer representatives taking an active role in negotiated price and quality issues with utilities, with the regulator then approving (or otherwise) the settlements. The regulator would also potentially become involved if no agreement could be reached. Governments could assist in facilitating the negotiated settlement process by helping to establish bodies to represent consumers (as described above).

Littlechild (2008) provides various examples of negotiated settlements in the United States and Canada, including those overseen by the Federal Energy Regulatory Commission (FERC) in the United States and the National Energy Board in Canada (both dealing with gas pipelines), and those facilitated by the Office of Public Counsel in Florida.

While the former bodies operate as regulators, the Office of Public Counsel is a consumer advocate created to provide legal representation for people in utility related matters. It intervenes in rate proceedings before the Florida Public Service Commission and counties involving various utilities (including water and wastewater). It performs independent analyses, presents testimony of expert witnesses, cross-examines witnesses from utility companies, and makes recommendations (OPC 2011).

The initial impetus for negotiated settlements stemmed from regulatory delays. For example, in the United States, the Federal Power Commission (FPC) — the precursor to the FERC — estimated that in 1960 it would take 80 years to clear a regulatory backlog even with a tripling of staff. The response was to encourage parties to settle their own disputes. Over the next decade, over half of the cases processed by the FPC were wholly or partly settled by the parties themselves. Over time, reliance on regulatory determination has diminished further (Littlechild 2008).

Advantages of negotiated settlements include reduced costs for the parties involved (in terms of both time and money), reductions in regulatory uncertainty and greater flexibility with regard to potential outcomes. The parties to a dispute are less constrained than the regulator. The reduced costs and greater flexibility associated with negotiated settlements can result in better deals for consumers.

It would be important that the body set up to represent consumers was truly representative of all consumers. This would not be an easy task but would be critical to the success of the negotiation process. It would be important that the body not be ‘captured’ by particular customers, such as major water users or disadvantaged groups.

Issues that would need to be determined would include how representatives for such a body could be chosen, whether such a body would be national or based in each

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state and territory, whether it represented customers across other utilities or just water, and what other responsibilities such a group might have with regard to consumer advocacy or research.

Victoria’s Consumer Utilities Advocacy Centre (CUAC) is probably the closest such organisation in Australia today. Despite it currently having a particular focus on disadvantaged groups, its structure is a useful starting point for considering governance issues. CUAC is funded by the Victorian Government and is a public company, limited by guarantee, established under the Corporations Act 2001 (Cwlth). The incumbent Minister for Consumer Affairs appoints the CUAC Board to operate as an independent advocacy organisation (CUAC 2011b).

Although formation of such bodies might initially require government funding, the Commission envisages they would ultimately be funded according to cost recovery principles with a surcharge on water bills.

INFORMATION REQUEST

The Commission seeks views on the desirability of establishing a consumer representative body, and on the appropriate scope, funding and governance model for such a body.

Third party access arrangements

Third party access arrangements seek to enable entities to gain access to the services provided by an infrastructure facility on commercial terms and conditions. Access arrangements are typically used when infrastructure facilities exhibit natural monopoly characteristics, and where, in the absence of regulation or competition from substitute services, facility owners are likely to obtain substantial and enduring market power. This market power could be exercised in two main ways, namely by charging access prices significantly above costs, or by denying access to the service/making access onerous.

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The national approach for dealing with third party access arrangements is via Part IIIA of the Competition and Consumer Act 2010 (Cwlth) (formerly the Trade Practices Act). As described by the National Competition Council (NCC): In broad terms, the [National Access Regime] provides a means of promoting competition in markets where the ability to compete effectively depends on being able to use a monopoly infrastructure service. At the same time, the regime ensures that infrastructure owners receive a commercial return and that incentives for efficient investment are not affected. (sub. 12, p. 1)

Part IIIA provides three ways for a third party to gain access to a service:

• declaration of an asset by a minister, following a recommendation by the NCC (declaration providing access seekers with a legal right to negotiate and a mandatory dispute resolution mechanism.)

• use of an existing access regime established by a state or territory and deemed to be ‘effective’

• seeking access under terms and conditions specified in a voluntary undertaking given by the service provider and accepted by the ACCC (PC 2010b).

The undertaking option is an alternative to declaration. It is designed to give infrastructure owners and operators greater certainty about the access conditions applying to their infrastructure.

Following a decision by the Australian Competition Tribunal to declare sewerage and interconnection services owned by Sydney Water, the New South Wales Government developed a State-based third party access regime for water infrastructure services under the Water Industry Competition Act 2006 (WICA) (NSW). While establishing third party access arrangements to facilitate entry to markets, the WICA also ‘restricts’ entry by establishing a licensing regime for private sector entrants requiring them to obtain licences in order to construct, maintain or operate any water industry infrastructure or to supply water (potable or non-potable) or provide sewerage services by means of any water industry infrastructure.

The NCC has said the WICA access regime ‘effectively mimics’ the Part IIIA regime, substituting IPART for the ACCC as the arbiter in any access dispute, and a decision of the Premier of New South Wales for a declaration decision under Part IIIA (sub. 12). The NCC did, however, conclude that the WICA regime meets the criteria to be certified effective and the relevant Minister accepted this recommendation in 2009 and certified the WICA as effective for 10 years. Following this, the sewerage services in New South Wales previously declared

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under Part IIIA had their declaration revoked (as a result of now being subject to an ‘effective’ State-based regime).

The NCC has raised doubts about whether the National Access Regime process would provide an adequate level of certainty about the terms of conditions of access to urban water infrastructure assets, while also noting that some urban water sector infrastructure assets might not meet the ‘national significance’ test required for declaration under Part IIIA. The NCC suggested jurisdictional regimes for access to gas pipelines and electricity infrastructure might represent a good basis for drawing up an equivalent regime for urban water: Governments have, for example, adopted jurisdictional access regimes for gas pipelines — which rationalise the process of determining what pipelines are regulated, allow for light handed and fuller forms of regulation and use of a national regulatory body — and for regulation of the electricity sector — which apply the relevant regulation to virtually all transmission and distribution infrastructure without requiring case by case declaration or coverage decisions. The Council considers that this approach could be used as a model for development of jurisdictional regimes for access regulation of urban water infrastructure. (sub. 12, p. 8)

The Commission has previously highlighted a number of concerns with the national access regime, and particularly its potential to discourage investment in vital infrastructure (PC 2001b). Against this, the urban water sector would benefit from increased competitive pressures and reliance on Part IIIA or the WICA might not provide this. The Commission notes an independent review of the National Access Regime is currently scheduled to be commenced by 31 December 2012. The Commission considers this review is well placed to make recommendations about the most appropriate future third party access arrangements for the urban water sector.

Third party access arrangements are typically more problematic with vertically-integrated entities, as there is an incentive for the infrastructure owner to favour their upstream or downstream operations. Therefore, under the non-vertically integrated sectoral models discussed in chapter 12, third party access issues might be less significant.

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11.5 Governance arrangements for regulators

Chapter 5 highlighted a number of potential problems associated with regulation of the urban water sector (even where regulation provides net benefits). The following section discusses what institutional and governance arrangements should be put in place to facilitate effective regulation.

Governance arrangements for regulators are important. Even relatively minor errors in the decisions made by regulators, or any perceived inconsistency in decisions that might increase concern about regulatory risk, can distort demand and discourage efficient investment. Such errors would be likely to have even greater ramifications where the private sector was involved in water provision. Moreover, the possibility of regulatory error could dissuade private sector entities from actually becoming involved in water provision.

Ensuring independence

Governments decided under the COAG Competition Policy Agreement of 1995 to separate regulation from ownership to address the inherent conflict of interest problems stemming from government ownership of service providers. However, governance arrangements are still critical in ensuring regulators are independent of government and at the same time accountable. Methods of appointing or removing regulators, arrangements for resourcing regulators and ministerial directions to regulators all have implications for independence. Regulators might also have increased independence if they report to a different minister (or ministers) to the minister with portfolio responsibility for water.

The Commission is of the view that the Nolan Committee recommendations for appointment of government boards highlighted earlier are also appropriate principles for appointing regulators.

Perhaps of greater importance are arrangements for removing regulators. If the removal of regulators is relatively difficult, independence is strengthened. However, if regulators were almost impossible to remove, this could lead to poor decision making and a lack of accountability. If removal of regulators is straightforward, they are more likely to comply with the wishes of government. Getting the balance right is difficult.

As an example of an accountability measure that could potentially undermine regulatory independence, the Economic Regulation Authority Act 2003 (WA) contains the following statutory provisions for the removal of a regulator by the Governor on the advice of a minister:

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(a) mental or physical incapacity to carry out the person’s duties in a satisfactory manner; (b) the person being an insolvent under administration within the meaning of that term in the Corporations Act 2001 of the Commonwealth; (c) neglect of duty; (d) misconduct; (e) incompetence; or (f) the person’s absence, without leave or reasonable excuse, from 3 consecutive meetings of the governing body of which the person had notice.

While most of these reasons are fairly standard for independent bodies, the inclusion of ‘incompetence’ in the list of reasons a regulator could be dismissed is unusual and brings an element of subjectivity, and carries some risk that it could be used to remove a regulator, on the pretext that they are incompetent if the minister disagrees with their regulatory decisions. On balance, the Commission considers such subjective criteria for the removal of regulators is inappropriate where a single minister has the power to dismiss (although such an arrangement might be less problematic were the parliament involved in a deliberative or consenting manner).

Importantly, the independence of regulators is likely to be maximised if communications between ministers and regulators are open to public scrutiny. Regulatory acts generally prescribe that ministerial directions should be publicly available, and this is appropriate. However, this does not preclude the possibility of informal communications between ministers and regulators.

IPART also raised the issue of the ability of ministers to direct regulators under legislation: This review should also consider the powers of governments to direct both water suppliers and regulators. For example, there is a provision in the IPART Act (Section 16A) for a portfolio minister to direct the Tribunal to include in prices the efficient cost of complying with specified requirements. These requirements are understandable to the extent that may allow a government to give effect to a political agenda that is important to it. However, overuse of such provisions in less important areas may weaken incentives for efficiency by requiring investments to take place for which the costs exceed the benefits. (sub. 58, p. 43)

The Commission agrees that overuse of such provisions could undermine regulatory independence. In the case of the specific direction cited, its appropriateness would most likely depend on the requirement being complied with, and whether the cost incurred of meeting the requirement should appropriately be met by consumers of water (or other infrastructure services if applicable) based on usual cost recovery principles.

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Conflicting objectives

Regulators, like water providers, also have to generally deal with a number of conflicting objectives when making determinations. Where regulators are given conflicting objectives, they must implicitly prioritise them. ACTEW Corporation highlighted the dilemmas faced by the regulator in the ACT: The current framework for water regulation in the ACT provides a broad range of factors to be balanced by the regulator. This is a very difficult assignment that effectively results in considerable discretion to the regulator and significant levels of regulatory risk for the utility. (sub. 45, p. 4)

Traditionally decisions about where the ‘public interest’ lies have been made by elected representatives, and there are strong reasons for this to continue. As such, regulatory acts ideally should not contain conflicting objectives and, where such conflicts are considered unavoidable, regulators should be given clear guidance by government on how to prioritise objectives.

However, this is generally not the case. For example, under Section 170ZI of the Queensland Competition Authority Act 1997 (Qld), the QCA has to have regard to the following matters when making a price determination: (a) the need for efficient resource allocation; (b) the need to promote competition; (c) the protection of consumers from abuses of monopoly power; (d) decisions by the Ministers and local governments under part 3 about pricing practices of monopoly business activities involving the supply of water; (e) the legitimate business interests of the water supplier carrying on the monopoly water supply activity to which the determination relates; (g) in relation to the monopoly water supply activity— (i) the cost of providing the activity in an efficient way, having regard to relevant interstate and international benchmarks; and (ii) the actual cost of providing the activity; and (iii) the quality of the activities constituting the water supply activity; and (iv) the quality of the water being supplied; (h) the appropriate rate of return on water suppliers’ assets; (i) the effect of inflation; (j) the impact on the environment of prices charged by the water supplier; (k) considerations of demand management;

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(l) social welfare and equity considerations, including community service obligations, the availability of goods and services to consumers and the social impact of pricing practices; (m) the need for pricing practices not to discourage socially desirable investment or innovation by water suppliers; (n) legislation and government policies relating to ecologically sustainable development; (o) legislation and government policies relating to occupational health and safety and industrial relations; (p) economic and regional development issues, including employment and investment growth.

No guidance is provided on, nor is it obvious, how these matters should be prioritised. Nor is such guidance provided in most equivalent regulatory acts across jurisdictions. This provides regulators with enormous discretion, potentially leading to regulators making decisions with ‘public interest’ connotations that should, in the Commission’s view, be made by ministers.

Where guidance about priorities is not provided by government, regulators are potentially less accountable for subsequent decisions, with almost any outcome being defensible. Where regulators have considerable discretion, they are also more susceptible to lobbying by interest groups seeking to determine the setting of priorities (PC 2001c).

The formation of a truly representative consumer body, as discussed earlier, would reduce the hazards of economic regulators seeing representing consumer interests as being their role.

Transparency and public consultation

It is important for regulators to consult widely if they are to make informed decisions. Typically, regulators are given the power to consult as they see fit. It is relatively rare for the manner in which they consult to be prescribed in legislation (although some acts allow ministers to determine consultative processes when initiating particular references to regulators). Some regulatory acts prescribe that hearings be held in public.

It is, of course, important to strike a balance between the need for consultation, and the desire not to unnecessarily burden urban water sector participants with compliance costs and ‘red tape’. Consequently, it seems appropriate for regulators to determine consultative processes on a ‘case-by-case’ basis, rather than having processes prescribed by governments.

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The Commission does see merit, however, in the approach in some areas (such as Victoria and South Australia with their economic regulators) of requiring regulators to publish a charter of consultation. These charters are intended to set out processes for regulators to publish their future work program, to notify interested parties of inquiries and decisions, and to undertake consultation with stakeholders.

The production of draft reports has the potential to significantly enhance the consultative process, while also providing greater quality assurance through opportunities for feedback. Draft reports can be used to promote more constructive dialogue between regulators and stakeholders, as well as providing stakeholders with greater guidance about the position of regulators. They can also provide a basis for effective discussion at subsequent public hearings.

The Commission notes that economic regulators tend to be more transparent and have better practices for public consultation than many regulators in the areas of health and the environment. Economic regulators also typically publish detailed reasons for their decisions, providing the public with greater reassurance that all of the costs and benefits of decisions have been adequately considered.

The Commission is of the view that there would be public benefits from more widespread adoption of these practices by health and environmental regulators. Moreover, as noted in chapter 5, many existing regulations in the health and environmental area do not appear to provide net benefits. Increased transparency and public consultation would be likely to reduce the number of regulations that were effectively a burden on the community.

Appeal processes

The potential for merit review is important both for safeguarding the rights of those regulated and for ensuring regulators follow due process in making their decisions. An independent review of the reasons for, and the processes used to arrive at, decisions can help in the identification and improvement of ineffective regulation. It can also highlight any insufficient reasoning or misuse of power on the part of the regulator. Moreover, the possibility of regulatory decisions being reviewed at a later stage encourages regulators to follow due process.

Given appeals are likely to be expensive and time consuming, it is likely there will be benefits from ensuring a relatively simple, straightforward appeal process. It is also important that the appeal body is independent from the regulator but, also, preferably from government. This is especially the case where the government owns water providers. The Australian Competition Tribunal would appear to be an appropriate body to hear appeals against regulatory decisions with respect to

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economic regulation, although the Commission has some concerns about the potential cost and timeliness of appeals to this body.

With regard to health and environmental regulation, there is no equivalent body and there might be greater reliance on civil and administrative tribunals (such as the Australian Government’s Administrative Appeals Tribunal, the Administrative Decisions Tribunal in New South Wales or the Victorian Civil and Administrative Tribunal), ad hoc panels or formal court processes (including bodies such as the Land and Environment Court in New South Wales or the Environment Resources and Development Court in South Australia).

INFORMATION REQUEST

There is also the question of third party appeals (that is, whether third parties not directly involved in a regulatory decision can appeal). While third party appeals can be problematic, appeal processes are likely to improve regulatory decision making and the Commission does not consider they generally should be prevented. Rather, efforts should be made to ensure appeal processes are optimal.

The Commission’s recent draft report on planning, zoning and assessments identified a number of practices which should reduce vexatious third-party appeals and reduce opportunities to ‘slow down’ planning processes. These included clear identification of appellants and their grounds for appeal, ensuring courts had the capacity to award costs against parties seen to be appealing for purposes other than planning concerns, and prohibition of appeals where parties had not objected at earlier stages of the planning process. Requirements for parties to meet and discuss issues (mediation) can also reduce the third party appeals which proceed to court (PC 2011d).

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Resourcing and powers

To operate effectively, regulators require adequate resourcing and sufficient powers to perform their tasks. Lack of resourcing (including a lack of relevant expertise) is a common reason for regulatory delays (PC 2009b). Governments should therefore ensure regulators are provided with adequate resources or, subject to appropriate cost recovery principles, should ensure there is provision within legislation for regulators to recover costs.

Financial independence of regulators is likely to reduce opportunities for political interference. If regulators are able to employ staff and allocate their own budget, this is likely to lead to greater independence. In Victoria, for example, the regulated water providers make a ministerially determined contribution to the costs of economic regulation by the Essential Services Commission.

If truly cost reflective, it is appropriate for the costs of regulation to be built into the prices ultimately paid by consumers (PC 2001a), and these funding arrangements are likely to promote the regulator’s independence. Independence would be further promoted if the room for ministerial discretion was removed (although there might be other reasons for maintaining it, such as to provide greater flexibility or to guard against regulators seeking additional revenue through ‘regulatory creep’ or, in other words, moving into areas previously not envisaged by government).

Where regulators are funded on a ‘cost recovery’ basis, charges should be regularly reviewed to ensure they are truly cost reflective. While adequate resourcing is imperative, it is also important not to provide excessive resources to regulators, or excessive opportunities for regulators to engage in cost recovery. These provide incentives for ‘regulatory creep’.

Regulation is also unlikely to be effective if regulators lack the necessary powers to perform their task, including the ability to obtain information from those regulated and other parties that have information relevant to the regulator’s decision making. However, the commercial-in-confidence interests of regulated entities, cabinet confidentiality considerations regarding government agencies and the privacy rights of individuals also need to be balanced against the need for relevant information and the benefits of transparent processes.

Is there merit in a national economic regulator for the urban water sector?

A number of participants have suggested a national economic regulator for the urban water sector would be preferable to the current arrangements of individual

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State and Territory regulators. WSAA, which recommended a review of the costs and benefits of introducing a national regulator, said: However, a single and national regulator — and nationally consistent principles to guide economic regulation — could provide for the following:

• standardised approach to economic regulation across all jurisdictions

• access to precedents and information from other industries

• superior ability to attract and retain staff with sufficient expertise and experience to administer economic regulation. (sub. 29, p. 23)

Cousins (2010) also argued that consideration should be given to forming a national economic regulator: Such a regulator would be more able to isolate itself from the tensions associated with State and local government relations which are more evident in Queensland than in other jurisdictions, than could the [Queensland Competition Authority]. (Cousins 2010, p. 44).

The Commission agrees there are a number of potential benefits from having a national regulator (rather than state and territory regulators). These include:

• economies of scale and scope in regulation

• enforcement costs might be reduced

• for companies trading in more than one jurisdiction, compliance costs might be reduced by the need to deal with only one regulator

• possibly reduced risk of regulatory error through greater pooling of expertise and resources

• greater consistency of legal interpretation

• increased ability to withstand political pressures at the state level (although this might be offset by pressures at the Commonwealth level).

However, these potential advantages have to be offset against some possible disadvantages of having a single national regulator. These include:

• reduced ability to design the most effective regulatory regime for the circumstances of any particular jurisdiction

• reduced local knowledge of the sector

• more difficult access to the regulator for stakeholders (although steps could be taken to alleviate this, and the regulator would presumably have offices around Australia)

• the consequences of regulatory error might be much more significant with only one national regulator

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• reduction in resources for state and territory regulators that need some scope economies to continue to discharge functions with respect to other industries.

Although there are benefits from moving to a national regulator, the Commission considers these benefits could be achieved (with fewer offsetting costs) by moving to a more consistent regulatory approach across jurisdictions. If price regulation of the urban water sector is to continue, COAG could look at developing principles to ensure more nationally consistent economic regulation of the urban water sector. This process would be distinct from the existing COAG/NWI pricing principles, with the focus on standardising regulations and regulatory procedures (and reducing regulatory burdens). Importantly, if moves are made in this direction, they should not preclude any jurisdiction from moving away from price regulation or moving to more ‘light handed’ forms of regulation.

The Business Council of Australia also suggested that, in addition to dealing with price and access matters, a national regulator could set ‘a range of technical standards such as the quality of drinking water’ (sub. 66, p. 25). Although there are advantages for sector participants in having fewer regulators, the Commission is of the view that drinking standards would be best left to health regulators rather than by an entity that would otherwise be first and foremost an economic regulator. Further, if regulators are given too many conflicting areas of responsibility, the conflicts would be very hard to manage.

Is regulatory inconsistency across jurisdictions a problem?

As discussed in chapter 5, some participants have expressed concern about regulatory inconsistencies between states and territories. For example, Nubian Water Systems stated: Regulation is possibly the greatest impediment to distributed systems making a contribution to achieving the objectives. There are multiple layers of regulation in each state with little uniformity, in policy and guidelines, among the states. In some cases state guidelines are opposed and with inexplicable rationale. (sub. 11, p. 3)

Nubian Water Systems also provided examples of perceived inconsistencies such as differences in the nature and responsibilities of the various regulators across jurisdictions, and different rules adopted for provision of recycled water (sub. 11).

The Commission notes that there has been significant effort in recent years to improve regulatory harmonisation as part of COAG’s ‘seamless national economy’ agenda. This has included efforts to harmonise regulation in a number of areas potentially affecting the urban water sector, including environment assessments and approvals, consumer protection, product safety and construction and plumbing

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codes. However, it is not clear to what extent these efforts have reduced the unnecessary regulatory burden on the sector created by regulatory inconsistencies, or the degree to which regulatory inconsistencies still represent a problem for players (or potential players) in the urban water sector.

INFORMATION REQUEST

11.6 Institutional and other changes to support improved water resource allocation

As discussed in chapter 6, the current restrictions on rural–urban integration are likely to be reducing the efficiency of water markets, and potentially resulting in higher cost options and inappropriate timing for sourcing and/or conserving water than would otherwise be necessary. Moreover, many of the institutions involved with water provision in Australia still reflect the historical ‘silo’ approach that treated urban and rural water as separate resources (PC 2008d) (box 11.2). Therefore, current institutional arrangements mean rural–urban transfers are not always easily facilitated.

There are a number of ways in which water can be transferred between rural and urban users. However, there are likely to be significant advantages from using market mechanisms for transferring water between rural and urban users. Markets can reveal the true valuations different users place on water in a manner that other mechanisms cannot.

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Box 11.2 Urban rural tensions as typified by Victoria In 1964, then Victorian Premier Henry Bolte famously stated that not ‘one drop’ of water would be taken from north of the Great Dividing Range to augment Melbourne’s water supply (Dunstan 2011). Almost 50 years later, tensions are still evident in Victoria regarding the possibility of rural–urban water trading. Trading of ‘temporary’ water (that is, seasonal allocations, as distinct from ‘permanent’ entitlements) began in Victoria in 1989, with trade in permanent entitlements commencing in 1991-1992. Trading rules widened in 1994 to allow trade out of irrigation districts, between supply systems and into the Sunraysia district (DSE 2007). Until 2006-07, trade was capped at 2 per cent of a districts’ entitlement, which was later increased to 4 per cent. (The 4 per cent cap was the same across all jurisdictions under the National Water Initiative, but was seen as biting harder in Victoria particularly as ‘irrigation districts’ were narrowly defined) (DSE 2007). Until October 2009, Victoria had also imposed a 10 per cent limit on the proportion of water access entitlements in any water supply system that could be owned without being associated with land (NWC 2009a). The National Water Commission saw the 4 per cent limit as impeding buyback programs, penalising willing sellers, distorting trade patterns, inhibiting desirable structural change and complicating interstate collaboration (NWC 2009a). Victoria, like all jurisdictions, has subsequently agreed to phase out the 4 per cent cap (from July 2011 in Victoria’s case, with a view to removing it fully only by the originally agreed 2014 NWI deadline) (NWC 2009a). The Sugarloaf Pipeline was completed in February 2010, connecting Melbourne’s water supply to the Goulburn River. Flows to Melbourne were limited to 75 gigalitres annually, made available from the 225 gigalitres expected to be saved from the Northern Victoria Irrigation Renewal Project (with Melbourne water utilities prevented from entering the permanent and temporary water markets to purchase additional water for Melbourne) (Victorian Government 2010a). However, following a change of government in Victoria it has been determined that use of the Sugarloaf Pipeline to supplement Melbourne’s water supplies will be limited to ‘critical human needs only’, and the pipeline is not currently in use (Melbourne Water 2011c).

Further, although markets can facilitate the transfer of water between willing buyers and sellers, they do not compel participation in such transfers. Moreover, an administrative reallocation could see water transferred from rural water users when these users might place a relatively high valuation on the water being transferred. Such transfers would also be unlikely to involve compensation.

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Some key aspects are in place

A number of reforms undertaken already, particularly in the rural water sector, provide a basis for water transfers. For example, the separation of water entitlements from land provides for increased opportunity for rural–urban transfers. There have also been a number of investments to remove physical constraints on rural–urban trade, such as the Sugarloaf Pipeline in Melbourne.

Jarrah O’Shea, Manager of Economics and Pricing for Coliban water, highlighted the significance of the changes in Victoria: Water authorities have been looking outside their traditional methods of supply to meet water demand and it is important to note that by 2013 every single urban water authority in Victoria will be obtaining water from another authority. It is this interconnectivity which has brought us new water supply opportunities; it has added a level of complexity with water trading and authorities can easily suffer impairment losses if the value of water goes down on the temporary market, and these can be in the millions of dollars. On the other hand though, interconnectivity is a fantastic opportunity and is essential for insuring the allocative efficiency of water. (trans., pp. 198–199)

However, as recognised by the Commission in 2010, there are still a number of impediments to trade. These include:

• volumetric restrictions on trade (currently being phased out)

• excessive termination and exit fees

• an absence of cost-reflective pricing in many areas, distorting incentives to trade

• delays in the processing of trades

• obstruction by water operators of the transformation of water rights into tradable entitlements (PC 2010a).

DRAFT RECOMMENDATION 11.7 All remaining impediments to rural–urban trade, particularly volumetric restrictions and excessive termination fees, should be removed as soon as possible.

Potential institutional arrangements

In the Commission’s 2008 research paper Towards Urban Water Reform: A Discussion Paper, the Commission split the various approaches to integrating rural and urban trade into limited, intermediate and full integration as follows.

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Limited integration

At a minimum, allowing urban and rural water authorities to trade amongst one another is one limited way of facilitating rural–urban trade. However, rural authorities are obliged to meet the water entitlements of their rural customers, meaning that, in the absence of population shifts, the amount of water available for them to trade is likely to be limited. Urban suppliers are also obligated to meet supply security targets, meaning scope to trade would generally be limited for them also.

As much of the water that authorities would be able to trade would typically be water ‘saved’ out of the allowance for distribution losses, a danger of this limited integration model is that it could overly encourage investment in water saving activities at the expense of other projects or other water sourcing programs (PC 2008d).

However, participants have told the Commission that trading between rural water authorities was extremely useful during drought conditions, enabling regions with abundant water to trade to areas with relatively little. The Commission understands some of these arrangements have since been prevented in some jurisdictions, despite rural authorities still believing they can promote an efficient allocation of water resources. The Commission considers these bans on trading should only be put in place where considered absolutely necessary, and should be regularly reviewed.

Intermediate integration

Rather than restricting water trading to water authorities, the intermediate integration model expands trading to include large water users such as irrigators, industrial users and environmental services providers.

To facilitate such trade, for example, urban users could be provided with entitlement rights to water which they could trade either between themselves, or with rural water users. Alternatively, without formally setting up such a market for entitlements, large urban water users could make irregular purchases from rural water users when necessary.

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Full integration

Full integration would involve enabling all water users, including households, to trade water. This could be done by establishing property rights for water for all users or through supply contracts.

Young, McColl and Fisher (2007) proposed allocating tradeable entitlements to households within a discrete urban water market (that is, with no rural participation). However, it is not clear that there would be significant benefits from setting up a system of household entitlements in the context of a purely urban water market.

The costs of establishing such a system would be very high (perhaps prohibitively so) (ACG 2007), although the benefits might be quite limited. There would also be considerable doubt about the willingness of households to participate in such a market, given that water represents a very small share of household expenditure (PC 2008d). As with intermediate integration, the investment implications of setting up such a market would be unclear, and there would be a risk that new, potentially innovative industry participants could be discouraged. There would also presumably be a need for even more extensive storage arrangements to be available to enable the efficient functioning of the market.

Were supply contracts used, there would still probably be very high transaction costs involved in trade coordination, even if electronic exchanges were set up to facilitate trade. As the Commission concluded in 2008, the benefits of moving from intermediate to full integration might be quite limited whereas the costs would be potentially much higher (PC 2008d).

Sibly and Tooth (2007) proposed an arrangement for periodically allocating (for example, by auction) existing water stocks held in urban catchments to virtual suppliers that then compete in providing bulk water. In addition to facilitating trade, the model proposed by Sibly and Tooth seeks to deal with the perceived market power of major industry players: The arrangement … removes market power in the bulk supply and retailing sections of the value chain. The catchment operator loses its market power via the compulsory sale of water stock. Due to low barriers of entry for suppliers, the market for selling the water into the system will be very competitive. Similarly there will be low barriers of entry for retailers. Competition among buyers and sellers in each of the bulk water and retail water markets establishes a market price for bulk and retail water supply. In determining current supply decisions, virtual water suppliers would compare the benefit of supplying water now (the current volumetric rate) with the benefit of leaving the water in the storages (the future volumetric rate). If, for example, a drought is predicted, suppliers would expect the future volumetric rate to rise, and would tend to

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leave water in the storages. This would drive up the current volumetric rate. In this fashion, competition for bulk water ensures that the price supplied from each dam will come to reflect the opportunity cost of keeping the water to meet future demand. (Sibly and Tooth 2007, p. 6)

Under the model, trading could take place in a number of ways, including via supply contracts, or through a model similar to that applying in the national electricity market, with a market operator determining spot prices for the supply of bulk water and facilitating payments between industry participants.

Sibly and Tooth acknowledged prices would become more erratic under their proposed model but said they believed concerns that this would harm disadvantaged consumers were misplaced:

The current inefficiently low volumetric rate in effect provides a subsidy to all households irrespective of their level of social advantage or disadvantage. It is hence costly because it is so poorly targeted. Social welfare objectives would be more effectively and transparently achieved by providing fixed subsidies on the water bill to those households that are identified as disadvantaged … Such a subsidy would be more equitable and give the disadvantaged an opportunity to benefit more at no cost to society. (Sibly and Tooth 2007, p. 13)

11.7 The Commission’s ‘Option 1’

As noted in chapter 10, the Commission has proposed five models considered to be representative of the various reform options available. Those involving major structural reform are contained in the following chapter. Option 1 is presented here, and can be thought of as representing the traditional vertically-integrated urban water provider model, but incorporating the governance improvements discussed in this chapter. Under Option 1, the Commission also envisages that the utility would have a responsibility for augmentation procurement and an explicit policy of contestability regarding sources of water supply (to ensure efficient resource allocation).

The inclusion of five potential reform models reflects there being no ‘one size fits all’ model for all regions, and also that different jurisdictions are at different starting points for reform. Option 1 is likely to be of most value in those circumstances where there is a vertically-integrated utility. However, the governance and institutional reforms contained in option 1 will add value in all circumstances.

The utility envisaged by the Commission under option 1 would be a corporatised entity (with the characteristics described in box 11.1) and possibly incorporated under the Corporations Act. However, the corporatised model would be fully

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implemented in a manner in which its potential benefits would be fully realised. This would mean:

• where conflicting objectives were unavoidable, governments would give clear guidance regarding which objectives were to be given priority

• there would be full disclosure of any ministerial directions to the utility

• boards would be appointed on merit, based on the Nolan committee recommendations discussed earlier

• where utilities were required to perform non-commercial activities, they would be fully ‘compensated’ through the provision of explicit CSO payments, which would be regularly reviewed as part of the budget process

• dividend payment levels would be recommended initially by boards (albeit in line with the government’s overall policies on dividends) for ministerial approval, with investment intentions to be reported in publicly available corporate plans.

There would be clear delineation about decisions to be made by ministers (that is, those with strong ‘public interest’ connotations), commercial decisions (to be made by utilities), decisions to be made by regulators and decisions left to consumers.

As detailed earlier in the chapter, the Commission would not consider price setting to be an essential feature of this model. Rather, unless an independent review found there were market power issues requiring a stronger regulatory response, the utility would have a charter with the shareholder government providing much of the detail currently determined by regulators. Matters to be covered under the charter would include:

• obligation to serve (security of supply and obligation to procure)

• processes and procedures for choosing supply augmentation (transparent, tenders for supply, public consultation and public reporting of the decision including a review of the decision by an independent body)

• principles for pricing and service offerings (including asset valuation and return on assets)

• process and procedures for setting prices that are transparent, involve public consultation and public reporting of decisions (including a periodic review by an independent body)

• borrowings and dividends policies

• customer service standard/hardship policies

• risk allocation (consumers, government shareholder, private suppliers)

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• clearly specified and fully funded CSOs.

There would be regular reporting by an independent auditor (or regulator) to ensure the charter was operating effectively. In addition to irregular performance reporting, the auditor would report on matters covered by the charter such as rates of return, the efficiency of utilities (in a predefined way) and current dividend policies.

If market power was considered to be an issue, there could be formal price monitoring, as currently occurs for south-east Queensland utilities. However, the Commission ultimately believes good governance procedures would render this unnecessary.

Supply augmentation decisions would be made in a transparent manner, with government only providing broad direction about supply targets to be achieved (effectively determining the ‘obligation to serve’ for utilities). Once the government set supply targets, there would be an obligation on the water utility to meet them. While the utility would be vertically-integrated, there would still be potential for competition ‘for the market’ via tendering and contracting out procedures.

Where regulators were involved, such as in the areas of health and the environment, their roles would be clearly clarified and their independence from government assured. Transparency would be increased by the publication of draft and final decisions and the reasons for these decisions. Regulators would be appointed according to the Nolan principles. Where regulators had conflicting objectives they would be given guidance about how those objectives were to be traded off. There would be appeal processes against regulatory decisions, and these would be kept as straightforward as possible.

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12 Structural reform options for large urban cities

Key points

• Structural reform can be an effective way to facilitate competition in the urban water sector, and in turn generate productive, allocative and dynamic efficiency benefits. Structural reform may also give rise to efficiency benefits that are unrelated to competition. In particular, structural reform concerned with horizontal aggregation or disaggregation of utilities is typically motivated by scale economies, and is most likely to be relevant for regional areas (chapter 13).

• Significant structural reform has been undertaken in Victoria, Sydney, south-east Queensland and Tasmania. In each case, reform has delivered distinct outcomes in terms of the consequent vertical and horizontal structure of the sector, and the extent to which competitive approaches have thereafter been used. – There is broad agreement that urban water reform in metropolitan Sydney and Victoria has delivered significant efficiency benefits. It is too early to assess the full impacts of structural reform in south-east Queensland and Tasmania, but a number of respondents to this inquiry indicated strong support for these reforms.

• Structural reform is not a cost-free exercise. It may lead to a loss of scale or scope economies, exacerbate skill shortages or reveal additional transaction costs, and there will be costs associated with breaking up and/or establishing new utility businesses. Unlike the reforms set out in chapter 11, structural reform is optional, and the case for pursuing structural reform should be assessed on its merits.

• Vertical and horizontal separation of the bulk water supply function (option 2) facilitates competition for the supply of bulk water services (bulk water supply, treatment, transfer and storage). Bulk water of different classes and from various sources will compete on merit and the least-cost combination of water supply will be used to satisfy new and existing demand (efficient bulk water resource allocation).

• Option 3 extends this type of competition to the wastewater treatment and discharge function, and provides strong incentives for innovation by wastewater treatment service providers, including the production of recycled wastewater products.

(Continued next page)

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Key points (continued)

• Extending this model to break up the monopoly retailer-distributor (option 4) would support yardstick competition between monopoly utilities, and strengthen competition between bulk water and wastewater treatment service providers.

• All State and Territory Governments should consider the merits of these and other structural reform options for large urban cities.

• There is insufficient evidence at this time to conclude that a competitive, decentralised urban water market (option 5) is feasible or cost-effective. – The Australian electricity and gas markets, and the rural water market, provide important lessons for the urban water sector, but are not appropriate blueprints for the development of an urban water market at this time. – Decentralised supply and demand decisions pose significant challenges for managing the security of urban water supplies. It is not clear that a competitive urban water market would deliver sufficient (efficient) investment in bulk water to achieve security of supply requirements.

The previous chapter (chapter 11) described a package of ‘universally applicable’ institutional, governance and regulatory reforms. These reforms can and should be implemented irrespective of the structural arrangements in place, and can be thought of as essential reforms for all Australian water and wastewater utilities. These reforms are expected to deliver significant benefits. However, structural reform presents an opportunity to obtain even greater efficiency gains by establishing contestability and competition in the urban water sector. Structural reform may also give rise to other efficiencies unrelated to the pursuit of competition.

Chapters 12 and 13 consider a range of options for structuring water supply and wastewater service delivery in Australia. Unlike the universally applicable reforms set out in chapter 11, these reform proposals are optional. It will ultimately be up to jurisdictions to determine, on a case-by-case basis, whether there is merit in undertaking structural reform.

This chapter (chapter 12) considers the costs and benefits of vertical and horizontal disaggregation of various elements of the supply chain, as it is through separation (as opposed to aggregation) that the prospects for competition improve. The chapter begins by describing the relationship between competition and the structural arrangements of an industry, the potential efficiency benefits of competition, and the various ways competitive pressure can manifest itself (section 12.1). The non-competition related efficiency benefits of structural reform are also identified. This section is relevant for chapters 12 and 13.

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Although structural reform provides greater scope for efficiency gains, it might also impose costs. The remainder of this chapter considers some of the efficiency consequences (costs and benefits) of three broad structural reform options that could apply in large urban cities (box 12.1) — option 2 is described in section 12.2, option 3 in section 12.3 and option 4 in section 12.4. The most significant anticipated benefit of these reforms is the achievement of efficient resource allocation in the bulk water element of the supply chain — that is, all classes and sources of bulk water will be able to compete on their merits to fulfil current and future demand. Finally, section 12.5 considers the prospects for achieving competitive, decentralised markets in the Australian urban water sector (option 5).

Box 12.1 Defining large urban cities The structural reform options set out in chapter 12 (disaggregation-based structural reforms) are most relevant for large urban water systems with multiple bulk water sources, or where there is potential for the development of multiple alternative bulk water sources (including large scale recycled wastewater or stormwater schemes). For the purposes of this inquiry, such locations are termed large urban cities. The Commission proposes that this encompasses the eight state and territory capital cities, and potentially a number of large, non-metropolitan urban centres — for example, Newcastle (New South Wales), Geelong (Victoria) and Townsville (Queensland). However, as set out in section 12.5, the Commission welcomes feedback on the practicality and cost-effectiveness of extending the structural reform options proposed in this chapter to either one, any or all of the state and territory capital cities, and/or to large regional towns.

The Commission acknowledges that the existing structural arrangements for supply of water and wastewater services vary significantly across and within jurisdictions, as do the demand and supply conditions (for example, the locations and types of available water sources). Consequently, the preferred approach to structural reform in Australia’s large urban cities is expected to differ. However, broadly speaking the Commission anticipates that where there is a case for structural reform, the preferred structural arrangements will loosely resemble either option 2, 3 or 4.

In regional and remote areas of Australia there is little scope to establish cost-effective competition in water supply and wastewater service delivery. Structural reform in these regions is generally motivated by establishing more efficiently-scaled water businesses, either via aggregation of small utilities or by breaking up jurisdiction-wide utilities that supply customers across a very large geographic area (chapter 13).

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12.1 Structural reform

Industry structure

An industry can be defined in terms of its horizontal and vertical structure. Vertical structure refers to the way in which successive elements of the supply chain are configured — that is, whether they are integrated (aggregated) or separate (disaggregated). Horizontal structure reflects how businesses are organised within each element of the supply chain (that is, whether a particular supply chain activity is carried out by a single business or multiple providers).

Industry structure is not only about the incidence of vertical and horizontal separation. It also extends to the type of separation (Cave 2006):

• ownership separation: separate ownership of the separated assets

• legal separation: separate legal entities under the same ownership. This might involve creation of an independent board and separate statutory accounts to enforce separation

• functional separation: particular activities of a business are operated as if they are independent, despite being owned by one entity. Under functional separation each business unit operates at ‘arms-length’ with other business units offering different services

• virtual separation: change at the transaction boundary only

• accounting separation (ring-fencing): identification of the cost elements in supply of retail and wholesale products. Common network elements are separately identified. Some versions of accounting separation may require separate profit and loss statements and balance sheets for the separate entities.

Together, the incidence and type of vertical and horizontal separation within an industry constitutes its structural arrangements. There are a range of structural arrangements that could feasibly exist within the Australian urban water sector. This range is bounded by two extreme cases, namely, a vertically-integrated monopoly utility providing all water and wastewater goods and services (this model has been the norm in Australia for a long time), and a vertically and horizontally disaggregated industry structure (decentralised competition). Structural change refers to any alteration to the prevailing industrial organisation.

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Structural reform, competition and efficiency gains

Structural reform as a facilitator of competition

Structural reform can facilitate greater competition (or market-based approaches), and thereby achieve more efficient and transparent outcomes in the urban water and wastewater sector. More precisely, structural reform can support competition if it involves vertical or horizontal separation. For example, breaking up a vertically-integrated entity might enhance contestability amongst providers of goods and services. Likewise, horizontal separation provides an opportunity to introduce yardstick (or comparative) competition and, pending other reforms, the development of competitive, decentralised markets in the longer term.

Pursuing structural reform to take advantage of its capacity to foster competitive markets is relevant for those areas of the water and wastewater supply chain that are potentially contestable (or alternatively, where it is feasible to achieve workable competition) as distinct from the natural monopoly elements (box 12.2).

Based on reform experiences in other infrastructure industries, the particular characteristics of the urban water sector, and the economic analysis undertaken on this issue to date, there is scope to achieve some level of competition in the provision of (figure 2.1, chapter 2):

• bulk water services – potable and non-potable bulk water supply (from various sources, including recycled wastewater and stormwater products) – bulk water storage – bulk water treatment – bulk water transfer (movement of water via the bulk water service providers’ own infrastructure — as opposed to the shared network, for example, from dam to treatment facility)

• water and wastewater retailing services1

• wastewater treatment and discharge services.

1 Includes retailing of potable and non-potable water supplies.

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Box 12.2 Contestable services and workable competition

Potentially contestable services A perfectly contestable market is ‘one into which entry is absolutely free, and exit is absolutely costless … In short, it is a requirement of contestability that there be no cost discrimination against entrants’ (Baumol 1982, p. 3–4). Contestable markets are characterised by ‘hit and run’ competition — if a business in a contestable market begins to earn excess profits, potential rivals will enter the market. In practice, there are different degrees of contestability and few markets are perfectly contestable. More commonly, markets are described in terms of whether or not they are ‘potentially contestable’. In many cases the threat of new entry can be sufficient to keep prices low and prevent the abuse of market power.

Workably competitive markets Workable competition (or effective competition) is regarded as a more realistic standard of economic performance. This concept evolved in response to concerns by economists about the shortcomings of framing public policy for oligopolistic markets on the theory of perfect competition (Markham 1950). The term workable competition was first used by J.M.Clarke in his article, Toward a Concept of Workable Competition (Clarke 1940). Clarke proposed criteria for judging whether competition was workable, including the importance of rivalry among selling units and the ‘free option of the buyer to buy from a rival seller or sellers of what we think of as ‘‘the same’’ product’ (Clarke 1940, p. 243). Since this time there have been a series of revisions and counter-proposals to these criteria. For example, Stigler defines a workably competitive industry as one where: (1) there are a considerable number of firms selling closely related products in each important market area, (2) these firms are not in collusion, and (3) the long-run average cost curve for a new firm is not materially higher than that for the established firm. (Stigler 1942, p. 2) More recently, Professor David Round (2002, p. 10) noted ‘the hallmark of a workably competitive market is flexibility and independence in decision making, with no coercion, and freedom to choose on the part of both producers and consumers’. Although no consensus has arisen over what might constitute workable competition, all bodies which administer competition policy in effect employ some version of it (OECD 2011a).

It follows that the non-contestable (or natural monopoly) elements of the urban water sector include:

• potable water supply network services – distribution – transmission

• non-potable water supply distribution network services

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• wastewater network services – distribution – transmission

• stormwater network services – distribution (collection of stormwater runoff from roads, parks and buildings, and transport to stormwater transmission network) – transmission (for discharge of stormwater to the environment).

The case for undertaking structural reform will ultimately depend on the balance of costs and benefits that reform brings about. These costs and benefits might arise as a consequence of greater competition following structural reform, or might be unrelated to competition. The following section describes a number of competition related efficiency impacts of structural reform. Other non-competition related efficiency consequences are considered later in this chapter.

Efficiency benefits of establishing competition

Competition should not be regarded as an end in itself (PC 2002). However, competition does serve as a mechanism for achieving allocative, productive and dynamic efficiency gains, and economic growth. For example, establishing competition between providers of water supply and wastewater services can provide a strong incentive for service providers to:

• seek out cost efficiencies and minimise costs, putting downward pressure on prices

• innovate, providing consumers with a wider range of goods and services

• undertake efficient investment

• improve the quality of services provided to customers.

Importantly, competition can drive efficient water resource allocation such that:

• at the demand end, available water resources are allocated to their highest value uses, consistent with the preferences of customers

• at the supply end, the least-cost (efficient) combination of water resources (of various classes and from different sources) is used to meet new and existing demand. As set out in chapter 6, there are significant potential gains from achieving more efficient bulk water supply investment decisions. The precise efficiency benefits of structural reform will depend, in part, on the type of competition that reform facilitates.

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Competition for the market

Competition for the market — in the context of the urban water sector — is where businesses compete (for example, via auction or tender) for the right to provide water and wastewater services.

This approach facilitates private sector participation, and imposes a strong incentive on bidders to reveal the minimum cost of providing services. For example, where there is competition for the provision of required bulk water services, service providers would compete on their merits to fulfil the demand requirement (existing and/or expected). This will promote efficient water resource allocation, as described above.

Competition for the market underpins the approach taken to water and wastewater service provision in South Australia. Since 1996, the South Australian Government has contracted out the management, operation and maintenance of Adelaide’s water, wastewater and recycled water treatment plants, and the city’s water and wastewater network infrastructure (box 12.3). Competition for the market is related to competition for supply inputs (such as competitive tendering and contracting out), and is discussed in more detail in chapter 6.

Box 12.3 Water supply in South Australia In January 1996, United Water (owned by Veolia) won the right to manage, operate and maintain Adelaide’s water and wastewater system for a 15 year period. Under this arrangement, SA Water (the state-owned public water corporation) retains ownership of water system infrastructure, and is responsible for all asset investment decisions, setting service standards, implementing the Government’s pricing policy, and billing and revenue collection. United Water’s contract expires at the end of June 2011. On 9 February 2011, the Minster for Water announced that the ALLWATER Consortium has been chosen to manage Adelaide’s water and wastewater networks for the next 10 years. The operation and maintenance contract is worth $1.129 billion.

Source: Caica (2011).

Competition in the market

Establishing competitive, decentralised markets for water services (competition in the market) is a much more complex task — and has more onerous preconditions — relative to competition for the market. Under this regime, multiple providers compete to supply a good or service to the same group of consumers, and

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consumers are able to choose between these competing providers. Market prices coordinate supply and demand decisions, including supply investment decisions, and forward and contingent markets allow market participants to manage risk and uncertainty.

There are no examples of competitive urban water markets anywhere in the world, although some progress has been made toward a competitive retail market in the Scottish water sector (appendix C). By contrast, retail and wholesale markets are well established in the Australian electricity and gas industries. There are valid reasons why such competitive, decentralised markets have not evolved in Australia’s urban water sector to date — this is discussed in section 12.5.

Notwithstanding the absence of competitive urban water markets in Australia, some urban water consumers are able to source water from multiple supply alternatives. For example, a growing number of urban water utilities are buying water from irrigators under bilateral agreements, in place of relying on traditional sources. This provides customers with greater choice over the type, quality and price of water they can purchase.

Likewise, growth in the number of locally embedded supply systems (including recycled, non-potable water products, rainwater tanks and so on) represents an increase in the number of supply options (albeit small-scale) available to water customers. Although these examples do not constitute evidence of competitive urban water markets, the emergence of alterative service providers can deliver some of the efficiency gains that a market might be expected to generate, such as imposing a competitive constraint on incumbent suppliers.

Yardstick competition

The concept of yardstick (or comparative) competition was developed in the 1980s as a way to limit the abuse of market power in monopolised utility industries, and is possible where there are multiple, comparable utility businesses. In practice, yardstick competition has been employed in several ways, ranging from simply reporting publicly on the performance of utilities, to the active use by economic regulators of ‘league tables’ as a means of setting prices (VCEC 2008). Marques and De Witte note: Yardstick competition is mainly aimed at public utilities where competition is not possible, where the main actors have little incentive to reduce the costs or where asymmetric information exists. This is particularly important in the water utilities sector, usually characterized by monopolistic features and by the presence of asymmetric information (moral hazard and adverse selection) which encourage rent seeking and a quiet life. (Marques and De Witte 2010, p. 42)

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Specifically, yardstick competition is expected to impose considerable pressure and incentives on utilities to (Mizutani, Kozumi and Matsushima 2009):

• become more efficient, leading to lower prices

• innovate

• improve service quality.

Yardstick competition may also strengthen information sharing and transparency, and provide opportunities for making comparative judgments about management performance, thereby driving out even further efficiency gains and supporting a market for managerial talent. The development of yardstick competition can also improve the effectiveness of regulation, where relevant. Specifically, the existence of multiple comparable utilities can also help to reduce the incidence of asymmetric information between regulator and regulated utility (IPART 2005).

The anticipated benefits of yardstick competition stem from the incentives this information provides for utilities to improve performance. Mizutani, Kozumi and Matsushima (2009) argue that some conditions must exist in order for yardstick competition to work properly, namely:

• homogeneity among businesses

• no collusion among businesses

• incentives for businesses to improve performance, including rewards and penalties.

The costs of yardstick competition are limited to the administrative and regulatory costs associated with monitoring, benchmarking and reporting on utility performance, assuming that horizontal separation has already been undertaken.

The Victorian water businesses are subject to a form of comparative competition by virtue of the performance benchmarking undertaken by the Essential Services Commission (ESC). The ESC has reported on the performance of the three metropolitan retailers since 1995. In 1996 the coverage of the ESC reports was expanded to include all Victorian urban water and wastewater businesses.

The NSW Office of Water reports annually on the performance of all water and wastewater utilities in New South Wales, and carries out some benchmarking of utility performance (NSW Office of Water 2010a). Performance reporting is also undertaken by the National Water Commission (NWC) and Water Services Association of Australia (WSAA), via the annual National Performance Report series (NWC 2010a).

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The economic regulator for water services in England and Wales (Ofwat) uses information on the relative performance of water businesses to set prices (appendix C). Variations of yardstick competition are also in place in Portugal, the Netherlands and Belgium (Marques and De Witte 2010).

Yarra Valley Water recognised the benefits of using comparative performance reporting in regions where monopoly utilities can be readily compared: One of the unique aspects of the regime in Melbourne is the fact that the retailers operate within one jurisdiction. This provides the Government (as owner) and regulators with greater capacity to compare performance than would otherwise be the case. For example, while comparisons can be made with interstate utilities — different regulatory regimes, local conditions and customer expectations — can make comparisons difficult. In addition, localised comparators provide additional impetus in that comparative performance and innovations are more readily observed, for example, when one retailer innovates it is difficult to ignore as the retailers share a common regulator, owner, stakeholders and media environment. (sub. 19, p. 18)

A number of studies have sought to estimate the productive efficiency of the three Melbourne retailer-distributors, and claim that yardstick competition explains some of the observed efficiency improvements. For example, Coelli and Walding (2005) found that the Melbourne businesses performed at or near the determined efficiency frontier in 2002-03. Likewise an Ofwat study (2007a), covering a number of international water businesses, found:

• on measures of cost efficiency for water services, the Melbourne retailer-distributors have performed well relative to other countries

• for wastewater services, the performance of the Melbourne retailer-distributors is better than that of UK wastewater businesses

• the Melbourne retailer-distributors performed relatively well on customer contact indicators, including complaints and call centre responsiveness.

Marques and De Witte (2007) used data envelope analysis to evaluate the performance of 122 drinking water utilities in Europe and Australia. South East Water was identified as being on the efficiency frontier (the other two retailer-distributors were considered outliers and excluded from the analysis).

Despite considerable evidence to indicate that the Melbourne retailer-distributors are performing efficiently, it is difficult to directly attribute this to the establishment of yardstick competition. The Victorian Competition and Efficiency Commission (VCEC) note: Domestic and international comparisons indicate that Melbourne’s retailers have performed relatively well against a range of service delivery indicators, with gains concentrated in the ten years immediately after the sector was disaggregated in 1995 …

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overall, this suggests that the extent to which competition by comparison operates to drive efficiencies in the sector has diminished over time, and that the potential role of competition by comparison will be relatively smaller in the future. However, the Commission considers there will continue to be a significant role for performance benchmarking carried out by the ESC and, at the national level, by the National Performance Report. (VCEC 2008, p. 54)

Competition for the resource

Competitive markets for the exchange and trade of water allow users to buy and sell water according to the value they place on it, with corresponding allocative efficiency gains. There are no formal, competitive markets for the exchange of urban water products, and the Commission has heard anecdotal evidence that some regional water utilities in New South Wales have been prohibited from trading water between towns on the same river. This contrasts with the Australian rural water market, where water is traded through the buying and selling of water access entitlements and allocations. The rural water market effectively constitutes a ‘cap and trade’ market arrangement (appendix C).

Establishing arrangements for formal trade in urban water entitlements would only be possible once property rights to water, wastewater and stormwater products have been clarified (chapter 6). Urban water trading would also require development of an appropriate water entitlement framework, trading arrangements and market rules, and various administrative mechanisms (such as establishing water accounting principles and a water register).

Summary Individual industry structures present different opportunities for the facilitation of competition. For example, a vertically-integrated industry structure can make use of competition for the market, but is not conducive to achieving competition within urban water markets, or trade in water products. Disaggregation-based structural reform will change the structural arrangements of an industry in a way that improves the prospects for competition, all else equal. Ruff and Swier (sub. 47, p. 15) consider ‘the best, or arguably the only, way to create effective and efficient competition in a network sector is vertical disaggregation or unbundling’. However, structural change is not without costs, and the case for proceeding with structural reform must take account of all of the associated benefits and costs. The following section considers some of the non-competition related efficiency consequences of structural reform. In some cases these impacts represent a

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significant cost, and may offset the competition related efficiency gains that structural reform is anticipated to deliver. This analysis will also be relevant for chapter 13, as aggregation-based structural reforms are typically motivated by the achievement of non-competition related efficiencies.

Other efficiency consequences of structural reform

Economies of scale

There is considerable evidence to suggest that water and wastewater services are characterised by economies of scale, which occur when the unit cost of production decreases as the volume of output increases. However, it is also true that when water utilities reach a certain size they begin to experience diseconomies of scale, such that the unit costs of production increase as output increases (IPART 2005).

It is important to distinguish between economies of scale and other related measures, such as economies of production density and economies of customer density. Studies of scale economies in water supply and wastewater service provision often use these measures interchangeably, making it difficult to draw robust conclusions and comparisons. Nauges and van den Berg (2008) provide a useful framework for thinking about these concepts (box 12.4).

Box 12.4 Terminology

Economies of production density

• How the costs of the utility change if the total volume of water produced and the total volume of wastewater treated are increased, but the number of water connections served (population) and network length (km) are held constant.

Economies of customer density

• How the costs of the utility change if total water produced, total volume of wastewater treated and the number of water connections (population) increase, but network length is held constant. Economies of scale

• How the costs of the utility change if all inputs (volume of water produced, volume of wastewater treated, the number of connections to be served, and the network length) are all increased.

Source: Nauges and van den Berg (2008).

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Returns to scale can be described by reference to the long-run average cost curve (figure 12.1). The long-run average cost curve reflects the minimum or lowest average total cost at which a business can produce any given level of output in the long run (defined as being when all inputs are variable), and is often termed the efficiency frontier.

Businesses that produce above the long-run average cost curve (at A in figure 12.1) are regarded as ‘inefficient’ (P1 > P2). In a contestable industry, new businesses are able to freely enter the market, and this provides sufficient incentive for the inefficient business to either become efficient or to exit the industry. In contrast, where the market is not contestable, competition from new entrants is not a source of improvement in productive efficiency. In this circumstance, structural reform may be regarded as an attractive option for driving efficiency improvements.

Figure 12.1 Long-run average cost curve

Price

P1 A

Qty Q1 Q4 Q2 Q3

The typical long-run average cost curve is u-shaped, reflecting increasing returns to scale (or economies of scale) where negatively sloped (Q1) and decreasing returns (diseconomies of scale) where it is positively sloped (Q3). The minimum point on the long-run average cost curve (Q2) is the minimum efficient scale — the long-run level of output where all economies of scale have been exploited. Minimum efficient scale is rarely a single level of output. More likely it is a range of output levels across which average cost is minimised, such that the business achieves constant returns to scale.

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Structural reform and economies of scale

Structural reform of the urban water sector will alter the operating scale of affected water businesses. Generally speaking, structural reform that involves horizontal aggregation of water businesses is motivated by moving businesses operating at Q1 closer toward Q2, so as to realise economies of scale efficiencies. In contrast, horizontal disaggregation may be desirable where a very large utility is exhibiting decreasing returns to scale (Q3), and there are expected efficiencies from reducing operating scale.

Changing the operating scale of water businesses via structural reform may also lead to efficiency benefits that are unrelated to scale (that is, reform may reduce utility operating costs for all levels of output, moving the utility closer toward the efficiency frontier). For example, horizontal disaggregation may provide opportunities for some form of performance benchmarking, and in turn impose strong incentives for efficiency improvements and innovation. Similarly, following disaggregation there may be scope to ease regulation, with a corresponding reduction in regulatory costs.

This suggests that horizontal disaggregation is not only relevant for very large utilities exhibiting diseconomies of scale. For example, there may be a case for breaking up efficiently-scaled water businesses if (1) the single utility can be disaggregated without any material loss of scale economies (that is, the separated utilities remain at minimum efficient scale) and (2) there is considerable scope to achieve other efficiency gains via such reform. This would mean the separated utilities produce at a lower long-run average cost than the single entity, all else equal, and therefore move closer toward the efficiency frontier. To the extent that structural reform provides incentives for innovation, it may also mean that the long-run average cost curve shifts down over time.

To determine the precise efficiency impacts of changes in scale it is necessary to understand:

• the shape of the long-run average cost curve

• whether the utility is likely to be below, at or above minimum efficient scale initially, and how structural reform will change this

• how efficiently the utility operates relative to the efficiency frontier, and if/how structural reform will change this.

In practice, it is difficult to observe these cost curves — economic regulators and/or corporation boards cannot be completely certain that any given level of output is being produced at minimum cost. One way to manage this is to use observable

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‘best-practice’ examples as a proxy for the long-run average cost curve. However these utilities may still incur costs above the efficient level.

This predicament is complicated by the heterogeneous nature of water businesses. Utility costs are driven by a range of factors that vary between locations and utilities, giving rise to unique cost structures (and long-run average cost curves) for individual businesses. This circumstance poses a number of risks for relying too heavily on existing studies of scale economies, as discussed below.

A word of caution

Despite the breadth of available literature on scale impacts, it is difficult to draw comparisons between two or more studies of economies of scale, or to extend the findings of one study to another region or circumstance. This is due to the highly diverse nature of the assumptions made by industry researchers and academics (such as the key drivers of a utility’s costs), and the considerable influence these assumptions can have in driving the results. In addition, it is often not clear whether studies control for factors such as production and customer density, drinking water standards and customer service standards.

This point was made by the Independent Pricing and Regulatory Tribunal (IPART): These studies cannot provide direct ‘evidence’ of the optimal size for water utilities in Sydney — operational characteristics differ significantly between water utilities, and so the conclusions of a study on one particular utility cannot be automatically applied to another. Given the lack of information specific to Sydney, the Tribunal considers there is insufficient information or evidence to determine whether Sydney Water is currently characterised by diseconomies of scale, let alone to determine the extent of any such diseconomies. (IPART 2005, p. 53)

Likewise, ACIL Tasman, in referring to a 2007 report by IPART on industry costs concluded: There is no general consensus on the question of whether there are increasing, constant or decreasing returns to size/scope in providing water and wastewater services. This might be seen as rather unhelpful — but it does tend to highlight the reality that strong conclusions will generally be very context-specific. (ACIL Tasman 2007b, p. ix–x)

The VCEC (2008, p. 59) made a similar point, suggesting ‘the point when diseconomies emerge probably will depend on a variety of local factors including the usage of the existing network, the condition of the infrastructure, and governance and regulatory frameworks’.

Against this backdrop, it is imperative that any assessment of scale impacts is undertaken with due regard to the particular circumstances of the affected water

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utilities. One of the most critical assumptions implicit in economies of scale studies is the relationship between scale and network costs. These costs represent a significant component of total utility costs, and can vary dramatically across different locations and circumstances.

For example, if a study has assumed that scale is increased without any increase in the number of networks managed by the utility (that is, new customers are connected to existing networks and there is no need for significant capacity expansion to accommodate additional customers), it would be inappropriate to expect the same scale impacts in a water system where new customers are connected to a separate network (especially if the new network is located at a considerable distance from the existing network). This point was emphasised by Frontier Economics: One has to be very careful about drawing inferences from cost studies in jurisdictions whose institutional arrangements are markedly different from our own. One of these differences relates to the size of the networks of pipes. For reasons of history, Japan and the United States have networks that are very small compared with that of Sydney Water. If scale economies are evaluated at the means of the sample data, the evidence of economies of scale from these much smaller networks may have little relevance to the Sydney Water pipes. (Frontier Economics 2004, p. 20)

To properly assess the net impact on network operating costs it is necessary to understand what a change in scale will imply for:

• the number of discrete water supply and wastewater networks managed by the utility

• network density and length

• distance between networks (relative location), including the scope for interconnection between networks

• the volume of water supplied, and the volume of wastewater treated

• size of the area served by the utility.

Other relevant considerations for assessing the costs and benefits of a change in scale include the geography, geology and topography of the region (as this affects pumping costs), variability of wastewater flows (wet weather flows), asset life cycles, climate and rainfall variability, and the distances between centres of urban demand (IPART 2007).

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Evidence of scale economies in urban water supply

Notwithstanding the risks associated with relying on existing evidence to draw general inferences about scale impacts, the available literature provides some important insights. This analysis generally considers how scale influences costs at the utility level:

• Strategic Management Consultants, in a 2002 report to Ofwat, use evidence from England and Wales to conclude that economies of scale are exhausted at about 400 000 connected properties (IPART 2005).

• Tynan & Kingdom (2005) consider a range of international data and conclude that utilities serving a population of 125 000 or less could reduce per customer operating costs by increasing their scale of operation.

• Mizutani & Urakami (2001) find that the optimal number of connections for a water supply utility in Japan is about 766 000.

• Martins, Coelho and Fortunato (2006) studied 218 municipal water and wastewater utilities in Portugal and found that small water utilities should merge where possible. The minimum efficient scale was estimated to be 15.6 megalitres (ML) per day.

• Fraquelli and Moiso (2005) suggest that size economies of water supply in Italy disappear as the number of customers served grows beyond 150 000 to 200 000.

• Torres and Morrison Paul (2006) find evidence that consolidation of small utilities in the United States might generate cost efficiencies, depending on the concurrent expansion of the network, but consolidation of already large utilities without corresponding increases in output density is not likely to be cost effective.

• Stone and Webster (2004) find that for English and Welsh water and sewerage companies there are strong diseconomies of size, such that a one per cent expansion in output implies a one and a half per cent increase in total cost.

In the Australian context, IPART observed: In serving approximately 1.6 million connections, Sydney Water is at or approaching a size at which water utilities in other jurisdictions have been found to experience diseconomies of scale. The Tribunal also noted that this number of connections is significantly larger than the minimum number that some sources assert is required to achieve economies of scale. (IPART 2005, p. 53)

The VCEC (2008, p. 58) found ‘there are modest economies of scale for small water utilities, with those supplying more than 200 ML of water per day (around

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73 gigalitres (GL) per annum2) experiencing constant returns to scale’. ACIL Tasman (2007b, p. 11) conclude that ‘estimates of the minimum efficient scale for water supply suggest a range from 125 000 to 1 million services inhabitants. For wastewater, the minimum efficient scale is less clear’. The Economic Regulation Authority of Western Australia (ERA), drawing on this report, found that ‘regional and remote areas in Western Australia are below the minimum efficient scale for water and wastewater utilities’ (2008, p. 108).

There is little empirical evidence on economies of scale in specific elements of the urban water and wastewater supply chain. However, Byrnes, Crase, Dollery and Villano considered the efficiency of wastewater utilities in Victoria and New South Wales and found: While the generally bigger utilities in Victoria appear able to attract better management expertise, giving rise to technical efficiencies, set against this is a loss of scale efficiency, insomuch as the results suggest that Victorian utilities exceed ‘optimal’ size. This finding adds weight to the argument that ‘bigger in not better’ in local public service delivery … with the obvious caveat that this result is confined to wastewater services. (Byrnes, Crase, Dollery and Villano 2009, p. 168)

IPART (2007) canvassed the literature on economies of scale in bulk water supply and water and wastewater treatment. IPART (2007, p. 19) concluded that ‘individual (water) sources generally experience increasing returns to scale (with respect to volume)’ but this only applies up to a certain point, and in many areas (over a period of time) more than one source is required. This upper bound might be determined by the geology of the site, or the intertemporal variation in water flow.

Likewise, individual water and wastewater treatment plants were considered to exhibit increasing returns to scale to a certain point. However, IPART noted: As demand increases it is possible that more complex treatment is required, offsetting the economies of larger treatment works, or that extra capacity is required. Tasman Asia Pacific (1997) also report that recent technological innovations have made small scale water and wastewater treatment operations increasingly feasible. (IPART 2007, p. 19)

DRAFT FINDING 12.1 Available evidence on economies of scale in the water and wastewater industry suggests:

• water supply and wastewater utilities are characterised by constant or increasing returns to scale (economies of scale) for a wide range of output levels

2 The VCEC pointed out that the Melbourne retailers supplied well in excess of this amount (~150 GL per annum) at that time.

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Economies of scope

Economies of scope exist if it is more economical to provide two or more related products together, than for each of them to be provided separately. Economies of scope may arise because there is significant sharing of inputs or facilities across multiple activities. The existence of economies of scope is often used to justify the production of upstream and downstream products in an integrated environment.

There are a number of ways that scope economies might arise in the urban water sector. Specifically, there is potential for economies of scope between two or more:

• water supply functions

• wastewater functions

• stormwater functions

• supply chains (for example, water supply and wastewater)

• functions of Local Government (for example, water supply and roads provision) — this issue is primarily relevant for regional water utilities, and is considered in chapter 13.

Little attention has been paid to assessing economies of scope efficiencies, particularly in Australia. The available literature does not lend itself to a definitive conclusion on scope economies between water supply and wastewater services. IPART notes: Evidence of economies of scope from the horizontal integration of water and wastewater services is mixed. While Hunt and Lynk (1995) found evidence of economies of scope, Stone and Webster (2004) found evidence of diseconomies of scope. On the other hand, Saal and Parker (2000) did not find evidence of economies of scope, but nor did they report finding evidence of diseconomies of scope. (IPART 2007, p. 23)

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Nauges and van den Berg (2008) find evidence of economies of scope between water supply and wastewater services in Brazil, Moldova and Romania, and conclude that for these countries it is more economical to deliver water and wastewater services simultaneously in these countries. Wagga Wagga City Council (sub. 54) considered that there are scope economies between water supply and sewerage services and recommended that integrating these services would create greater opportunities for Integrated Water Cycle Management.

ACIL Tasman and IPART both conclude that there are currently few, if any, economies of scope in combining water and wastewater functions. However, ACIL Tasman note: The trend towards wastewater being considered increasingly as a potential source of water supply (through indirect, and even direct, potable supply of recycled water) does flag the possibility of increasing scope economies in the future — that suggests some caution in seeking a separation based only on historical use patterns. However, joint ownership of the water and wastewater streams should not be essential to exploiting these growing synergies under institutional arrangements that embody sound procurement planning and, possibly, access arrangements. Care is needed — but not necessarily avoidance. (ACIL Tasman 2007b, p. xii)

Evidence for economies of scope between different water supply activities is somewhat stronger, providing some support for vertical integration of water supply functions. For example:

• Stone and Webster (2004) found some evidence of economies of scope from the vertical integration of water production and distribution functions in England and Wales, but diseconomies of scope from the vertical integration of wastewater collection and treatment/disposal functions.

• Torres and Morrison Paul (2006) cite efficiencies between retail and wholesale due to sharing of source water resources, pumps, treatment facilities and transmission lines, and consider that these efficiencies are particularly significant for smaller utilities.

• Hayes (1987) finds significant scope economies for joint production of retail and wholesale water services for small utilities, but these scope efficiencies decline with size.

• Garcia, Moreaux and Reynaud (2004) consider there to be potential gains from vertical integration due to transaction costs and market imperfections, but note that total economies of vertical integration dissipate at 2 300 to 2 400 ML per year, and suggest that strong diseconomies of vertical integration are present at 2 700 ML per year.

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In Australia, ACIL Tasman considered the extent of scope economies between retail and wholesale water supply, and determined that these are most significant for small utilities: It would appear that economies of scope are derived from economies of ‘shared common costs’. Within relatively small utilities, the cost difference between maintaining separate organisations and a single combined entity represents a significant portion of unit cost. By contrast, the large urban water and wastewater utilities have grown far beyond the point at which the cost difference is likely to impact significantly on unit cost. Indeed, it is more likely that other inefficiencies, such as increased bureaucracy, overwhelm any cost saving. (ACIL Tasman 2007b, p. 33)

However, ACIL Tasman also acknowledged that: The threshold output at which economies of vertical integration dissipate may be imprecise and specific to the economic and environmental circumstances in which the water suppliers are operating. (ACIL Tasman 2007b, p. 33)

The VCEC (2008, p. xxv) considered the case for separating the retail and distribution functions in Melbourne, but concluded that it was not efficient (at least not in the short term) due to uncertainty about the potential benefits and costs. Sydney Water Corporation commented on the merits of vertically separating the retail function from distribution services: We had a look at taking retail out — we try to run it as a least cost operation rather than one that’s making margins — but it is such a small part of our operations that we can’t see why the British think that taking retail out is going to make it more competitive. (trans., p. 112)

Frontier Economics considered the potential for scope economies between wastewater network services and wastewater treatment and discharge: The evidence supports the possibility that independent contractors could undertake the treatment and disposal of wastewater. Stone & Webster found that there were diseconomies of scope between the volume of raw sewage and the number of sewerage connections. This led them to suggest that there may be diseconomies of scope between the collection of waste water and its treatment/disposal … the implication of this finding would be that sewerage services could be more efficiently provided by separating the business functions of treatment & disposal and waste water collection. (Frontier Economics 2004, p. 29)

In summary, there is no consensus in the literature to determine whether there are material scope economies between water supply and wastewater services. Evidence in favour of vertical integration of water supply functions is stronger, but this tends to depend on the specific functions under consideration, and the location, size and circumstances of the utility. In this context, the observations made earlier regarding the limited generality of economies of scale studies apply equally to studies of

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economies of scope — to understand the true magnitude of scope efficiencies between two or more supply chains or supply chain elements, a location-specific (and utility-specific) assessment is required.

INFORMATION REQUEST

Can you provide the Commission with any further information or analyses on scale and scope economies in the urban water sector?

Transaction costs

Transaction costs are the costs of providing a good or service through the market rather than having it provided from within the business. Vertical separation may increase total transaction costs, as costs that were previously internalised are revealed: Outside the firm, price movements direct production, which is coordinated through a series of exchange transactions on the market. Within the firm, these market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur-co-ordinator, who directs production … the operation of a market costs something and by forming an organisation and allowing some authority to direct the resources, certain marketing costs are saved. (Coase 1937, p. 388 & 392)

Transaction costs comprise search and information costs, bargaining and decision costs and policing and enforcement costs — including costs associated with administering relevant legislative, regulatory and licensing requirements. IPART considered the impact on transaction costs as part of its review of Sydney Water: Vertical unbundling can involve significant transactions costs, and … there is insufficient information available to guarantee that the cost of such structural reform would be outweighed by the associated benefits at this point in time. (IPART 2005, p. 60)

Ballance and Taylor (2005), in response to a finding made by Stone and Webster that UK water utilities are too large, cautioned: While the findings from the study might indicate that a more efficient structure than the one observed at present is possible, the transaction costs associated with changing the current structure should not be ignored and one would want to be a lot more confident of the benefits. (Ballance and Taylor 2005, p. 61)

However, evidence from reform in other industries suggests that these costs may not be prohibitively high. For example, ACIL Tasman found that the transition and

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transaction costs of structural reform of the electricity industry turned out to be significantly less than first envisaged: Economies of vertical integration existed in the electricity industry as vertically integrated electricity commissions undertook new investment, operated both power stations and the transmission network and scheduled these assets to meet demand. However, it now appears that the transaction costs in separating out this function are not significant. In the case of the National Electricity Market (NEM), they appear to be lower by an order of magnitude than the wholesale price reductions experienced shortly after the NEM commenced. (ACIL Tasman 2007b, p. xiii)

Likewise, ACIL Tasman (2007b) suggests that no major transaction costs have been incurred since reform of the gas sector.

The full range of potential efficiency impacts of structural reform are extensive. For example, structural reform can lead to changes in the level of market information and transparency, can mean customers are located closer to (or further away from) the utility that serves them, or can exacerbate (or mitigate) skill shortages. These impacts are discussed in more detail as part of the assessment of individual structural reform options (sections 12.2 to 12.4, and chapter 13). The analysis contained in chapters 12 and 13 assumes that all of the universally applicable reforms set out in chapter 11 have been implemented, and that property rights to water, wastewater, stormwater and recycled water products have been clarified (chapter 6).

The remainder of this chapter considers the costs and benefits of breaking up the vertically-integrated entity (option 1, chapter 11), and pursuing alterative industry structures that foster greater competition for the provision of contestable water and wastewater services (sections 12.2 to 12.4). Section 12.5 considers the costs and benefits of taking reform even further, with a view to establishing decentralised, competitive markets for urban water services.

The Commission does not assume that there is a case for pursuing structural reform in one or all of Australia’s large urban cities. Nor does the Commission consider that the structural reform options presented here are necessarily the ‘right ones’ for individual water systems. Instead these options, and the associated discussion of their costs and benefits, should be regarded as a starting point for jurisdictions to assess the case for structural reform in Australia’s large urban cities.

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12.2 Reform option 2: Vertical and horizontal separation of the bulk water supply function

Reform option 2 seeks to exploit some of the competition related benefits of structural reform by:

• vertically separating the bulk water supply function from other elements of the supply chain

• horizontally disaggregating the bulk water function, such that individual supply sources are owned by separate, legal entities.

Motivation for reform

The primary motivation for implementing this option is to build on the benefits of option 1 by establishing competition for provision of bulk water services.

Under option 2, all available sources (and classes) of bulk water would compete on merit to fulfil existing and new demand (or security of supply requirements), in a least-cost manner. This is expected to support efficient investment in — and operation of — bulk water infrastructure (efficient bulk water resource allocation), and in turn, generate significant net benefits for the Australian urban water sector (chapter 6).

Option 2 will also promote greater innovation by bulk water service providers, including the development of innovative proposals for supply augmentation (or demand management). This will provide end users with greater choice, and facilitate discovery of lower-cost bulk water supply options, including recycled stormwater and wastewater products.

Divestment of the bulk water supply function from the monopoly entity provides for greater transparency in decision making, a stronger perception by service providers of competitive neutrality and greater private sector involvement (relative to option 1).

Institutions

Option 2 would require setting up a single, government-owned ‘retailer-distributor’3. The retailer-distributor would be responsible for:

3 The term retailer-distributor is used to describe the integrated monopoly utility in options 2, 3 and 4. However, the functions of this entity are not necessarily limited to retail and distribution

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• meeting relevant security of supply / obligation to serve requirements, and would need to procure adequate bulk water supply augmentation accordingly

• potable water supply network services – distribution – transmission

• non-potable water supply distribution services

• water and wastewater retailing services

• wastewater network services – distribution – transmission

• wastewater treatment and discharge services

• stormwater transmission and discharge services. Multiple, commercially-oriented bulk water service providers would operate under this option. These entities would provide one or more bulk water services, namely:

• bulk water supply (potable and non-potable): – harvesting and collection of bulk water (via dams, rivers, aquifers and so on) – production of bulk water (via desalination) – production of recycled water products (including recycled stormwater and wastewater for indirect potable reuse, or direct non-potable use)

• bulk water treatment

• bulk water storage

• bulk water transfer.

Stormwater collection would also be undertaken as a vertically separate service from the retailer-distributor. Specifically, individual local councils would be responsible for collecting stormwater4 in their municipality and transporting it to the stormwater transmission network for discharge to the environment. Alternatively, local councils may choose to harvest and treat stormwater for reuse, if there are commercial incentives to do so.

services only. Rather, this will vary between options, as described throughout the remainder of this chapter. 4 As set out in chapter 2, stormwater collection refers to all local drainage services.

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This arrangement is broadly consistent with how stormwater services are currently provided in most large urban cities. By way of example, stormwater in Melbourne is managed by local councils and Melbourne Water. Specifically, local councils are responsible for the stormwater distribution network, including gutters, local drains, road networks and street and property drainage. This network discharges stormwater into regional drains, rivers and creeks (the stormwater transmission network, managed by Melbourne Water), where it then flows to the bays (Melbourne Water 2011a).

There are significant economies of scope from retaining management and operation of the stormwater distribution network with local councils, as this network contributes to a range of other council functions. This is consistent with the view of the Queensland Water Commission (QWC): Stormwater services have significant relevance to other Council functions, particularly road construction and drainage. Some of the assets serve multiple functions (for example some floodways or waterways may serve as green space, parkland or sporting fields) … on balance it is the view of the Commission that stormwater drainage assets and responsibilities should remain with Councils. (QWC 2007, p. 32)

Arrangements for stormwater collection and distribution remain unchanged under each of the structural reform options presented in this chapter — in contrast, the arrangements for stormwater transmission and discharge will vary across options 2 to 5. As in option 1, an independent auditor would be responsible for monitoring and reporting on the performance of the retailer-distributor against its charter (this would be in addition to the benchmarking undertaken by the NWC and WSAA). The institutions involved in the provision of water and wastewater services under option 2 are identified in figure 12.2.

The role for government remains largely unchanged from option 1. The key differences are:

• The charter would impose an obligation on the retailer-distributor to procure sufficient bulk water services, and detail the procurement process that must be followed.

• The independent performance auditor would be tasked with undertaking an ex-post assessment of the procurement decisions taken by the retailer-distributor.

• State and Territory Governments would need to break up incumbent monopoly suppliers and establish new bulk water businesses. This will require dealing with existing property rights to these sources (for example, determining how the three Melbourne retailer-distributor’s entitlements to water should be managed), and clarifying property rights to wastewater and stormwater products (chapter 6).

STRUCTURAL 329 REFORM OPTIONS

Each of the options described in this chapter (and the undertaking of structural reform more generally), present a range of financial and accounting issues that will need to be resolved by relevant governments. This includes developing arrangements for valuing public assets, transferring this infrastructure to new entities, disposing of any surplus assets, assignment and funding of employee entitlements, managing any financial risks faced by governments as a result of the reform process, and so on.

The Commission recognises that these are important matters. However, similar issues have confronted — and been dealt with — by governments on a number of occasions as part of previous reform processes. The Commission does not consider that management of these issues in the urban water context will impose significant costs or complexities on affected governments.

Figure 12.2 Structural arrangements under option 2a, b

BWS 1 BWS 2 BWS 3 BWS 4 Aquifer R-U trade Desal Dam

Retailer-distributor

(undertakes wastewater treatment and discharge services) Use recycled

Customers stormwater Independent for indirect potable reuse performance auditor performance

Transfer collected Use recycled stormwater to stormwater for retailer-distributor direct, non-potable for discharge reuse SW 1 SW 2 SW 3 Discharge to environment Use for internal council purposes a The three figures presented in this chapter (figures 12.2 to 12.4) set out some of the key features of the structural reforms options described in sections 12.2 to 12.4 respectively. These diagrams are not intended to capture the full range of transactions that would occur amongst market participants under each option, and should be viewed as highly simplified illustrations of how each option might operate. The arrows reflect the flow of services between industry participants. b BWS = Bulk water service provider; SW = Stormwater distribution service provider.

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Retailer-distributor

Under option 2, the retailer-distributor remains responsible for the provision of water supply and wastewater services to domestic households and commercial customers, so as to satisfy demand and meet relevant security of supply requirements. However, the retailer-distributor has no ownership interest in bulk water assets under option 2, and cannot provide bulk water services internally. Instead, the retailer-distributor will purchase required services from external parties via long-term, bilateral contracts.

Procuring services in this way will require the retailer-distributor to take a position — in advance — on the type and volume of bulk water services it is likely to require. Depending on how demand out-turns relative to these expectations, the retailer-distributor may end up holding excess supply, or facing a supply shortfall. The retailer-distributor will be required to manage imbalances internally, for example, by purchasing storage services in times of surplus supply, or by entering into agreements with service providers that provide scope to vary contracted volumes in the short term (for example, take or pay provisions). These strategies may also be used by the retailer-distributor to hedge against expected future price fluctuations. In the event large industrial users are able to operate independently of the retailer-distributor, this would provide the retailer-distributor with an additional alternative option for managing risk, uncertainty and demand and supply imbalances.

The retailer-distributor would retain ownership of wastewater treatment plants and all network infrastructure (with the exception of the stormwater distribution network). Accordingly, the retailer-distributor would be able to provide the following services internally (although the retailer-distributor could elect to contract out any or all of these services):

• potable water supply network services (transmission and distribution)

• non-potable water supply distribution services

• wastewater network services (transmission and distribution)

• wastewater treatment and discharge services

• stormwater transmission and discharge services.

The institutional arrangements imposed via the charter will compel the retailer-distributor to operate these assets at least cost. This will require the utility to assess the competitiveness of alternative offers from bulk water service providers on the basis of cost, reliability, risk-sharing arrangements and so on (criteria to be set out in charter). The retailer-distributor will need to consider where on the network

STRUCTURAL 331 REFORM OPTIONS

bulk water will be injected by service providers, as this will determine the quantum of transportation and pumping costs imposed on the retailer-distributor. It is via these arrangements, and the consequent decisions taken by the retailer-distributor, that this option is expected to support efficient resource allocation.

Network augmentation (and investment in wastewater treatment assets) will be the responsibility of the retailer-distributor. Revenue earned by the utility (as determined by the pricing principles set out in the charter) will allow for sufficient revenue to undertake efficient levels of investment and maintenance in these assets.

Bulk water service providers

Following structural separation, the bulk water supply sector will consist of multiple (horizontally separate) bulk water service providers that own and operate bulk water assets on a commercial basis. These service providers would compete on merit to provide bulk water services to the retailer-distributor, using bulk water of different classes and from various sources. This supports efficient (least-cost) investment in, and use of, bulk water resources.

A number of these bulk water service providers will have been established as part of the structural reform process to assume ownership of existing bulk water assets. Existing assets could be divested into new companies based on type, for example, dam assets might be transferred to a new, independent ‘dam company’ (or multiple dam companies if necessary). Other existing assets (such as aquifers, desalination plants and so on) would similarly be transferred to separate new bulk water companies. These businesses would contract with the retailer-distributor to provide bulk water services. It is likely that these ‘incumbent’ bulk water providers would be publicly-owned, at least initially.

Importantly, this option encourages private bulk water service providers to enter the market for service provision. Investors in bulk water assets may secure a sales agreement with the retailer-distributor ahead of building new infrastructure, such that the retailer-distributor serves as the foundation customer (and possibly the only customer) for a new supply source. Alternatively, investors may offer bulk water services without any pre-commitment from the retailer-distributor (this might apply in cases where the investment requirement is not significant).

Both incumbent and new bulk water providers would own all infrastructure related to their respective supply sources and would be responsible for all maintenance associated with these assets. Bulk water providers can seek out cost efficiencies by undertaking tasks on a joint basis to realise economies of scale efficiencies, or via competitive outsourcing — for example, an incumbent bulk water company may

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provide storage services or treatment services on behalf of a new entrant bulk water provider. In the event a bulk water provider plans to build new capacity that is not in ready proximity to the shared network, or is to be injected into the network at a congested point, the retailer-distributor and bulk water provider would be free to negotiate, as part of their contract, to share the cost of necessary network augmentation (if both parties stand to benefit from the investment).

In some cases, the retailer-distributor may already hold entitlements to water in existing bulk water supply sources. Options for integrating these arrangements include:

• Allocating water entitlements to the retailer-distributor, but transferring ownership of the underlying asset infrastructure to the relevant incumbent bulk water provider. – In the case of dam water for example, the retailer-distributor would pay the dam company for provision of services associated with managing the dam asset (for example catchment management fees or water treatment fees), but would not pay any amount for the actual water.

• The water entitlements could be vested with the incumbent dam company. The retailer-distributor would then have to contract with the dam company for that water, just as it does for any other bulk water source.

The preferred approach to dealing with existing water entitlements may depend on perception it creates for new entrants about the degree of contestability in bulk water service provision. Specifically, divesting the retailer-distributor of all financial interest in existing bulk water sources (both commodity and infrastructure) might imply more robust and genuine competition.

Stormwater distribution services

Relevant Local Government councils would be responsible for stormwater collection and distribution services under option 2. Councils would either transport collected stormwater to the transmission network for discharge to the environment, or treat stormwater for reuse. In some cases, local councils might directly discharge stormwater into the environment. Recycled stormwater might be used by councils:

• for other council purposes (thereby reducing the total volume of water purchased from the retailer-distributor)

• to supply the retailer-distributor or large users with potable or non-potable water supply (via contract).

STRUCTURAL 333 REFORM OPTIONS

Private parties would be able to negotiate with local councils to undertake stormwater collection services independently of councils. For example, local businesses and residents might wish to collect stormwater and produce recycled stormwater products for on-site use, and/or for sale to the retailer-distributor. In this context, stormwater service providers (local councils or private providers) can compete with bulk water service providers to fulfil the potable and non-potable water supply requirements of the retailer-distributor, imposing a further source of competition among bulk water service providers.

The Moonee Valley Racing Club stormwater project provides an example of local businesses undertaking on-site stormwater harvesting (box 12.5).

Box 12.5 Stormwater harvesting by Moonee Valley Racing Club In 1993, the Moonee Valley Racing Club (MVRC) implemented a stormwater harvesting scheme that collects stormwater runoff from rooftops, hard surfaces and surrounding streets and uses the recycled stormwater for irrigating the racecourse. In 2009, MVRC sought to further reduce its use of drinking water for irrigation. This involved:

• installation of a gross pollution trap to trap rubbish and sediment and thereby minimise the flows that are used for flushing out pollutants

• increase dam capacity (storage) to 23.5 million litres to allow for greater capture of large rainfall events. The scheme is reported to already be delivering significant benefits: The original annual water saving target of 42.7 million litres has already been exceeded and, along with other initiatives at the racecourse, the project is on track to save 60 million litres in the first year, amounting to a 70 per cent reduction in water consumption. (City West Water 2011, p. 2)

Source: City West Water (2011).

Assessment of option 2

Option 2 is expected to have both competition and non-competition related efficiency consequences.

Competition related impacts

The primary rationale for pursuing vertical and horizontal separation of the bulk water supply function is to introduce competition for the provision of bulk water services.

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Efficient resource allocation

By making bulk water service providers compete on their merits to satisfy existing and new demand for bulk water, the true cost-competitiveness of alternative bulk water supply sources will be made explicit. This will ensure the most efficient (least expected cost) combination of bulk water supply sources (including bulk water of different qualities) is drawn upon (efficient bulk water resource allocation).

This contrasts with current arrangements, where decisions around the type and level of investment in (and operation of) bulk water assets are generally prescribed by government, which is unlikely to result in efficient investment and dispatch decisions (as evidenced by the Commissions’ modelling). Achieving more efficient bulk water resource allocation is expected to deliver significant efficiency gains for the urban water sector, and is the most substantial anticipated benefit of option 2.

As set out in chapter 11, external service providers can offer to provide bulk water services to the integrated utility under option 1 (for example, via contracting). However, the anticipated benefits of this arrangement are not expected to be as large as the efficiency gains that will be realised under option 2 — this is because of the incentives option 2 creates for new market entry relative to option 1.

Specifically, option 2 promotes greater transparency in decision making by the retailer-distributor, and a stronger perception of competitive neutrality. By consequence, prospective investors can be more confident that procurement of bulk water services by the retailer-distributor is undertaken without bias, and that governments cannot, or will not, interfere in procurement decisions. As the number of new entrants increases, contestability amongst service providers will strengthen, with direct benefits for the cost and quality of services.

Establishing competition amongst service providers is an important — but not sufficient — condition to ensure that relevant services are provided optimally (that is, efficient resource allocation is achieved). This requires that the retailer-distributor prudently consider the full range of investment options offered by competing service providers (that is, adopts a real options approach).

This is a further advantage of option 2. Under option 1, there is a risk that the retailer-distributor will overlook or discount efficient investment options offered by external parties because it regards the cost and risk of dealing with third parties as too high. That is, the vertically-integrated entity may have an inherent tendency (real or perceived) to regard internal options as least cost, regardless of the true economics of competing alternatives. In some cases, the utility may simply be unaware of other, more competitive options. Option 2 — by forcing the retailer-distributor to deal with competing service providers — directly addresses

STRUCTURAL 335 REFORM OPTIONS

this issue, and increases the likelihood of the retailer-distributor taking least-cost, efficient investment decisions. (The retailer-distributor may have some capacity to source bulk water services internally if it chooses to produce recycled wastewater products. This is considered further in option 3.)

Finally, option 2 presents an opportunity to benchmark the efficiency and performance of individual bulk water suppliers (and managers), and to use this information to drive out further productive and dynamic efficiency gains. This was recognised by the QWC as a potential benefit of having multiple bulk water suppliers in place of a single entity: While the level of competition at the bulk supply point will initially be minimal, there will be scope for comparative competition between the two bulk suppliers. (QWC 2007, p. 36)

However, the recent decision to integrate the two south-east Queensland supply businesses removes any opportunity for yardstick competition at the bulk water level — at least in the near term.

Innovation

The precise efficiency gains that result from forcing the retailer-distributor to take a real options approach to bulk water supply provision will critically depend on the range and diversity of services offered to the retailer-distributor.

As set out above, there are good reasons to expect that option 2 will encourage new market entry. In addition, option 2 provides strong commercial incentives for service providers to innovate in order to gain a competitive advantage over their rivals. Innovation and the entry of new service providers to the market will ensure the retailer-distributor encounters greater choice in terms of the type, price and quality of bulk water services it can purchase (including more innovative supply augmentation options), further contributing toward achievement of efficient resource allocation.

Incentives for innovation may also extend beyond water supply services. In particular, option 2 may encourage service providers to produce innovative ‘joint products’: Sydney Water also has hydroelectric plants progressively coming online. These plants generate renewable energy from water passing through pipes. Together, hydroelectric and co-generation plants generate about 20 per cent of Sydney Water’s energy. (Sydney Water Corporation, sub. 21, p. 10)

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In sum, option 2 is expected to focus bulk water service providers on the full range of commercial opportunities available to them. However, to harness the full benefits of innovation it is critical that property rights to water (potable and non-potable), wastewater and stormwater products are clarified, and that inefficient (public health and environmental) regulatory barriers to innovation are removed (chapters 5, 6 and 11). Without significant progress on these fronts, innovation will be constrained.

Innovation by service providers may also strengthen post-reform if creating specialised bulk water companies allows for more focus on the operation and management of specific bulk water assets relative to option 1 (a form of economies of scope), or if company managers are more driven to pursue innovation out of managerial pride.

Price signals start to emerge

Option 2 drives competition for bulk water services, but falls shorts of fostering competitive, decentralised markets. Notwithstanding this, the contracts between the retailer-distributor and service providers will provide some insights about underlying market prices, and will more clearly expose the true economics and cost-competitiveness of individual bulk water supply sources. As described earlier in this section, this is a critical requirement for achievement of efficient resource allocation.

Vertical separation of the bulk water function also limits the capacity for the monopoly entity to strategically shift costs between supply chain elements. This will help ensure the true costs of water services are transparent, which in turn promotes more cost-reflective and efficient pricing of water services.

Non-competition related impacts

Scope efficiencies

Opponents of vertical disaggregation often refer to the economies of scope losses between supply chain elements. For example, if bulk water supply and water retailing share common resources (for example, office facilities, payroll systems, or corporate staff), vertical separation will force duplication of these resources, and lead to an increase in total costs for the sector, all else equal. In this instance, the relevant concern is whether separation of the bulk water function from other elements of the supply chain is likely to impose significant scope losses.

STRUCTURAL 337 REFORM OPTIONS

Few parties responding to the inquiry commented specifically on this issue — perhaps in part due to the fact many large urban cities have already undertaken some degree of vertical separation. The Water Corporation expressed broad support for retaining a vertically integrated structure in Western Australia: The other benefit of an integrated utility is that the one organisation is making decisions that bring in the whole water cycle … People talk about information asymmetries; information asymmetries exist because some organisations generate the information and others try and get the information. If you can have the decision making done efficiently within the (one) organisation with all the information, I think that is going to lead to a better outcome. (trans., p. 318)

The Commission anticipates that option 2 could reduce any scope efficiencies that exist between network operation and management of bulk water supply assets. Specifically, the retailer-distributor’s short-term network operating decisions are constrained by the (long-term) bulk water service contracts it has entered into. In contrast, the integrated utility (option 1) is responsible for dispatch and transmission of bulk water (that is, managing both the commodity and the capacity), affording the utility considerable freedom to adjust supply volumes in the short term in response to changes in demand and supply in certain parts of the network.

This suggests that the integrated utility may be more effective at minimising network operating costs (for example, by adjusting incoming flows to avoid network congestion, or to minimise pumping costs) compared to the retailer-distributor (option 2). This constitutes a potential economies of scope loss associated with option 2.

On balance, the Commission does not regard this as an insurmountable issue. The retailer-distributor may elect to manage this commercial risk by negotiating more sophisticated (and flexible) contracts with service providers, as is common practice in the gas industry. However, this does represent an additional transaction cost of option 2, as discussed in the following section.

In contrast, there may be scope efficiencies from vertical separation if, for example, creating specialised business units focused on separate stages of the supply chain leads to productive efficiencies in service provision. It is reasonable to assume that this motivated, at least in part, the decision to vertically separate the bulk water function in Sydney, Melbourne and south-east Queensland.

As set out in section 12.1, the available literature does not provide strong evidence one way or the other regarding the materiality of scope economies between water supply functions for large vertically-integrated utilities. In practice, the extent to which vertical separation leads to economies of scope gains or losses will ultimately depend on the specific characteristics of the water system.

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Scale efficiencies

Option 2 may also give rise to scale impacts. Incumbent bulk water supply sources will be owned and operated by separate entities following reform, and this may lead to some duplication of costs at the bulk water level.

It is difficult to estimate these scale impacts with any accuracy, given the lack of available literature on scale efficiencies in specific elements of the supply chain. However, the issue of scale economies at the bulk water supply level was considered by the QWC as part of the water reform process in south-east Queensland. The Commission determined that there was benefit in having multiple entities rather than a single bulk water provider (it was ultimately determined that two bulk water supply businesses be established in south-east Queensland — WaterSecure and SeqWater): Based on submissions received … and subsequent discussion with various stakeholders, there is wide support for the formation of three or four bulk supply entities … it is proposed that the Western Corridor Recycled Water Scheme together with the Desalination Plant be constituted as a stand alone Manufactured Water entity (and) … that two bulk water supply businesses be established, comprising south-east Queensland significant dams and aquifers (QWC 2007, p. 28).

It should also be recognised that option 2 does not preclude separate entities from undertaking tasks on a joint or cooperative basis, where there are scale efficiencies from doing so. For example, in Tasmania a number of services are undertaken by a ‘common service provider’ on behalf of the three water and sewerage corporations, to preserve economies of scale efficiencies.

On balance, there is no compelling evidence to indicate that structural reform akin to option 2 would impose significant scale or scope losses, were it to be implemented in large urban cities. Indeed, considerable vertical separation (and some horizontal separation at the bulk water supply level) has already been undertaken in Sydney, Melbourne and south-east Queensland, suggesting there are net efficiency gains available from such reform.

In addition, the success of private parties in providing stand-alone bulk water services suggests there are commercial benefits on offer from these activities, despite any scale or scope losses associated with providing these services in a disaggregated environment. For example, in the case of Sydney Water Corporation (sub. 21) water treatment services are provided by the private sector under build-own-operate arrangements.

Even where there are scale or scope losses from reform, these should not be viewed in isolation of the potential efficiency benefits that vertical separation will deliver.

STRUCTURAL 339 REFORM OPTIONS

Ruff and Swier considered that scale and scope impacts of structural reform should not distract policy makers from the pursuit of broader competition objectives: Critics of such unbundling, including the vertically integrated monopoly, have argued (and still do) that such unbundling reduces the economies of scale, scope and coordination that justified vertical integration in the first place … such monopoly economies are often historical and static, while the main purpose of introducing competition is to get the forward-looking and dynamic efficiencies that come with innovation and better investment decisions. Any competitive reform involves costs, benefits and risks; it should be undertaken only if the benefits are likely to outweigh the costs, and with a well-considered (preferably phased and adaptive) implementation strategy to minimise the risks. (sub. 47, p. 15)

Indeed, the broader competition related efficiency benefits of structural reform appear to have contributed to the VCEC’s decision to retain the separation of the retail-distribution function in metropolitan Melbourne, despite the cost savings on offer: The information available to [VCEC] suggested that there would be operating and capital cost savings of between $19 million and $25 million per year from merging three retailers into one. Most of these savings would be in operating costs, rather than in capital expenditure. (VCEC 2008, p. xxiii)

The VCEC concluded that there would be a range of costs and risks associated with reintegration that would serve to outweigh these benefits, including ‘the potential loss of dynamic efficiencies through, for example, less flexible decision making, or slower uptake of cost-reducing innovations’. The costs and benefits of horizontal separation at the retail-distribution level are discussed in more detail in section 12.3.

In contrast, in late 2010 the Queensland Government determined that it would be cost effective to reintegrate the two bulk water supply businesses in south-east Queensland (Seqwater and WaterSecure) into a single supply authority from 1 July 2011 (Fraser and Robertson, 2010). The Government estimated that the merger would give rise to cost savings in the range of $18 million per year. The rationale for reintegration in this instance was driven entirely by these costs savings, as the desalination plant (owned by WaterSecure) is scheduled to go into standby mode in 2011, thus removing any scope for achieving competition related efficiency benefits in bulk water supply.

Following the Queensland floods in January 2011, the desalination plant was used to produce drinking water for Brisbane, Ipswich, Gold Coast and Logan, and played a critical role in securing the drinking water supply over this period. However, the Commission understands that the plan to temporarily shut down the desalination plant in 2011 remains in place.

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Transaction costs

A vertically-integrated water business is able to internalise a range of transaction costs that will be revealed via structural separation. These transaction costs include:

• the retailer-distributor negotiating contracts with bulk water service providers – includes the costs of drawing up and monitoring contracts that specify the economic and legal obligations of transacting parties

• measures taken by the retailer-distributor to cost-effectively manage risk and uncertainty, including changes in supply and demand (and prices) – includes the premiums paid for flexible supply contracts, the costs of addressing short-term supply and demand imbalances, and additional network operating costs (a consequence of having less flexibility to operate the network relative to option 1). These costs will be lower if there is scope for trade with large users, and if the retailer-distributor is well informed (for example, about changes in supply and demand conditions, and future price fluctuations)

• administering relevant legal, legislative and regulatory requirements – these costs may increase under option 2 due to the larger number of participants involved in the provision of services

• an expanded role for the independent performance auditor – the auditor must review and assess the efficiency of contracts entered into between the retailer-distributor and service providers

• coordination of urban water sector participants on industrywide issues.

It is difficult to estimate the precise magnitude of transaction costs that might arise as a consequence of option 2. However, the Commission is not aware of any evidence that suggests the Melbourne, Sydney or south-east Queensland water sectors are confronting significantly higher transaction costs as a consequence of structural reform. In addition, in many cases businesses are already incurring many of the transaction costs that would be revealed under option 2, for example, most water utilities outsource a number of services to external parties via contractual arrangements.

Skilled labour

A number of participants considered that structural separation within the urban water sector might lead to a net increase in demand for skilled labour, for example, asset managers, engineers and chemists. In turn, this could put upward pressure on

STRUCTURAL 341 REFORM OPTIONS

the costs of hiring and retaining skilled staff, potentially offsetting some of the efficiency gains of structural reform. If — at the extreme — individual bulk water service providers are unable to secure adequate numbers of skilled personnel to operate assets and deliver services efficiently, there may be adverse impacts on asset maintenance, public health outcomes and customer service under option 2.

The Commission considers that this scenario is unlikely to materialise in large urban cities where labour supply is strong. The undertaking of structural reform might in fact attract new employees to the water and wastewater industry (relative to option 1), thereby easing skill shortages. As the number of utility businesses increases, prospective employees may view the employment, progression and career development opportunities in that industry more favourably, and subsequently move into the water sector. By contrast, where a single, vertically-integrated utility dominates the industry, employees have little scope to change employers or move roles (except internally) — prospective employees may view opportunities for career advancement as too limited, and be deterred from entering the water industry.

In any case, option 2 does not preclude service providers from contracting out services to private contractors that they are unable to provide internally (and/or efficiently) due to inadequate resources. Many bulk water providers are already doing this. If vertical separation were to increase pressure on demand for skilled labour within the sector, this issue is not expected to be insurmountable.

However, the issue of skill shortages in the water and wastewater industry might be more problematic for regional water utilities, as labour supply is less plentiful in these regions, and opportunities to outsource operational tasks or capital works in a cost-competitive manner might be more limited. This is discussed in more detail as part of assessing the case for structural reform in regional areas (chapter 13).

Finally, there will be direct, start-up costs associated with breaking up the vertically-integrated entity and establishing new water utility businesses. It is difficult, at this point, to speculate on the precise costs involved with disaggregation, and in practice this will vary across locations and utilities. However, it is reasonable to expect that non-trivial costs will be incurred each time a new entity is established. These ‘transition’ costs of structural reform are relevant for each of the options considered in chapter 12 (and for the regional reform options canvassed in chapter 13), and should be considered as part of the assessment of each option.

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Conclusion

Vertical separation of the bulk water supply function, coupled with greater contestability within this function (via horizontal separation), is expected to generate significant productive, dynamic and allocative efficiencies, and drive greater innovation in service provision. These benefits are expected to be particularly large where:

• new bulk water supply sources are required

• the scope for new entrant (private) service providers is strong

• barriers to product and service innovation (for example, recycled water products, or multiple service offerings) are low – this requires that property rights to water, wastewater and stormwater products are well established, and for inefficient (public health and environmental) regulatory barriers to be removed

• large users are able to participate directly in the market (retailer-distributor has greater flexibility for managing imbalances)

• it is feasible to efficiently separate incumbent bulk water assets and establish new businesses (the costs of undoing existing arrangements are not prohibitively high)

• there is a high risk (or at least strong perception) of government interference under the vertically integrated approach (option 1)

• there is growing customer demand for alternative products and services (including recycled water products, non-potable water and so on). Notwithstanding the potential benefits of option 2, the precise impacts of vertical and horizontal separation of the bulk water supply function are expected to be location (and utility) specific, making general statements on the case for structural reform impractical. It would be prudent to consider the precise costs and benefits of option 2 on a case-by-case basis.

12.3 Reform option 3: Vertical and horizontal separation of the wastewater treatment function

Option 3 extends option 2 by establishing competition for wastewater treatment and discharge services. This presents an opportunity for achieving further competition related efficiency gains relative to option 2, but will involve additional transaction costs and scale and scope impacts.

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Motivation for reform

The wastewater treatment and discharge function would be vertically separated from the monopoly retailer-distributor under option 3, and wastewater treatment services would be purchased via bilateral contracts with service providers. Existing wastewater treatment assets would be horizontally disaggregated and individual treatment plants would thereafter be owned by separate, independent legal entities. Investors would be able to build new facilities and compete with incumbent wastewater treatment service providers to fulfil the requirements of the retailer-distributor. Outside of the wastewater treatment and discharge function, option 3 retains the same arrangements as option 2.

The principal potential benefits of option 3 (relative to option 2) are:

• efficient investment in — and use of — wastewater treatment assets – introducing competition at this level of the supply chain will ensure the least (expected) cost combination of wastewater treatment services are engaged by the retailer-distributor to fulfil service requirements (existing and new)

• innovation in wastewater treatment processes, giving rise to lower-cost (and/or higher quality) service options – as service providers seek to gain a commercial advantage over one another, there will be sharper incentives for innovation and the discovery of alternative approaches to wastewater management and discharge – in particular, option 3 is expected to focus service providers on the commercial opportunities available via recycling and reuse of wastewater products

• greater competition for bulk water supply services – to the extent that recycled wastewater products serve as an alterative source of potable and non-potable water for the retailer-distributor, option 3 will support greater competition amongst bulk water service providers, with corresponding efficiency gains.

Institutions

Option 3 is largely characterised by the same institutional arrangements as option 2. However, the retailer-distributor no longer provides wastewater treatment services internally, and must procure these services from wastewater treatment service providers. Wastewater network services (transmission and distribution) would continue to be provided by the integrated utility. The institutional arrangements that define option 3 are depicted in figure 12.3.

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Figure 12.3 Structural arrangements under option 3a

BWS 1 BWS 2 BWS 3 BWS 4 Dam R-U trade Desal Aquifer

Use recycled Retailer-distributor stormwater for indirect Use recycled potable reuse wastewater

Customers for indirect

potable reuse Independent Use recycled Transfer collected stormwater or auditor performance stormwater to wastewater for Undertake retailer-distributor direct, non-potable wastewater for discharge reuse treatment

SW 1 SW 2 WWT 1 WWT 2 Discharge to environment

Discharge to Use for internal environment council purposes a BWS = Bulk water service provider; SW = Stormwater distribution service provider; WWT = Wastewater treatment service provider.

Wastewater treatment service providers

The market for wastewater treatment and discharge services would function in much the same way as the market for bulk water services (option 2). Wastewater treatment service providers would compete on merit to satisfy the service requirements of the monopoly entity. The retailer-distributor would assess these alternatives and select the most efficient (least expected cost) combination of water treatment and discharge services to meet demand, whilst meeting all relevant environmental standards.

Contracted service providers would receive wastewater from the wastewater network (managed by the retailer-distributor), undertake treatment of wastewater (to varying standards) and would be responsible for the discharge of treated wastewater to the environment. In the event a treatment facility is not connected to the established wastewater network, the service provider would also be responsible for transporting wastewater from the wastewater transmission network to a treatment facility (wastewater transfer).

STRUCTURAL 345 REFORM OPTIONS

As an alternative to discharge, service providers can elect to treat wastewater further and produce recycled wastewater products (where there is a commercial incentive to do so). Recycled wastewater could potentially be used on-site by the wastewater treatment service provider, sold to the retailer-distributor (as a source of potable or non-potable water supply) or sold to other large users (if relevant). In this context, there is potential for these service providers to take on the dual role of wastewater treatment service provider and bulk water service provider

Assessment of option 3

This section describes the additional efficiency impacts of option 3 relative to option 2.

Competition related impacts

Efficient resource allocation is not limited to bulk water supply sources. Option 3 provides similar incentives for efficient investment in — and operation of — wastewater treatment facilities. As the retailer-distributor can no longer provide for these services internally, it will engage the services of external wastewater treatment companies on a commercial basis via bilateral contracts. This provides clear incentives for competition between incumbent and new wastewater treatment service providers.

Vertical separation of the wastewater treatment and discharge function from the monopoly entity is important in encouraging new entrants into the market. Prospective investors will have greater confidence that wastewater treatment services are procured transparently and without bias. In turn, this will encourage greater private sector involvement in wastewater treatment activities, with corresponding efficiency benefits.

Innovation by wastewater treatment service providers will be an important benefit of option 3, as companies seek to gain a commercial advantage over one another. This will give rise to new, lower-cost and better quality approaches to water treatment and discharge, with direct benefits for consumers of these services. Incentives to capitalise on the commercial value of wastewater products will also be explicit under this option, providing a strong impetus for wastewater treatment service providers to explore further opportunities for wastewater recycling and reuse.

As with option 2, service providers might see value in undertaking innovation that extends beyond water and wastewater service provision directly, via the production

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of joint products. For example, a wastewater treatment service provider may choose to use the sludge or bio-solids from wastewater to produce fertiliser: Bio-refinery is emerging as a key sustainable source of energy. Sydney Water has been quick to adopt this tool to harness energy from its processes and reduce reliance on fossil fuels. (Sydney Water Corporation sub. 21, p. 10)

Production of innovative joint products is expected to expand in future years, as governments and businesses seek out ways to reduce their reliance on natural resources. For example, in New York City, the Department of Environmental Protection is looking to extract heating fuel from sewage sludge and butanol from the algae generated by wastewater. Methane produced from sewage treatment plants might also be used to provide power to homes (Australian Financial Review, 11 February 2011, p. 64).

Finally, option 3 is expected to further strengthen competition in the market for bulk water services. As the range, price and quality of recycled wastewater products on offer continues to improve (in response to introducing contestability in the wastewater treatment market), this will have direct benefits for the degree of competition amongst bulk water service providers (for potable and non-potable water services).

Importantly, option 3 ensures that the retailer-distributor has no ownership interest in any type of bulk water supply. In contrast, under option 2 the wastewater treatment function remains integrated with the retailer-distributor, such that the retailer-distributor is potentially both a consumer and producer of bulk water services (to the extent that it elects to produce recycled wastewater products). There is some risk that this integration of functions will reduce contestability (real and/or perceived) in the bulk water market, and potentially jeopardise some of the expected efficiency benefits of option 2.

For example, prospective investors might expect that the retailer-distributor will regard its own recycled wastewater products as the preferred source of bulk water supply (potable and/or non-potable), regardless of the true cost-competitiveness of alternative options. In this sense, option 3 preserves true separation of the upstream and downstream functions, which might serve to encourage greater new entry by bulk water investors relative to option 2.

Non-competition related impacts

Option 3 will be associated with an increase in total transaction costs (all else equal), as retailer-distributors must now contract for an additional service in place of undertaking this internally. This arrangement will also mean the independent

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performance auditor’s role will increase, as it must monitor and assess the wastewater treatment contracts entered into by the retailer-distributor.

As for option 2, there will be scope and scale impacts from structural separation. The scope impacts are not expected to be significant — while there may be some operational synergies between wastewater treatment and wastewater network management, the loss of such economies under option 3 is unlikely to be a primary concern. Indeed, a number of private, stand-alone wastewater treatment plants already operate in different regions of Australia, suggesting any economies of scope losses have been outweighed by other efficiency gains.

Scale impacts may be a more critical consideration for this reform option. Horizontal separation of wastewater treatment assets might lead to a loss of economies of scale, all else equal. Likewise, there might be implications for any skilled labour shortages if disaggregation leads to an increase in demand for wastewater treatment plant staff. These issues should be considered on a case-by-case basis, and weighed against the potential competition related efficiency benefits of reform option 3.

Conclusion

Vertical separation of the wastewater treatment and discharge function, coupled with greater contestability within this function (via horizontal separation), is expected to generate efficiency benefits and drive greater innovation by service providers, particularly with respect to recycled wastewater products. This will have flow on benefits for competition in the bulk water services market. However, the benefits of establishing competition in this element of the supply chain are not expected to rival those associated with competition for bulk water services (option 2). The merits of proceeding with the type of structural reform will depend on the balance of associated costs and benefits, including the impacts on scale and scope economies.

12.4 Reform option 4: Horizontal separation of retail-distribution

Option 4 is characterised by the same arrangements for the supply of bulk water services, wastewater treatment services and stormwater collection services as option 3. However, option 4 involves horizontal separation of the monopoly retailer-distributor to create multiple geographic monopolies. This sort of reform has already taken place in Melbourne and south-east Queensland.

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Motivation for reform

Option 4 is intended to:

• further strengthen contestability and innovation amongst service providers, relative to options 2 and 3

• introduce yardstick competition at the retail-distribution level, so as to impose an incentive on utilities to seek out cost efficiencies, improve service quality and innovate (with respect to tariffs, and the quality, security and source of water provided to end users).

Multiple ‘purchasers’ of bulk water, wastewater and stormwater services also presents an opportunity for trade in these services, leading to greater allocative efficiency. By restricting the geographic region serviced by individual utilities, option 4 might also allow utilities to better accommodate the preferences and requirements of each region, and implement more location-specific pricing arrangements.

Institutions

Each of the government-owned retailer-distributors would retain responsibility for:

• potable water distribution services

• non-potable water distribution services

• water and wastewater retailing services

• wastewater distribution services. A distinguishing feature of option 4 (figure 12.4) would be the establishment of a single, network transmission entity (or water grid manager) that would provide all transmission (shared) network services:

• potable water transmission services

• wastewater transmission services

• stormwater transmission services.

Other supply chain elements would be organised as per option 3.

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Figure 12.4 Structural arrangements under option 4a

Network Transmission Entity

BWS 1 BWS 2 BWS 3 BWS 4 Dam R-U trade Desal Aquifer

Discharge collected stormwater via stormwater Use recycled transmission wastewater for network indirect potable reuse RD RD RD

Independent

Use recycled Use recycled

stormwater wastewater and Wastewater performance auditor for indirect stormwater for treatment potable reuse direct non-potable reuse

SW 1 SW 2 WWT 1 WWT 2 Discharge to environment Discharge to environment Customers a BWS = Bulk water service provider; SW = Stormwater distribution service provider; WWT = Wastewater treatment service provider; RD = Retailer-distributor.

Option 4 assumes that appropriate institutional and governance arrangements are in place for the network transmission entity. This implies additional costs for government, for example the cost of regulating this entity to prevent the abuse of market power, or alternatively, the cost of developing an adequate charter — and accompanying monitoring arrangements — to ensure network services are provided (and priced) efficiently.

The independent performance auditor’s role will necessarily expand under option 4 as it will be required to monitor the performance of multiple utilities (in place of a single utility), benchmark performance to foster yardstick competition between the retailer-distributors, and monitor the network transmission entity.

The retailer-distributors

Each retailer-distributor would be independently responsible for securing sufficient services to meet customer demand and a security of supply requirement (so each retailer-distributor has an obligation to serve customers in their geographic region).

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Accordingly, the retailer-distributors must enter into a series of bilateral contracts with relevant service providers for bulk water services, wastewater treatment and discharge services and network transmission services.

The retailer-distributors could elect to act cooperatively, or form a consortium, if they consider this to be a cost effective way to manage risk and uncertainty, or minimise costs.

As in options 1, 2 and 3, the retailer-distributors would be required to procure all required services in an efficient, least-cost manner, and would be subject to review by the independent performance auditor. In addition, option 4 supports the development of comparative or yardstick competition between the retailer-distributors. Specifically, the independent auditor would compare, assess and benchmark the performance of the retailer-distributors — to the extent that this is relevant. The utilities would be compared on a range of metrics related to cost-effective and efficient service delivery, quality of service provision and social and environmental outcomes. This option does not entail full retail competition and customers would be unable to choose their preferred retailer-distributor. Instead, this would be determined on a geographic basis similar to that currently in place in Melbourne.

Option 4 opens up the prospect for informal trade between the retailer-distributors. For example, entities can trade contracted bulk water supply, treatment services or network capacity with each other on a voluntary basis. Development of a ‘bulletin board’ system (or a variation of) — as exists in the gas market — could help facilitate trade in services and capacity by providing all retailer-distributors with ready access to information on available water and network capacity. Increased trading opportunities should help utilities better manage the costs and risks associated with short-term supply and demand imbalances. Trading opportunities would be even more expansive if large water users were able to operate as independent buyers and sellers of water services.

Network transmission services

Due to the ‘shared’ nature of transmission network assets, and their natural monopoly characteristics, arrangements must be made for appropriate and efficient investment in, and operation of, the infrastructure, and to ensure access to these networks is provided on a fair, efficient and least-cost basis: The key to the success of such unbundling is that the entity that controls the network is not a competitor in the market for the commodity itself, and hence … has no incentive to make life difficult for those who are competing in the market. (Ruff & Swier, sub. 47, p. 15)

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To this end, a transmission network entity could be established under option 4 to provide network services to the retailer-distributors (and to commercial service providers and large users if relevant) via a contract-carriage5 model. The independent transmission network entity would own and operate:

• potable water transmission network

• wastewater transmission network

• stormwater transmission network.

Users of these networks would enter into long-term, bilateral capacity contracts with the transmission entity for required network services. These contracts would assign ‘capacity rights’ to respective networks, and may specify specific network injection and discharge points, or allow for short-term adjustments to contracted capacity volumes (for example, via take or pay provisions, or use it or lose it arrangements).

In most cases, contracts for bulk water and wastewater transmission services would involve the retailer-distributors, bulk water and wastewater treatment service providers and large users (if relevant). In contrast, stormwater transmission services might be negotiated by the local councils (that collect the stormwater), the retailer-distributors (on behalf of local councils) or private parties involved with stormwater collection (for the primary purpose of recycling and reuse).

The transmission network entity would have similar governance arrangements to the retailer-distributors. It would have a charter governing its operations setting out pricing and investment principles for network services and would be subject to review against a range of criteria by the independent performance auditor.

The transmission entity would be entirely responsible for maintenance and investment in these assets. To facilitate this, prices for network services would be set so as to provide the entity with sufficient returns to undertake efficient levels of network maintenance and investment. Long-term capacity contracts between the transmission entity and users would support investment in network augmentation.

As set out above, the retailer-distributors would be able to trade network capacity with each other under this option, providing utilities with considerably more flexibility to manage short term imbalances (relative to options 2 and 3). Capacity

5 In a contract carriage market, network users (such as the retailer-distributors) would contract for a volume of water to be delivered over a specified time period, which translates into a network capacity requirement. The network transmission entity would sell this capacity right to the retailer-distributor in the form of a transportation contract. Contract carriage models are common in gas markets, such as in the United States and Australia (outside of Victoria).

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trades might need to be approved by the transmission network entity, particularly if there is any alteration to the volume of capacity required, or the location of network injection/withdrawal.

The transmission network entity would face clear incentives to seek out efficiencies in its operation of respective networks (though it must do so in a way that honours bulk water supply contracts, including the volumes and locations of bulk water and wastewater injection and withdrawal — so this is its operating constraint). For example, the network entity may be able to ‘rearrange’ flows on a network (via swap arrangements with network users) to ease congestion, or reduce pumping costs, thereby minimising the overall costs of network operation. In this context, the network transmission entity would perform a similar network optimisation role to that of a water grid manager (box 12.6).

The Commission recognises that some jurisdictions have already undertaken significant structural reform, and in doing so, have established arrangements for urban water and wastewater supply that differ from those described by options 2, 3 and 4.

South-east Queensland is an example of this — to adopt any of the options proposed in this chapter a number of further reforms would be required in this region. For example, a water grid manager that owns entitlements to bulk water and determines which bulk water sources should be used to meet demand (as per the south-east Queensland water grid manager) is not consistent with assigning responsibility for investment in, and use of, bulk water supply assets with retailer-distributors (a common feature of each of the options proposed in this draft report).

As set out in section 12.5, the Commission is interested in the views of industry participants on the costs and benefits of adopting the structural reform options proposed in this chapter — including the merits of pursuing further reforms in regions that have recently established new arrangements for urban water supply. The Commission acknowledges that the reforms already undertaken in some jurisdictions may achieve many — if not all — of the same benefits that are expected from the reform options proposed by the Commission. In such cases, the case for further reform may not be justified.

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Box 12.6 Water grid manager A water grid manager (WGM) is a relatively new organisational concept for exploiting efficiency gains in the urban water sector. There is no single definition of a WGM. In general terms, a WGM is designed to optimise the operation of the water grid (network). However, the precise arrangements for ownership of bulk water and network infrastructure; responsibility for investment in these assets; and entitlements to bulk water volumes, can vary across different WGM models. The south-east Queensland WGM (SEQWGM) provides a useful example of one characterisation of the WGM concept.

South-east Queensland water grid manager The SEQ water grid was established in 2008 in response to what became known as the` ‘Millennium Drought’. The role of the SEQWGM is to manage the operation of the grid, with the aim of maintaining regional water security at minimum cost. The SEQWGM does not own any infrastructure assets but owns the water entitlements. It purchases bulk supply and transport services, sells water and water services to grid customers and oversees the physical operation of the water grid. The Department of Environment and Resource Management (Qld) has highlighted the advantages of this arrangement: Operated as a connected network, the system yield of current sources of supply is at least 14 per cent higher than the sum of their individual yields. Asset utilisation will also improve, exploiting latent capacity and thereby deferring or avoiding the need for system capital expenditure. (sub. 60, attachment 2, p. 21) With the urban water sector becoming increasingly connected, there have been further proposals for WGMs in other parts of the nation. For example, in 2007 Yarra Valley Water proposed the introduction of a WGM for Melbourne in a submission to the Victorian Competition and Efficiency Commission (VCEC). In response, the VCEC expressed doubts about the effectiveness of a WGM in Melbourne until there was a much ‘freer’ water market (VCEC 2008, p. 196). The Commission understands the formation of a WGM is still under active consideration in Victoria. The network transmission entity (NTE) (option 4) is effectively one variation of the WGM concept. Most importantly, the primary role of the NTE would be to achieve efficient network operation (minimise the total cost of operating network infrastructure). The NTE would not own any entitlements to bulk water. Instead, bulk water investment decisions would be dictated by the retailer-distributors and would be underpinned by bilateral contracts with service providers. The NTE would own the network, and would be responsible for efficient maintenance and investment in this infrastructure. The Commission considers that there is merit in a range of alternative WGM models. In practice, the most efficient arrangements for grid management are likely to vary depending on the precise circumstances and characteristics of each water system. The NTE is regarded as an appropriate way to support efficient network operation where there are multiple buyers and sellers of bulk water, and where decisions around bulk water investment and dispatch are taken external to the network owner/operator.

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Assessment of option 4

Competition related impacts

Option 4 is expected to support yardstick competition at the retail-distribution level, strengthen incentives for innovation by upstream and downstream service providers, strengthen competition amongst providers of bulk water supply and wastewater treatment services, and permit trade in water — albeit in an informal, limited context — with consequential allocative efficiency benefits.

Greater competition between (and innovation by) service providers

The market for bulk water and wastewater treatment services is expected to be more efficient under option 4, in response to the emergence of multiple buyers of these services.

Under options 2 and 3, the single retailer-distributor would serve as the monopsony buyer of bulk water and wastewater treatment services (where only one buyer faces many sellers). This is regarded as a form of imperfect competition. As the only purchaser of services, the monopsonist retailer-distributor might dictate terms to service providers in the same manner that a monopolist controls the market for its buyers. This can lead to adverse efficiency impacts for investment in, and operation of, bulk water and wastewater treatment infrastructure.

Option 4, by breaking up the monopsony buyer, is expected to reduce or eliminate any market power held by the retailer-distributor, with corresponding efficiency gains. Specifically, option 4 is more characteristic of a oligopsony market form (where numerous suppliers are competing to sell their product to a small number of buyers). As there are multiple buyers and multiple sellers involved in this option, the arrangements are starting to more closely resemble what might be regarded as a ‘proper’ market for water services.

Where a single buyer is replaced by multiple buyers that are subject to comparative performance reporting, it is expected that demand for services will become more sophisticated and diverse (for example, the retailer-distributors, in an effort to differentiate themselves or seek out cost efficiencies, might demand new and innovative products and services from service providers). This represents a further source of competitive pressure on bulk water and wastewater treatment service providers to innovate and respond to customer needs, with corresponding benefits for the prices and quality of these services.

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In addition, the public reporting of utility performance (below) will provide market participants (including prospective investors) with more information on the cost, price and quality of various water services, which is important for encouraging new (and efficient) entry. Prospective service providers may also be attracted to the market in response to greater demand for less traditional water and wastewater services.

Yardstick competition between retailer-distributors, driving efficiency and innovation

Comparing and benchmarking the performance of similar water utilities provides a potentially powerful incentive for businesses to seek out cost efficiencies, innovate and provide better quality services to customers. In addition, the public nature of the reporting on utility performance (and by association, the performance of managers) imposes a strong incentive on managers to exploit all available efficiency benefits. This information is also effective in supporting a market (or at least sharper price signals) for managerial talent.

Yarra Valley Water considered: Comparative competition has created a dynamic environment leading to innovation and creativity. It is Yarra Valley Water’s experience that individuals respond positively to the challenges presented by comparative competition, and this has helped in building an achievement oriented and vibrant culture, which helps retain and attract talented staff. (sub. 19, p. 18)

In practice, the value of comparative competition in driving productive efficiency is highly dependent on the extent to which utility performance can be meaningfully compared, and the accuracy and quality of published information. Some participants query the value of yardstick competition on that basis. For example, Ruff and Swier (sub. 47, p. 9) ‘doubt that this type of analysis would be of much value given that even efficient costs for different urban water sectors depend on history, geography, etc’.

IPART recognise the benefits of yardstick competition in the Melbourne context, but consider: Before such a regime is introduced elsewhere, it is imperative that expected efficiency gains from comparative competition outweigh the potential losses from the duplication of administration costs, and any scale efficiency loss. It should also be considered as to whether comparative competition can be achieved without zonal disaggregation through transparent and publicly accessible benchmarking of inter-catchment utilities. (sub. 58, p. 10–11)

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The prospect of establishing yardstick competition at the retail level was identified by the QWC as a key benefit of the urban water reform process in south-east Queensland: Comparison between prices charged by different Retail Businesses will provide a benchmark of relative efficiency … there is also scope for innovative product offerings which better meet customer needs or potentially reduce the cost of supply. (QWC 2007, p. 36–7)

The QWC also considered that horizontal disaggregation would support future introduction of full retail competition, should this be deemed efficient: If the State Government decides in the future to introduce retail competition, it will be important at that time that there are no barriers to competition in the retail market. Current reforms therefore should not allow a retailer with excessive market power to become established… the Commission therefore proposes the establishment of three retailers. (QWC 2007, p. 30)

Yardstick competition is expected to drive greater innovation by the retailer-distributors. Indeed, much of the innovation that has been undertaken to date in Melbourne with regard to recycled water products has been at the initiative of the retailers. Yarra Valley Water regard innovation as one of the key benefits of water reform in Melbourne: One of the major benefits of comparative competition is the impetus it provides for innovation and the diverse approaches that are taken to solve common problems. The most successful approaches over time are validated and adopted by the other retailers. Having three retailers competing through comparative performance has delivered many examples of innovative solutions at state, national, and in many cases, international level. The existing structure drives each retailer to distinguish itself from the others. Having three organisations striving to position their own companies to be leaders diversifies the opportunities for innovative improvements. (sub. 19, p. 18)

Innovation can provide customers with greater access to desired water products and services, and allow customers to use water for activities they value more highly than others. For example, utilities may begin to offer customers products that vary in terms of the structure or level of tariffs, the security of water supply, the billing cycle period, payment method, and so on. Rural markets in Victoria (Coliban Water and Central Highlands Water) already offer customers a range of flexible water products with different security settings. Scope for innovative product offerings was identified by the QWC as a significant potential benefit of urban water reform in south-east Queensland: There is significant potential for retailers to offer their customers a range of segmented products based on a number of different attributes including: volume (which may have a time dimension, for example peak daily demand); quality, including variations in the supply source such as raw water, potable water, desalinated water and recycled water;

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reliability or security (expressed in terms of certainty of supply and the extent to which it may be subject to restrictions; and location (where it is delivered to, or taken from, which impact on transport costs). (QWC 2007, p. 37)

Opportunities for trade and allocative efficiencies

Option 4 will provide retailer-distributors with the opportunity to informally trade water products and services with each other. This will provide utilities with greater flexibility to manage risk and demand and supply imbalances. The potential benefits of trade are verified by evidence that many utilities are already trading with rural water businesses and individual irrigators where they are able to do so.

This option will not give way to a formal market for the exchange of water (say, as exists for rural water) however, option 4 lays the foundations for subsequent development of more competitive, decentralised markets for water services, pending the achievement of other reforms. Trade not only enhances allocative efficiency within the sector but also provides participants with sharper price signals about the value of water products and services, moving the sector closer towards a transparent ‘spot price’ for water, relative to options 2 and 3.

Non-competition related efficiency benefits

Economies of scale and scope

Replacing the single retailer-distributor with multiple geographic monopolies may reduce scale economies. However, this is only likely if disaggregation produces utilities that are below minimum efficient scale (section 12.1). If the disaggregated utilities continue to exhibit constant returns to scale following structural reform, the scale impacts of reform are neutral. On the other hand, if the monopoly retailer-distributor is characterised by diseconomies of scale, there may be efficiency gains from horizontally disaggregating the utility. As for options 2 and 3, the economies of scale and scope impacts of option 4 will be location (and utility) specific, and should be assessed on a case-by-case basis.

Based on the available evidence, the Commission does not expect that horizontal separation at the retail-distribution level will impose significant scale efficiency losses for large urban cities. That is, the scale of regions such as Sydney, Adelaide and Perth is sufficient to ensure that multiple utilities can be created without causing these businesses to operate below minimum efficient scale. This is consistent with Yarra Valley Water’s statement that horizontal separation in metropolitan Melbourne has been beneficial:

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Outside the situation of very small suppliers, there are likely to be diseconomies of scale. That is, as utilities get larger, costs actually increase because of the complexities of larger organisations … Studies generally show that water utilities of comparable size to those in Melbourne are already at scale. (sub. 19, p. 11–12)

This view was supported by econometric work undertaken by the Centre for Efficiency and Productivity Analysis which indicated that the three Melbourne retail water utilities were either at or near the ‘efficiency frontier’ (Yarra Valley Water, sub. 19, p. 12). In regard to the prospect of establishing multiple retailer-distributors in Sydney, Sydney Water Corporation commented: It (horizontal separation) has been looked at a few times. The difficulty is the geography. If you were going to split up Sydney’s area, the obvious split-off would be Illawarra, which we service. How you’d actually define Illawarra in area terms you’d need to have a close look at. There have been some studies, about the time of corporatisation, of splitting Sydney more or less down the middle of the harbour and the Parramatta River. That always sort of floundered because the network is more like a spider web, and you lose quite a lot of network efficiency doing that. It would be possible, but that hasn’t really ever got anywhere. The Illawarra is not really big enough. If they split off, their prices would probably rise, largely because their wastewater treatment is very high quality. We would probably need another 30 000 or so people down there for it to be doable, but it’s coming I think. (trans., p. 111)

In contrast, a 2004 report by Frontier Economics claimed: There is prima facie evidence that it may be efficient to divide the activities of Sydney Water into a number of enterprises … there may well be within Sydney three separate retail natural monopolies, serving the regions of North Head, Bondi and Malabar … The retail businesses should combine the activities of billing, customer service, and distribution of water and wastewater within each region. (Frontier Economics 2004, p. 31)

The net impact of option 4 on scope economies is unclear. On the one hand, option 4 will eliminate any scope economies between network functions and retail functions (vis-à-vis options 2 and 3). In addition, achieving efficient network operation may be more complex under this option, due to the larger number of parties using the network.

On the other hand, establishing a specialised network transmission entity might lead to more efficient operation of, and investment in, network infrastructure (economies of scope efficiencies). In particular, separation of network functions from other supply chain elements may reveal information about the relative costs of potable and non-potable water in different regions of the network, and the costs of moving water around the network. By comparison, this information will be internalised under options 2 and 3. These price signals will assist retailer-distributors in

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operating their businesses efficiently, and will provide important signals for efficient network investment.

Transaction costs Network users must contract for transmission services with the network entity under option 4. This imposes an additional layer of contractual arrangements (relative to options 2 and 3), and places upward pressure on total transaction costs. The net impact of option 4 on the costs of risk management for the retailer-distributors is uncertain. Utilities must contract for network capacity in advance, which represents another source of risk for the utility, should demand or supply conditions change. However, option 4 also provides utilities with greater scope to manage risk and uncertainty, as they are able to trade water and network capacity with each other. The role of the independent performance auditor will increase under option 4 to include:

• monitoring and review of the network transmission entity

• monitoring and review of each of the retailer-distributors

• comparative performance reporting and benchmarking of the retailer-distributors performance. The costs associated with administering other regulatory, legislative and licensing arrangements may also increase under option 4, as a consequence of the larger number of participants involved in the sector. If large users are able to buy (or sell) potable and/or non-potable water independently of the retailer-distributors, it might be necessary to develop (informal or formal) arrangements that provide these users with access to the retailer-distributor owned distribution networks. This issue is not unique to option 4, and would also be relevant under options 2 and 3. This could be achieved via third party access arrangements, or obligations imposed on the retailer-distributors (via the charter) to provide access to large users on certain terms and conditions. The cost of developing necessary access and pricing arrangements may be relatively minor given the number of available precedents (including the New South Wales third party access arrangements for water distribution networks, and various examples of gas transmission pipeline pricing and access arrangements).

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Better focus on geographic markets

The creation of multiple geographic monopolies may allow individual retailer-distributors to take greater account of geographic and community specific factors, relative to options 2 and 3.

In turn, this could drive localised water supply solutions that are more tailored to the needs and circumstances of the particular region. Option 4 might also provide an opportunity to achieve more location-specific (efficient) pricing, as the disaggregated retailers will have jurisdiction over a smaller geographic area, relative to the single utility approach. Option 4 might also be more popular with customers, for example, if they value an arrangement that puts retailer-distributors in closer proximity to the customers they serve, thereby facilitating more community engagement, and utility-customer integration.

Conclusion

Structural reform, akin to what has been described here as option 4, might be attractive where:

• the monopoly retailer-distributor is sufficiently large to ensure that horizontal separation will not impose economies of scale losses (that is, the utilities operate at minimum efficient scale) – or alternatively, where the monopoly retailer-distributor exhibits diseconomies of scale, or the costs of separation are sunk (as horizontal disaggregation has already taken place)

• there are genuine prospects for yardstick competition between retailer-distributors – performance can be benchmarked in a meaningful way (most likely in regions where geographic conditions are similar)

• the presence of multiple buyers (retailer-distributors) is expected to drive greater competition and innovation by service providers

• there are benefits from implementing more regional-specific water solutions, and/or more location-specific pricing arrangements

• the cost of developing regulatory mechanisms for dealing with access issues are minimised.

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A final word on assessing the case for structural reform

Over the course of this inquiry, the Commission has considered a wide range of quantitative and qualitative evidence on the costs and benefits of structural reform. This exercise has revealed that, in many cases, assessments of structural reform options are limited to (or strongly driven by) the scale and scope impacts. Of particular concern is that the case for structural reform is often dismissed on the basis of anticipated scale or scope losses alone.

The impacts of structural reform extend well beyond scale or scope. It is critically important for industry participants, governments and policy makers to distinguish between assessments of:

• the costs and benefits of a change in the operating scale or scope of a utility (holding competition constant)

• the case for structural reform.

As set out in section 12.5, the Commission recommends that State and Territory Governments undertake a comprehensive review of the costs and benefits of pursuing structural reform in large urban cities. It is vital that this work considers the full range of costs and benefits of structural reform, and in particular, gives explicit regard to the competition related efficiency benefits of structural reform.

The Commission acknowledges that scale and scope impacts are an important aspect of this assessment. However, the gain or loss of economies of scope due to structural reform should not be interpreted as a case for or against structural reform. All associated costs and benefits from structural reform should be weighed up by jurisdictions, and a decision made on that basis. Indeed, it is quite possible for structural reform to be assessed as efficient — despite imposing scale and/or scope losses — on the basis of anticipated competition related benefits.

12.5 Reform option 5: Decentralised competition

The structural reform options described so far in this chapter present considerable opportunities for efficiency gains via the use of competition. Option 2 is expected to drive competition for the provision of bulk water supply services, while option 3 extends this to wastewater treatment services. Option 4 retains these features and also provides for yardstick competition at the retail-distribution level.

However, these options fall short of establishing a decentralised, competitive urban water market (or competition in the market for urban water services). Competition of this kind is often described as ‘full’ or ‘complete’ competition, as it exhibits

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many (if not all) of the characteristics that define a perfectly competitive market. This sort of competition is common in a range of product and service markets, but has proved to be a more ambitious goal for infrastructure network industries.

Competitive markets in Australian network industries

Despite these difficulties, competition has now been successfully established in Australia’s electricity and gas industries, following considerable economic, regulatory and institutional reform. In addition, a market for rural water currently operates in Australia (appendix C). These markets have delivered significant efficiency benefits for industry participants and the economy more generally. The arrangements that govern these markets are sophisticated and complex. However, to facilitate discussion around the appropriateness of extending these models to the urban water sector, a brief overview is provided below.

National Electricity Market

The National Electricity Market (NEM) is a wholesale market for the supply of electricity to retailers and end users in Queensland, New South Wales, the ACT, Victoria, South Australia and Tasmania. Some of the key aspects of NEM include (AEMO 2010a):

• Exchange of electricity between generators and wholesale consumers (retailers and large end use customers) is facilitated through a compulsory pool, and electricity trading is conducted as a spot market.

• Supply and demand are instantaneously matched in real time through a centrally coordinated dispatch process administered by the Australian Energy Market Operator (AEMO). – Generators offer to supply the market with specific amounts of electricity at particular prices. AEMO stacks these bids in ascending price order and generators are progressively scheduled into production to meet prevailing demand. The spot price for each half-hour trading period is the price all generators receive and all customers pay.

• Trends in spot price movements provide signals for future investment in generation and transmission.

Wholesale gas markets

The majority of wholesale gas in Australia is sold under confidential, long-term contracts. Wholesale gas contracts typically include take or pay clauses, and

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contract prices might be reviewed periodically during the life of the contract. Gas retailers and major users must estimate requirements ahead of time and nominate these to producers and pipeline operators (subject to contractual terms). Producers and storage providers inject the nominated quantities of gas into the transmission network for delivery to customers.

This process typically creates imbalances, due to short-term variations between a retailer’s nominated injections and their actual withdrawals from the system. In most cases, pipeline operators manage physical balancing and AEMO manages financial settlements for imbalances.

The Victorian gas wholesale market is distinct from other jurisdictions in that a spot market exists for managing gas balancing. This market works in much the same way as the NEM settlement process, and is operated by AEMO. The spot price only applies to net injections or withdrawals (the difference between contracted volumes and actual amounts traded). Overall, gas traded at spot prices account for around 10 to 20 per cent of wholesale volumes in Victoria (AEMO 2010b).

Similar arrangements have recently been developed in eastern Australian to create a day-ahead wholesale spot market in gas for balancing purposes (the Short Term Trading Market). AEMO operates the financial market but does not operate the actual flow of gas (which remains the responsibility of pipeline operators).

The Australian Energy Regulator (AER) is the economic regulator of gas transmission pipelines outside of Western Australia. Seven transmission pipelines are currently subject to full regulation (access arrangements). Four pipelines are subject to light regulation (meaning the pipeline owner must publish prices and access terms and conditions on its website).

Outside of Victoria, the providers of gas transmission pipelines negotiate commercial contracts to sell transportation services to customers (retailers). A contract typically features a maximum daily quantity allocation and sets a capacity charge, which must be paid regardless of the amount of gas that a customer transports on the pipeline.

The Victorian Transmission System (VTS) is a covered pipeline and access to, and tariffs for use of, the VTS are regulated by the AER. The VTS is operated by AEMO under a market carriage system. When gas is shipped on the VTS, tariffs are payable to both AEMO and APA Group (the owner of the VTS). Transmission tariffs reflect the actual cost of gas delivery.

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Rural water market

An overview of the rural water market is provided in appendix C. The key point to note about this market is that it operates as a ‘cap and trade’ system — that is, there is a limit on the total amount of water available for trading. In effect, the rural water market is focused on achieving efficient allocation of a discrete volume of rural water. This reflects the nature of rural water resources (that is, rural water is a scarce and finite resource), and the motivation for development of a market in the first place — namely, to ensure those (agricultural, industrial or domestic) users that value rural water most highly are able to access it.

In contrast, the urban water market is not bound by a cap or limit on the supply of urban water. In fact, the largest efficiency gains available in this sector are expected to come from achieving more efficient investment in new water supply infrastructure (that increases the total volume of water available for purchase).

What does this mean for urban water?

A number of commentators have suggested that arrangements similar to those that characterise the NEM be applied to Australia’s urban water sector (henceforth referred to as option 5). For example, Ruff and Swier (sub. 47, p. 22) consider that ‘market concepts that have been useful for electricity and gas networks can be adapted to water and might be useful for creating water markets in large urban systems’. The Commission understands that a decentralised market approach is one of the options that is being canvassed in Victoria.

The Commission acknowledges that an option 5 approach may deliver efficiency benefits in excess of those achievable under options 2, 3 and 4, all else equal. However, the success of competitive, decentralised markets in other infrastructure industries does not imply that the same outcomes can or would be achieved in the urban water context. In addition, there might be additional costs or risks associated with establishing these arrangements that are unique to the urban water sector. The absence of any precedent of urban water markets anywhere in the world compounds the risk and uncertainty associated with this option. Of most concern is how the security of Australia’s urban water supplies would be maintained under option 5 — that is, will NEM-type arrangements be adequate to support efficient levels of investment in bulk water supply infrastructure? For this to be the case, there needs to be sufficient certainty that:

• the price signals that arise under option 5 (via the spot market) are an accurate reflection of the underlying demand and supply position. This is critical to

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ensure market participants receive appropriate information about the need for supply augmentation

• market participants will respond to these price signals in an efficient manner — that is, the appropriate type and level of investment is undertaken (and in good time).

In the event one or both of these conditions is not met, pursuing option 5 would constitute putting the security of Australia’s urban water supplies at great risk, which in turn might have potentially catastrophic consequences.

A spot market, by definition, clears short-term imbalances. This is an appropriate mechanism for guiding supply and demand decisions in the NEM, as electricity must be balanced in real time (it cannot be stored). Likewise, it is appropriate that the spot price guides and informs investment decisions, as trends in spot prices are an accurate indication of the true position of the electricity market, and the need (or not) for investment in new generation capacity (for example, high spot prices over an extended period might suggest a need for supply augmentation).

Extending this argument to the urban water sector is problematic. Water can be stored, and it can be stored in large volumes for considerable lengths of time. This introduces an intertemporal element to urban water supply and demand decisions — the volume of water that a supplier elects to dispatch (or a consumers chooses to purchase) will depend on current circumstances and expectations about future market conditions.

A spot market that only reflects the short-term position of urban water supplies will not necessarily provide accurate signals about actual urban water supply and demand circumstances — this might lead to sub-optimal market decisions and inefficient (inadequate) investment in bulk water infrastructure. In turn, this could have serious consequences for the security of urban water supplies — a circumstance that is extremely difficult and costly to rectify in the short to medium term.

This does not imply that spot markets are entirely infeasible or futile in the urban water context. Gas is also a storable commodity (albeit to a more limited extent), yet a spot market operates alongside the Victoria gas wholesale market, and a short term trading market is emerging in the eastern states. However, these markets are primarily for balancing purposes (that is, only residual demand and supply is traded in these markets).

Even if option 5 were considered to provide accurate and sufficient price signals for investment, there is no way of guaranteeing that market participants will respond to

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these price signals appropriately. For example, there are indications that the electricity industry is facing material security of supply issues due to insufficient investment in generating capacity, casting doubt on the assumption that investors respond to price signals efficiently under these arrangements.

In light of the risks posed by option 5 for urban water supply security, and the material consequences of any breach of security of supply, option 5 is not a feasible or efficient option for the Australian urban water sector, at least not at this time. This circumstance might change in future, particularly as jurisdictions gain experience with market arrangements that facilitate competition for urban water services (options 2 to 4).

DRAFT FINDING 12.2 There is a range of structural options for urban water supply in Australia’s large urban cities, including:

• Option 1: a vertically-integrated utility

• Option 2: vertical separation of the bulk water supply function from other elements of the supply chain, and horizontal separation of the bulk water supply function

• Option 3: vertical and horizontal separation of the wastewater treatment function (in addition to option 2)

• Option 4: horizontal separation of the retail–distribution function (in addition to option 3)

• Option 5: a fully competitive, decentralised urban water market. There are potentially significant risks and costs associated with establishing a fully competitive, decentralised market for urban water services at this time (option 5), and it is unlikely that the benefits justify the costs. This should be reviewed on a periodic basis. The potential benefits of options 2, 3 and 4 are much more compelling. State and Territory Governments should undertake a detailed assessment of the full costs and benefits of undertaking structural reform in large urban cities.

INFORMATION REQUEST

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13 Reform in regional areas

Key points

• It is neither appropriate nor practical to develop a ‘one size fits all’ definition of the regional water sector. Regional water utilities face diverse supply and demand circumstances and are subject to wide-ranging governance and institutional arrangements. Relative to metropolitan water utilities, regional utilities: – serve fewer (and less densely distributed) customers – tend to incur higher capital and operating costs per customer connection – do not generally have access to alternative bulk water supply sources – are usually responsible for setting their own water prices.

• Some regional water utilities do not fully recover costs, and are not financially independent of the governments that operate them. For example, 4 per cent of New South Wales water utilities failed to fully recover costs in 2008-09, and a further 35 utilities earned a negative economic real rate of return for water services. It is not clear whether some of these utilities are operating on a commercially viable basis.

• Skill shortages are a concern for water utilities in regional and remote areas.

• Utility compliance with a range of public health and environmental regulations, and performance against best-practice principles and customer service standards, is generally lower in regional areas. Non-compliance with the Australian Drinking Water Guidelines (ADWG) is most common amongst (but not unique to) small regional utilities — the 12 New South Wales utilities that failed to comply in 2008-09 are located in regional areas and serve between 1000 and 5300 properties each.

• Structural reform that involves horizontal aggregation of regional utilities (including the transfer of water assets and revenue) can allow businesses to exploit economies of scale efficiencies, share resources and internalise transaction costs. Significant structural reform has been undertaken in regional Victoria and Tasmania, and these experiences provide important lessons for reform in other areas.

• Where aggregation is efficient, a regional water corporation model is the best-practice organisational structure, although the county council model also has merit. A regional alliance can facilitate greater resource sharing and does not involve significant changes to the assets and responsibilities of member councils. However, the binding alliance model may expose participating councils to significant financial (and other) risks. The voluntary alliance model involves fewer risks and costs, but relies on ongoing cooperation and commitment by councils.

(Continued next page)

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Key points (continued)

• There is scope to achieve material efficiency gains via aggregation of water utilities in regional New South Wales and Queensland. State Governments, in consultation with Local Governments and affected communities, should determine the precise approach to water reform in these jurisdictions, including the appropriate size, boundaries, composition and organisational structure of utilities. – In undertaking this work, State Governments should take explicit account of all costs and benefits including the impact on network operating costs, water system planning and resource management, and local communities (and employment).

• New South Wales has made significant progress toward regional water reform, via the Inquiry into Secure and Sustainable Urban Water Supply and Sewerage Services for Non-Metropolitan NSW. It is critical that the findings of this work are now drawn upon to develop a reform program. The Commission endorses the majority of the recommendations of the Armstrong and Gellatly report. A similar process should be initiated in Queensland as a matter of priority.

• There has been little comprehensive analysis of the potential costs and benefits of disaggregating the large public water corporations in Western Australia, South Australia and the Northern Territory. Potential benefits of disaggregation include more effective water resource management, opportunities for yardstick competition and location-specific pricing arrangements, scale economies (if the utility exhibits decreasing returns to scale), encouraging locationally-based innovation and putting utilities and customers in closer proximity. Relevant State and Territory Governments should undertake this analysis and publicly report on the findings.

• Given the potentially severe consequences for public health of a breach of drinking water quality standards, compliance with the health critical elements of the ADWG should be mandatory for all utilities. Utility performance against all elements of the guidelines should be reported on annually by jurisdictions. Sanctions would apply for non-compliance with the mandatory requirements, and councillors and directors of utilities would be personally liable. Where utilities do not comply with other elements of the guidelines, a risk management plan must be developed and implemented, in consultation with relevant State and Territory Government health departments.

• There is a role for State and Territory Governments to provide Community Service Obligation funding to support water and wastewater service provision in small and remote communities, including Indigenous settlements, that are otherwise uneconomic to supply. The quality of services provided to Indigenous communities should be comparable to the standards of services provided to non-Indigenous communities of a similar size and circumstance. Water supply and wastewater outcomes in Indigenous communities should be reviewed and reported on regularly.

This chapter begins by providing an overview of the regional water, wastewater and stormwater sector (the regional water sector). Water utilities that serve customers in

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regional and remote areas are confronting a range of challenges, and these are also described in section 13.1, drawing on evidence provided as part of this inquiry.

Structural reform that involves horizontal aggregation or disaggregation of regional water utilities is one way of addressing these challenges (or at least some of them), but is not without costs. To determine whether there is a case for aggregation of regional water utilities, an assessment of the potential benefits and costs is undertaken in section 13.2. This is followed by section 13.3, which appraises the various organisational structures that could support regional water utilities.

Finally, section 13.4 addresses a number of other issues that are relevant to the sector, such as the role for government in subsiding regional water services, arrangements for improving the quality of drinking water, the challenges associated with servicing Indigenous communities, and the merits of breaking up large, jurisdiction-wide water utilities (horizontal disaggregation).

13.1 Regional water, wastewater and stormwater sector

The purpose of this section is to identify the distinguishing features of the regional water sector, and to set out the primary motivations for considering structural reform. For the purpose of this chapter, the term ‘regional water utility’ is used to characterise regional utilities that provide water supply services, wastewater services or both, unless stated otherwise.

What makes regional Australia different?

‘Regional Australia’ — in the context of this inquiry — encompasses all areas of Australia that receive reticulated water and wastewater services, but are located outside of large urban cities (box 12.1, chapter 12). This means the regional water sector includes large, regional towns through to remote villages and Indigenous settlements.

As such, it is not practical to develop a ‘one size fits all’ definition of the regional water sector, or a regional water utility. The utilities that serve regional areas face diverse supply and demand circumstances and are subject to wide-ranging governance and institutional arrangements. In South Australia, Western Australia and the Northern Territory regional areas are serviced by (for the most part) the same utility that provides water services to metropolitan areas. By contrast, there are 106 water utilities serving customers in non-metropolitan New South Wales (table 13.1).

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Notwithstanding the disparity in geographic, demographic and economic conditions, and in the institutional arrangements for supply of services within the regional water sector, there are a number of features that are common to most regional water utilities. These characteristics are important to recognise as part of assessing the case for reform.

Table 13.1 Regional water utilities

Jurisdiction Regional utilities Size of regional utilities

Number of property connections (approximately) New South Walesa 106 26 large (> 10 000) 26 medium (3 001 to 10 000) 19 small (1 501 to 3 000) 25 very small (200 to 1 500) Victoriab 13 Regional water and sewerage corporations (14 000 to 134 000) Queenslandc 71 11 large (> 25 000) 26 medium (1 000 to 25 000) 34 small (< 1 000) South Australia 3 South Australia-wide water utility (1.5 million) Coober Pedy District Council (1 500) Roxby Downs Waterd (1 300) Western Australiae 5 Western Australia-wide water utility (1.1 million) Four small local utilities Tasmania 3 Regional water and sewerage corporations (43 000 to 95 000) Northern Territory 1 Northern Territory-wide water utility (80 000) ACT 1 ACT-wide water utility (145 000) a Sydney Water Corporation, Hunter Water Corporation, Hawkesbury Council and Sydney Catchment Authority are not included in this figure. Ten regional New South Wales utilities do not have water supply (wastewater utilities only) (NSW Office of Water 2010a). b Excludes the three Melbourne metropolitan water businesses. c There are 83 urban water and wastewater service providers and 77 non-urban service providers in Queensland. 71 of the urban service providers are located outside of south-east Queensland (DERM sub. 60). d Roxby Downs Water is a separate business unit of Roxby Downs Council. e The Water Corporation supplies the majority of water customers in Western Australia. Bunbury is supplied by Aqwest and Busselton by Busselton Water. Rottnest Island Authority and Hamersley Iron also provide potable water supply services (ERA 2011c). Sources: ACTEW Corporation (sub. 45); DERM (sub. 60); District Council of Coober Pedy (2011); ESC (2011); NSW Office of Water (2010); NT Power and Water (2011); Roxby Downs Council (2010); SA Water (2011a); Water Corporation (sub. 78).

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Key characteristics of the regional water sector

In the large majority of cases, regional water utilities operate within general purpose Local Government councils, or as ‘stand-alone’ public water corporations (state-owned or council-owned). Governments and industry participants have recently contemplated (and in some cases introduced) a number of alternative options for organising water utility businesses (box 13.1).

Regional water utilities vary significantly in terms of customer numbers and geographic coverage. Broadly speaking, these utilities have fewer customers (property connections) relative to metropolitan water businesses — giving rise to a considerably smaller revenue (rates) base — and annual residential water supplied per property is generally less than in capital cities (Armstrong and Gellatly 2008, p. 20). The percentage of domestic properties without water meters is considerably higher in regional areas relative to city centres (AECOM 2010, p. 30).

There is high variability in the price paid for water across regional communities, and this is a consequence of costs and pricing policies (AECOM 2010). In New South Wales, the Independent Pricing and Regulatory Tribunal (IPART) sets prices for Hunter Water Corporation, Gosford City Council, Wyong Shire Council1 and Country Energy (Broken Hill). The Essential Services Commission (ESC) determines water and wastewater prices in Victoria. In regional Queensland and other areas of New South Wales prices are not regulated by an independent economic regulator (chapters 2 and 7). Instead, prices are set by Local Government water utilities. The NSW Best-Practice Management of Water Supply and Sewerage Guidelines set out best-practice water supply pricing principles for regional water utilities in New South Wales.

The limited availability and proximity of bulk water sources in regional areas can impose significant capital and operating costs on utilities. Regional water utilities are often heavily reliant on rainfall dependent water sources, and in many regional areas one main water source may supply a number of towns (serviced by different water utilities), as well as large water consumers (such as irrigators or major mining sites and processing facilities). Regional water utilities generally have limited options for diversification due to their location — for example, establishing physical linkages between water supply systems may not be feasible or cost-effective (AECOM 2010).

This circumstance may serve to limit the economies of scale benefits from utility amalgamation (that is, if water systems cannot be connected). However, aggregation

1 Gosford City Council and Wyong Shire Council are now the Central Coast Water Authority.

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also presents opportunities for improved asset management and better access to skilled labour, and achievement of these benefits would not necessarily be impeded by the interconnectedness (or not) of water supply systems.

Box 13.1 Service delivery models in regional Australia

General purpose Local Government council General purpose councils provide a range of functions including roads, waste disposal, childcare and health services. Under this model councils retain direct responsibility for the operation and management of water supply and sewerage services. However, the water supply and wastewater operations of all councils are required to be financially ring-fenced from other council activities. In some councils, the water supply and wastewater function is a distinct, separate business unit operating on a commercial basis, for example, Shoalhaven Water (Shoalhaven City Council, sub. 15).

Regional alliance The regional alliance model is a relatively new organisational concept for local councils and/or local water utilities. Under this model, certain functions are provided centrally (such as strategic planning) and paid for by member councils on some apportioned basis. Assets and responsibility for service delivery are retained by member councils. Member councils can be compelled (by legislation) to remain members of the alliance (binding alliance), or a more informal arrangement may be adopted (voluntary alliance). Under the binding alliance approach an alliance entity is established as a distinct legal entity from councils. The extent of the body’s functions, autonomy and powers are matters for participating councils to determine. County council County councils are single-purpose organisations that operate independently of local councils, with boards of management appointed by the constituent councils. County councils operate as vertically-integrated businesses and own and operate all assets. Public water corporation A public water corporation is managed by a board of directors appointed by the shareholders (where the shareholders are either the local councils (a ‘council-owned water corporation’), or the state government (a ‘state-owned water corporation’)). Tasmania provides an example of the council-owned water corporation model, while regional Victoria comprises multiple state-owned water corporations. Establishing a corporation involves transferring asset ownership and operating responsibility from the existing regional water utilities to the corporation. Some public water corporations operate as dual energy and water service providers (for example, Country Energy and Water (Broken Hill), NT Power and Water and ACTEW Corporation).

Distribution networks are a major investment component of water supply system costs, and customer density has a large effect on infrastructure costs. The lower population density of regional areas means that capital costs per customer are

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generally higher, for example, there are more wastewater treatment plants per head of population, and fewer customers per kilometre of water supply main (NSW Office of Water 2010a, p. 54). The NSW Performance Monitoring Report 2008-09 shows that the number of properties served per kilometre of water supply network is as low as five in some regional areas (NSW Office of Water 2010a). In Tasmania, Cradle Mountain Water has the highest number of pump stations per 100 kilometres of wastewater network — a consequence of servicing the mountainous west coast of Tasmania (OTTER 2011).

Operating, maintenance and administration costs (OMA) per property tend to be higher in regional areas across all states and territories (NSW Office of Water 2010a, p. 56). Factors that contribute to this include the:

• number of small, discrete urban water systems operated by the utility (network costs)

• distances between centres of demand in regional areas, including the remoteness of some customers

• physical characteristics of regional water systems, including challenging geology, geography and topology — these features can have a significant effect on water transportation costs, particularly in pumped systems (as compared to gravity-fed systems).

Regional water utilities in Victoria, New South Wales and Queensland typically earn a lower economic real rate of return (ERRR) relative to their metropolitan counterparts (NSW Office of Water 2010a, p. 59; and chapter 2). This issue is discussed further in the following section.

Critical issues confronting the regional water sector

This inquiry has heard evidence to indicate that — in many areas — regional water utilities are financially sound, compliant with regulatory and legislative requirements and responsive to changing demand and supply conditions, and that services are provided to customers in an efficient and effective manner. However, in other parts of regional Australia there are valid concerns about the viability of water businesses, and the safety and quality of services provided to customers. The precise reasons for this are varied, and are often specific to the local circumstances of the relevant water system.

Notwithstanding this, over the course of this inquiry a number of issues have emerged as common challenges for regional water businesses. The Commission anticipates that the universally applicable reforms set out in chapter 11 will deliver

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significant efficiency gains for regional water utilities, avoid unnecessary regulatory costs and may serve to alleviate some of these challenges. In certain cases there may be merit in pursuing structural reform of the regional water sector to achieve additional efficiency benefits, and this is the focus of chapter 13.

It is important to recognise that the capacity of reform (of all kinds) to remove or even reduce some of the challenges facing regional water utilities is limited. Indeed, some small, remote regional water businesses face extremely challenging circumstances that are beyond the control of the utility, and are unlikely to change irrespective of the reforms adopted.

The principal concerns confronting regional water utilities — as presented to this inquiry — are set out below, ahead of an assessment of the scope for structural reform (via aggregation) to address some of these issues.

Financial self-sufficiency

Economic and financial viability is a critical pre-requirement for any efficient business. Kempsey Shire Council claimed: The single most critical issue affecting the long-term sustainability of water utilities is financial sustainability. Whilst governance and regulatory impediments may frustrate and delay advances, without an adequate source of funds, real change and advancement will be illusionary. (sub. 30, p. 8)

Similarly, the AECOM report prepared for Infrastructure Australia asserts that ‘in addition to operation and maintenance costs, a water utility should be able to raise the capital for any alterations or additions to their existing system to respond to changes in technology, regulation, climate and community expectations’ (AECOM 2010, p. 10). Financial self-sufficiency was a key objective of the reform processes pursued in regional Victoria: Up until the mid 80s successive Victorian State Governments had provided subsidies to the various water trusts and sewerage authorities to assist in the financing of capital works. These subsidies were economically inefficient and provided no real incentive for water authorities to stand on their own feet. At the time the phase out of those subsidies commenced, they were costing the State Treasury around $30 million per year. (Gleeson 1999, p. 8)

However, based on the evidence presented to this inquiry, financial self-sufficiency remains an elusive goal for a number of regional water utilities. These businesses do not recover the total costs of supplying water and are generally not able to comply (or at least, fully comply) with relevant regulations and standards. Adequate provision by utilities for necessary capital improvements is a particular concern in

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regional areas, as a significant portion of the existing asset stock is currently (or soon will be) in need of renewal or replacement.

Full cost recovery

AECOM (2010, p. i) observed ‘less than full cost recovery is a common feature of water utilities servicing regional areas’. In New South Wales 4 per cent of utilities did not fully recover costs for water supply in 2008-09 (and 3 per cent for wastewater). The four utilities that did not achieve full cost recovery were Albury, Cowra, Mid-Western Regional and Cobar Water Board. Albury has over 10 000 connected properties (and Cowra and Mid-Western Regional between 3000 and 10 000 each) demonstrating that problems with achieving full cost recovery are not unique to small regional water utilities (NSW Office of Water 2010a).

The Commission recognises that the number of New South Wales utilities failing to fully recover costs has declined over time. However, the 2008-09 NSW Performance Benchmarking Report indicates that 35 regional water utilities (in addition to the four identified above) reported a negative ERRR for water supply services in 2008-09 (and 24 utilities had a negative ERRR for wastewater services). A similar outcome was observed in 2007-08 — 25 regional water utilities reported a negative ERRR for water supply services (and an additional seven utilities failed to fully recover costs) (NSW Office of Water 2009).

The ERRR parameter used by the NSW Office of Water is based on the same metric reported on by the Water Services Association of Australia (WSAA) and the National Water Commission (NWC) as part of the National Performance Report series (indicators F17 to F19). For example, the ERRR for water and sewerage services (F19) is defined as: Revenue from water and sewerage business operations less operating expenses (operating, maintenance and administration costs + current cost depreciation) for the water and sewerage business, divided by written down replacement cost of operational assets for the water and sewerage business. (NWC and WSAA 2010b, p. 81)

In response to the high number of utilities reporting negative ERRRs, the NSW Office of Water observed: The current drought has adversely affected the economic real rate of return for many local water utilities (LWUs) as the lower volume of water supplied to customers has reduced the LWU’s revenue from usage charges. Where the reduction in the water supplied to customers has exceeded the LWU’s estimate, the revenue and rate of return have been lower than forecast. However … 35 LWUs have responded by significantly increasing their 2009-10 charges in order to achieve full cost recovery. Each LWU should continue to set each year’s tariff to raise the required revenue (based on the

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analysis in your LWU’s current 30-year financial plan) on the basis of its careful estimate of the volume of water to be supplied to customers over the next financial year. This is particularly important during periods of drought and water restrictions in order to ensure the LWU continues to meet its obligation to achieve full cost recovery. (NSW Office of Water 2010a, p. 10)

The report states that ‘full cost recovery is achieved if either the economic real rate of return or the return on assets is greater than or equal to 0’ (NSW Office of Water 2010a, p. 23). The Commission’s view would be that returns at this level fail to provide any returns to debt or equity. The 35 regional utilities referred to above did not meet either of these benchmarks in 2008-09, but were considered to be fully recovering costs due to making a subsequent commitment to significantly increase 2009-10 prices.

The incidence of very low or negative ERRRs is not unique to New South Wales regional water utilities. A number of regional utilities in Victoria also reported negative ERRRs for water supply in 2008-09 (for example, Central Highlands Water (-2.5 per cent); Goulburn–Murray Water (-4.1 per cent); South Gippsland Water (-0.8 per cent); Western Water (-0.7 per cent) (NWC and WSAA 2010a). These utilities have earned consistently negative or low rates of return for consecutive years. For example, South Gippsland Water reported an annual return for water supply services of -0.4, -3.9 and -2.2 per cent respectively over the period 2005-06 to 2007-08. Likewise, Central Highlands Water and South Gippsland Water both earned negative rates of return in 2006-07 (-1.9 and -3.9 per cent) and 2007-08 (-6.4 and -2.2 per cent) (NWC and WSAA 2010a).

Although the Commission was not able to find comprehensive data on cost recovery by regional water utilities in Queensland (outside of the NWC and WSAA reporting), a Queensland Department of Environment and Resource Management (DERM) presentation to the Water Pricing Conference in September 2010 (entitled Taps and Toilets) suggests (DERM 2010c, slide 43):

• utilities servicing less than 10 000 connections do not recover the full cost of service provision (and the differential is as large as $250 to $300 per connection for the smallest utilities)

• utilities that serve between 10 000 and 60 000 connections either slightly under-recover or over-recover costs.

In a submission to this inquiry, DERM (sub. 60) noted that the Queensland Government has provided substantial financial assistance to Local Government water utilities, reflecting the financial dependence of these utilities on State Government funding. This funding was allocated via the Water and Sewerage

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Program ($633 million over four years) and the Small Communities Assistance Program ($71 million over four years).

The three Tasmanian water and sewerage corporations are not yet fully recovering costs. The Office of the Tasmanian Economic Regulator (OTTER) found that for 2009-10, Southern Water had an ERRR of 1.08 per cent, followed by Ben Lomond Water with 0.63 per cent and Cradle Mountain Water with -0.45 per cent: If it is assumed that a real rate of return to reflect full cost recovery is approximately seven per cent per annum, then all three corporations are generating rates of return significantly below full cost recovery levels. (OTTER 2011, p. 116)

It had been expected that these utilities would move towards full cost recovery following commencement of independent price regulation from July 2012. However, this now appears to be in some doubt: The State Government has previously said it does not support a full cost recovery model and Ms Giddings [Tasmanian Premier] again reiterated that point yesterday when she released, for public consultation, another key water and sewerage-related document — the draft Water Service Pricing Regulations. ‘Full cost recovery is not a policy of Government in the short or even medium term’ she said. (Hobart Mercury, 10 March 2011)

Ensuring all water and wastewater utilities achieve full cost recovery is a critical element of urban water reform. The Commission is concerned that such a large number of regional water utilities are reporting negative or low ERRRs, and questions whether a number of these utilities are operating on a commercially viable basis.

Although short-term fluctuations in revenue and costs above or below anticipated levels are normal, it is vital that utilities achieve genuine cost recovery over the lifecycle of capital assets (that is, utilities recover their full financial costs including capital expenditure for replacement of existing assets and to expand the stock of assets to meet increases in demand, required service standards, and any increases in regulatory obligations). For utilities that earn a negative ERRR on a consistent basis, it is not clear that this will be possible (even if forward charges are subsequently increased). This could have serious implications over the longer-term, as utilities are required to maintain and replace water system infrastructure.

This is consistent with OTTER’s observation (above) that achieving full cost recovery is not as simple as maintaining a (marginally) positive ERRR each year. In practice, a rate of return of at least 5 to 6 per cent per year is more likely to be consistent with genuine full cost recovery over the capital cycle, and in some cases the required rate of return may be considerably higher than this (as in the case of Tasmania).

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In 2008 the Productivity Commission released a report on the financial performance of Government Trading Enterprises (GTEs) over the period 2004-05 to 2006-07 (PC 2008b). In undertaking this review, the Commission determined that, to be commercially viable, water utilities needed to earn a return in excess of 5.8 per cent — the risk-free rate of return — based on the 2006-07 interest rate on a 10-year Australian Government bond. The Commission found that only five of the monitored GTEs achieved this level (the average return was 4.9 per cent).

INFORMATION REQUEST

The universally applicable reforms set out in chapter 11 — and the pricing principles set out in the charter specifically — are aimed to ensure that all regional water utilities achieve genuine full cost recovery.

Respondents to this inquiry have suggested that a range of circumstances can limit a utility’s ability to recover efficient costs and achieve financial independence. Though not an exhaustive list, these factors are summarised below. The Commission does not presume that these cost drivers are necessarily a reflection of inefficient water utility operations, or that reform (structural or otherwise) will be the silver bullet solution. Rather, the purpose of this section is to identify the unique cost characteristics of regional water utilities, with a view to considering how effective (if at all) structural reform may be in reducing these cost pressures.

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Capital costs

Following a long period of less than efficient levels of maintenance and investment in water system infrastructure, many regional utilities are facing significant and growing capital costs to repair or replace ageing assets. Armstrong and Gellatly (2008) anticipate that a significant portion of regional water utility’s assets will require replacement over the next 30 years as they come to the end of their economic life. Some utilities have not made adequate provision for such expenditure, and the Commission is concerned that this problem may extend beyond those regional utilities that have been identified as not fully recovering costs.

Respondents also pointed to the concurrent population decline (shrinking rates base) in some regional areas, and the implications this has for capital (and operating) costs per person. Kempsey Shire Council (sub. 30, p. 14) commented ‘on a simple economies of scale basis, smaller water and sewerage schemes suffer on a unit cost basis due to the relatively small number of customers they serve’. The NSW Office of Water (2010a) notes that regional water utility capital costs have also been under pressure due to climate reasons, as low rainfall affects water demand and drought security, with corresponding impacts for investment.

Insufficient financial resources for necessary capital works was a key driver of recent urban water reform in Tasmania. The Tasmanian Ministerial Water and Sewerage Taskforce (MWST) identified a range of reasons for this, including constraints on local utility borrowings: Borrowings by Local Government are controlled via the Local Government Act 1993 to ensure that councils do not borrow beyond their means. These financing constraints may mean that some councils (particularly, but not limited to, small councils) may not be able to borrow enough to finance future infrastructure developments. (MWST 2006, p. 10)

Operating costs

A number of respondents to this inquiry have suggested that regional water utility operating costs are under immense pressure due to an increasing allocation of water to the environment, rising standards for water and wastewater treatment, and the consequences of prolonged drought, climate change and greater rainfall variability on the yields of regional water utilities’ traditional water sources (dams and rivers). These utilities often have few alternative (and affordable) water sources due to the absence of network interconnections between supply systems. The NSW Office of Water (2010a, p. 12) reported that OMA costs have been increasing due to ‘more

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stringent standards for sewage treatment, reduced sewage volumes and increasing management costs’.

Several regional water utilities expressed serious concerns about the costs associated with attracting, retaining and training skilled staff, and the burden of meeting growing regulatory and administrative requirements. For example, Kempsey Shire Council (sub. 30, p. 4) considered that water and sewer infrastructure project costs are escalating ‘due to national and international demand for skills and resources’. These issues are discussed in more detail below.

Revenue generating capacity

The ability for regional water utilities to raise revenue has been under pressure due to:

• a downward trend in the volume of water sold per property (in New South Wales, average annual residential water supply was 175 kL in 2008-09, a reduction of 47 per cent over 18 years) (NSW Office of Water 2010a)

• static or declining populations in some areas of regional Australia (particularly inland areas), reducing the customer (rates) base

• prices that do not always reflect the actual cost of service provision, including location-specific costs. In some regional areas there is considerable seasonal variation in population size — posing a further set of challenges for regional utilities: This is particularly the case for municipalities with itinerant populations, where demand on water and wastewater infrastructure increases considerably during the tourist season. Infrastructure needs to have the capacity to accommodate such peaks. However, council income from such infrastructure typically reflects base municipal population levels, resulting in an inability to earn adequate revenues to enable a council’s infrastructure to service peak demand. (MWST 2006, p. 10)

Limited scope for revenue generation and growing capital and operating costs has direct, adverse consequences for the financial capacity of regional water utilities to undertake investment, leading to poor service quality and significant public health and environmental risks. For example, for a water utility servicing a very small population, constructing a water treatment plant has a high cost per person — without access to sufficient debt capital to fund the investment, it may take years to raise the necessary funds (AECOM 2010, p. 10). This will have direct and potentially serious consequences for the quality of services delivered.

To ease the financial stress some regional water utilities are under — and thereby alleviate the associated sub-optimal outcomes for water consumers — it is critical

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that regional water businesses seek out and exploit cost efficiencies and price water and wastewater services efficiently. In extreme circumstances assistance from government may be required to ensure compliance with mandatory standards.

One way of facilitating such outcomes is via structural reform of the regional water sector, and specifically, horizontal aggregation of whole water utilities. For example, operating costs might reduce if neighbouring water businesses are able to share resources (such as skilled labour, corporate services or administrative functions) to exploit economies of scale efficiencies, all else equal. Alternatively, aggregated utilities might be better placed to access debt capital relative to stand-alone entities. As discussed in chapter 12, structural reform is not just about scale, and utility aggregation may give rise to other benefits that are unrelated to operating size, for example, more effective water resource management.

However, the efficiency benefits (including scale benefits) of aggregation are not automatic or uniform, and will not be achieved without incurring costs. In practice, the balance of costs and benefits that are achieved via aggregation will depend on the characteristics of the individual water utilities in question, including the density of customers, the number (and interconnectedness) of networks, and the geography and topology of the region (chapter 12). The case for undertaking structural reform of this kind is considered in more detail in section 13.2.

It is important to remember that structural reform is not the only way that efficiencies can be achieved in the regional water sector, and in most cases, pressing ahead with structural reform in isolation of other reforms will be ineffective. Regulatory, institutional and governance reforms will be critical to ensure regional water utilities achieve financial self-sufficiency, efficient pricing arrangements and productive efficiencies, as detailed in chapter 11.

Skills shortages

Concerns about insufficient skilled labour are not unique to the regional water sector, or even to the Australian water sector more generally. Many infrastructure industries are reporting problems with respect to attracting and retaining sufficient numbers of skilled staff.

In the regional water sector, skills shortages are a two-dimensional problem. As skilled labour becomes more difficult to secure, utilities are forced to dedicate greater resources toward attracting, retaining and training staff, putting upward pressure on costs. Secondly, where utilities cannot access appropriate skilled persons, there are direct consequences for asset management and the quality of services delivered to customers. For example, the knowledge and experience of

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operation and maintenance staff is directly linked to the safety of drinking water delivered to consumers (AECOM 2010).

Many regional water utilities responding to this inquiry have indicated that they encounter considerable costs, delays and difficulties in hiring skilled staff. This appears to be a particular concern in rural and remote areas, and is expected to worsen as the existing workforce ages, and populations in inland regions decline. The Local Government Association of Queensland (LGAQ) considered: A lack of skills capability is a national problem that is manifested strongly in Queensland. The water industry has not placed enough emphasis on attraction, retention and up skilling. With a workforce with a high average age, retirement of baby boomers will have a large impact on the industry over the next five years. (sub. 20, p. 6)

Similarly, WSAA (sub. 29, p. 33) note ‘many areas of New South Wales are unable to attract skilled staff owing to declining populations and the associated reductions in the provision of community services’. Kempsey Shire Council (sub. 30, p. 20) expect that there will be ‘major shortfalls in staff capabilities and a significant loss of expertise due to retirement over the next 5–10 years’ and that this shortage will coincide with increasing demand for skilled people to operate high technology treatment plants.

Skills shortages were identified as a problem in the Tasmanian urban water sector pre-reform: Tasmania’s population is highly dispersed, which gives rise to diseconomies of scale … This unfavourable statewide situation is arguably compounded by the existing structure of the water and sewerage sector, which sees the business in the hands of 28 owners, each competing for skilled resources and operating at a sub-optimal scale. (MWST 2006, p. 11)

In 2008, COAG asked the International Centre of Excellence in Water Resources Management (ICEWaRM) to undertake a national audit of labour and skills shortages in the water sector (National Water Skills Audit). ICEWaRM reported in June 2008, and predicted a significant emerging skills gap in the Australian water sector. ICEWaRM foreshadowed that nearly half of those employed in the water sector in 2018 will need to be new recruits, and many will require tertiary training. Areas of key skills shortages include science and engineering, management, and technical and trades areas. These shortages were forecast to persist into the foreseeable future (ICEWaRM 2008).

The reasons for reported skills shortages are numerous. Armstrong and Gellatly, identified the following drivers (2008, p. 94):

• utilities cannot offer competitive remuneration

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• graduates are attracted to city areas

• the number of graduates from disciplines such as engineering are insufficient relative to demand

• the ageing profile of the industry, and looming retirements.

A number of regional utilities demonstrated that they are actively trying to manage this impending labour shortfall via a range of traineeships, mentoring programs, succession plans and incentives to attract, retain and train new staff. For example, Kempsey Shire Council (sub. 30, p. 20) have commenced a ‘grow our own expertise’ scheme, that focuses on up-skilling staff and mentoring employees. Water Quality Research Australia commented: Water Quality Research Australia also addresses the ongoing national need for a sustainable training program for young water professionals, in a climate of limited national investment in training, by offering a strong education and training program which focuses on developing tertiary-qualified individuals, skilled in research up to a postgraduate level for the water industry. (trans., p. 274)

In 2009 — in response to the ICEWaRM audit — COAG committed to a National Water Skills Strategy to address skills shortages in the water industry. The four objectives of the strategy are (DEWHA 2009):

• attract and retain skilled staff in the water industry, whilst giving due consideration to the effects of market forces on staff availability, including in rural and regional areas

• augment the technical skills base in the water industry, through actively promoting demand for skills development and training

• improve the training and skills support base for rural water managers (such as councils and property managers)

• develop a capacity building strategy for remote and regional communities, particularly Indigenous communities, to build practical skills in water resource management and planning.

In support of the strategy, the Australian Government agreed to fund a range of initiatives from the Raising National Water Standards program of the NWC, including (DEWHA 2009):

• a pilot program to trial development of training in water management skills for remote and Indigenous communities

• development of skills and training standards for operators of potable water treatment facilities

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• the H2Oz water industry marketing campaign (the water industry’s own initiative aimed at addressing the skills shortage).

The Australian Government also agreed to provide funding to enable the Australian Water Association (AWA) (on behalf of the Water Industry Skills Taskforce (WIST), and with support from the NWC) to develop a business plan to implement the COAG National Water Skills Strategy.

Notwithstanding these efforts, there is a genuine fear throughout the sector that regional water utilities will not be able to resource their businesses effectively, posing serious risks for the quality, safety and reliability of services provided by these businesses. This concern is particularly acute amongst smaller regional water utilities: Skills shortages are likely to be more pronounced in smaller local water utilities … as a result of a reduced population, and therefore, skills base to draw from … large water utilities are less likely to experience chronic skills shortages as a result of their customer base including a large town/regional centre, and their ability to compete for skills in a competitive human resources market. (Armstrong and Gellatly 2008, p. 90)

As the technological sophistication of the sector increases, for example, in response to greater use of recycled water, this skills problem may be exacerbated, putting further pressure on utilities. LGAQ commented that where existing assets are replaced with more advanced ‘new technology’ plants, regional water utilities often do not have sufficient skills to operate these assets, and incur additional costs finding and attracting the required staff (sub. 20, p. 14). AECOM observed that ‘treatment plant operators working in regional areas do not receive access to the same level of training provided in the larger metropolitan areas’ (2010, p. 19).

Water utility aggregation is not expected to solve the skills shortage problem altogether. In practice, it is likely that a range of complementary short-term and long-term measures will be required to ensure the long-term sustainability of the water industry workforce. Water Quality Research Australia suggested: It is … critical that quality frameworks and qualified operators for water supplies are implemented. Competency based training and qualifications for operators, as well as a skilled professional workforce within the water industry, will help to ensure the provision of safe water for consumers. Investment and activities that encourage this should be very highly supported. This requirement is becoming more of an imperative because of the issues associated with an ageing workforce and the loss of significant industry, but also corporate knowledge in operating water services. There needs to be consideration on how to mitigate the issues associated with a loss of key staff, which will range from senior management through to technical operators, to assist in limiting the impact on the water industry in the long term and the provision of safe water to consumers. (trans., p. 276)

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Notwithstanding the complexity of the labour shortage problem, it is expected that structural reform (aggregation) will provide utilities with greater scope to share resources, thereby reducing total demand for skilled labour via workforce rationalisation. In addition, aggregated water utilities may be more effective in attracting and retaining skilled staff, for example, by virtue of their organisational structure or geographic location. In this sense, utility aggregation — where it is efficient — can form one part of the solution to the skilled labour shortage problem in the urban water sector. This is consistent with the findings of Armstrong and Gellatly: A suite of measures [should] be implemented in coordination with one another … [including] incentives to communities of small water utilities to undertake training … pooling human resource needs amongst local water utilities, increasing size of local water utilities, providing skills development opportunities for local water utilities’ staff, outsourcing skills needs to the private sector and increasing the capacity of training and development organisations. (Armstrong and Gellatly 2008, p. 5)

Compliance with public health and environmental regulations and standards

Non-compliance with public health and environmental regulations is not unique to regional water utilities. However, the incidence of non-compliance tends to be higher in regional areas relative to metropolitan cities. Compliance with the 2004 Australian Drinking Water Guidelines (ADWG) is a particular issue for regional water utilities2. The AECOM report documents a range of problems with drinking water quality throughout regional Australia (2010, p. 15):

• Water supplies to five of the 18 selected towns in Victoria were affected by algal blooms in the 2007-08 reporting period, while three of the selected towns issued boil water notices.

• Three of the seven towns in the Northern Territory reviewed by AECOM showed non-compliance for total coliforms, indicating inadequate treatment, poor disinfection or recontamination issues.

The three recently established water and sewerage corporations in Tasmania continue to face difficulties complying with public health and environmental regulations, a legacy of the local council water utilities the corporations replaced:

2 Compliance with the ADWG is not mandatory. However, the NWC reports on utility compliance against these guidelines (NWI Indicator H3). Individual (jurisdiction-based) regulatory agencies are responsible for managing drinking water quality. Some jurisdictions use the ADWG as the relevant drinking water standards and monitor utility compliance against these guidelines. In other regions, a separate set of standards applies (although these standards are generally based on the ADWG).

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We have a large number of boil water alerts, generally serving low population numbers. My business [Southern Water] has a proportionately high number of water and wastewater failures per 100 kilometres of pipeline compared to any of the other benchmarks that are out there. (Southern Water, trans., p. 408)

OTTER reported that in 2009-10, 24 small drinking water supply schemes (servicing 1.1 per cent of the Tasmanian population) operated with a permanent boil water alert. In total, four per cent of the Tasmanian population serviced with reticulated water supply received non-compliant drinking water in 2009-10 (OTTER 2011). Similar problems were observed with respect to wastewater services: The Tasmanian water corporations are underperforming … Major utilities (those with between 50 000 and 100 000 customers) in other states generally achieved higher than 99 per cent compliance of sewage treatment, while Ben Lomond Water and Southern Water reported only around 94 per cent compliance (volume-weighted). Similarly, Cradle Mountain Water’s sewage compliance is well below the expected levels, and compared to other non-major utilities across Australia (those with between 20 000 and 50 000 customers), is performing below the average, with only 85 per cent of sewage volume compliant with regulatory limits. Other similar sized water utilities reported an average 94 per cent compliance (excluding Power and Water in Darwin) of treated sewage in 2008-09. (OTTER 2011, p. 90)

In 2008-09, 99 per cent of the 20 700 drinking water samples tested in New South Wales were compliant with the ADWG. However, the non-compliant samples were virtually exclusive to the regional water utilities. Specifically, 12 regional utilities (each serving between 1000 and 5300 properties) were deemed non-compliant3 with the ADWG (NSW Office of Water 2010a).

A common explanation for poorer utility performance against public health and environmental obligations in regional areas is insufficient internal resources and capability, including a lack of skilled staff, and inadequate infrastructure, asset maintenance, and operating processes — circumstances that tend to be most common amongst smaller water utilities. In contrast larger utilities, by virtue of having greater access to financial resources and specialist skills, are more likely to achieve compliance with regulatory standards: Smaller utilities have a much lower compliance with best-practice management requirements than large ones. It is important to recognise that this is not a reflection on the ability of staff in small utilities who are almost all doing exceptionally well in trying circumstances. Rather, it is a reality that corporate structures, access to specialist technical skills and financial resources offer the opportunity to be proactive and to

3 For an individual water utility to comply with the ADWG, the required number of samples must be tested and at least 98 per cent of the samples must contain no E.coli.

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consistently meet planning, public health and environmental requirements. (Armstrong and Gellatly 2008, p. 25)

Evidence of positive correlation between utility size and regulatory compliance is found in Queensland and New South Wales. LGAQ (sub. 20, p. 14) refer to a study undertaken by DERM that found compliance with drinking water quality standards is correlated with the size of service providers — while statewide 0.57 per cent of samples contained harmful organisms, across small service providers (under 25 000 connections), the incidence per sample rose to 3.31 per cent. Likewise, large utilities in New South Wales have a significantly higher level of overall compliance with the Best-Practice Management of Water Supply and Sewerage Guidelines relative to smaller utilities (Armstrong and Gellatly 2008).

A number of inquiry respondents pointed out that non-compliance by smaller regional water utilities is not necessarily a reflection of operational inefficiencies, but more a consequence of the extremely challenging supply and demand conditions faced by these businesses (conditions which are generally outside of the control of the utility), rendering compliance uneconomic and/or infeasible. Water Quality Research Australia commented: In Queensland and New South Wales there are smaller entities producing water that, due to economies, it’s difficult for them to … actually meet some of those guidelines … there’s a perception that those utilities aren’t either doing their job or they’re not providing safe drinking water. It’s often the fact that they’re doing their best to provide the safe drinking water within the boundaries that they have, but it might be that the total level of salt is higher than what the ADWG says, whereas they might have a 100 per cent E coli compliance. So it can be very difficult. (trans., p. 278)

Similarly, Armstrong and Gellatly (2008) found that regional water utilities have more water main breaks, sewer main chokes and sewer overflows relative to the New South Wales median. However, the majority of sewer breaks and chokes are beyond the direct control of utilities — such incidents usually increase during times of drought, and as a result of storm events (Byrnes, Crase, Dollery and Villano 2009).

Notwithstanding this general trend, non-compliance with the ADWG is certainly not unique to small and/or financially unviable water utilities. In New South Wales, Cowra, Yass Valley and Gunnedah were all non-compliant with the ADWG in 2008-09 (NSW Office of Water 2010a). AECOM (2010, p. ii) found that ‘even those utilities that earn sufficient revenue to allow a dividend payment to State Government shareholders sometimes fail to supply high quality drinking water’ and ‘all states demonstrate water quality results non-compliant with the ADWG’. AECOM conclude that there are insufficient institutional incentives for utilities to achieve compliance.

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Structural reform is not the only way to improve utility compliance with public health and environmental regulations and standards. However, aggregation is expected to provide utilities with greater financial capacity to undertake efficient investment, and better access to skilled staff, which in turn should improve utility performance against these standards. Notwithstanding this, to guarantee utilities comply with particular standards, regulatory arrangements may also be required. This is discussed in more detail in section 13.4.

Regulatory and administrative burden

A number of respondents to this inquiry commented on the high costs imposed on water utilities by the existing regulatory and legislative framework, and considered that regional utilities face proportionally greater costs and difficulties managing these requirements relative to metropolitan utilities.

Specifically, respondents consider the existing arrangements to be excessive, cumbersome and inconsistent, and in some cases, an impediment to efficient service provision. Submitting parties commented on the non-trivial burden that performance reporting to government agencies imposes, and the overlapping and fragmented roles and responsibilities of government agencies involved in urban water matters. These concerns are covered in chapter 5, and can be summarised as follows:

• The level of performance required by regional utilities has trended upward over time, and these standards (particularly with regard to public health and environmental outcomes) are not determined with reference to costs and benefits.

• Reporting requirements on regional utilities have increased, both in terms of the frequency of reporting, and the scope of activities that are subject to reporting.

• The legislative and regulatory framework is ad hoc and inconsistent — the roles of government agencies are not clearly defined, and often overlap, causing confusion for water utilities, and exacerbating compliance costs.

A rising regulatory hurdle, in concert with a cumbersome regulatory framework, has direct cost impacts for utilities. Businesses are forced to dedicate greater resources towards understanding their obligations, and achieving (and demonstrating) compliance. Kempsey Shire Council (sub. 30, p. 18) commented ‘environmental and public health standards have led to a significant increase in the capital and operating costs of water utilities’. Likewise, Water Quality Research Australia considered:

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It must be recognised … that there is a cost in meeting legislative requirements, resourcing, monitoring and reporting costs. These are often intrinsic, often hidden costs at the moment, that are needed to develop, maintain and audit compliance. These costs should be duly acknowledged as a necessary cost of business. (trans., p. 275)

The NSW Office of Water claim that rising sewage standards explain a significant component of recent increases in utility costs: More stringent requirements for compliance with the Department of Environment, Climate Change and Water (DECCW) licences for larger sewerage systems (these often require nutrient removal and disinfection facilities), are a key driver of OMA (operating, maintenance and administration) costs in New South Wales … the statewide median OMA cost has risen from $240 to $340 per property over the past 17 years, largely due to more stringent standards for sewage treatment and increased management costs. (NSW Office of Water 2010a, p. 42)

There is a widespread concern amongst utilities that revisions to regulatory arrangements are not made on the basis of rigorous cost–benefit analysis, and in particular, do not consider the cost impacts on water utilities and the communities they serve.

Similar themes emerged as part of the Armstrong and Gellatly inquiry, with submitting parties noting that ‘agencies often have conflicting or overlapping goals and objectives and local water utilities are forced to deal with these’ (2008, p. 70). The inquiry recommended that the ‘reporting and regulatory roles undertaken by State Government agencies be reviewed with a view to streamlining these requirements and to ensure a consistent approach across these agencies’ (2008, p. 5).

Way forward

Regional water utilities face a range of complex economic, demographic and geographic challenges, and there is no ‘one size fits all’ solution to addressing these issues. In certain cases there may be no solution, as some of these issues reflect the reality of water supply and wastewater service provision in regional areas, and will not be removed or even alleviated via reform.

Notwithstanding this, the Commission expects that the universally applicable reforms (chapter 11) will lead to material efficiency gains in the regional water sector. In addition, some of the problems confronting these utilities are driven by the sub-optimal operating scale of businesses, suggesting there is also a role for structural reform.

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In particular, horizontal aggregation of water utilities is expected to lead to operational efficiencies in some regional areas of Queensland and New South Wales. The principal motivations for pressing ahead with aggregation are to establish utilities with sufficient financial capability and skilled staff to deliver efficient and safe water and wastewater services. Other potential benefits of utility aggregation, such as better water system planning and resource management, can also be important. The undertaking of such reform in Tasmania and regional Victoria, and recent contemplation by the New South Wales Government of a regional reform process, adds further weight to this claim.

However, structural reform does impose various costs — in particular, there will be costs involved with establishing the new water utility, and aggregation implies the transfer of relevant assets and revenue away from Local Government councils. However, councils would also be relieved of current and future operating and capital cost obligations, so it is important to consider how the full range of benefits and costs compare (section 13.2). This section does not assess the relative merits of different organisational structures that could or should be adopted by aggregated regional water utilities — these matters are considered separately in section 13.3. The costs and benefits of horizontal disaggregation of large jurisdiction-wide water utilities (as exist in South Australia, Western Australia and the Northern Territory) are considered in section 13.4.

13.2 Case for horizontal aggregation of utilities

The purpose of this section is to set out the potential costs and benefits of horizontally aggregating multiple regional water utilities to form larger utilities. This structural reform option is of most relevance to regional areas serviced by water businesses operating on a relatively small scale, such as throughout regional New South Wales and areas of Queensland outside of south-east Queensland.

For the purposes of this assessment, aggregation implies the transfer of responsibility for water and wastewater service provision, and ownership of related assets, away from Local Government councils. This draft report does not consider the costs and benefits of amalgamating entire local councils, as this is outside of the terms of reference for this inquiry, but it does consider the consequences of removing these services from direct council provision. The regional alliance model is a legitimate alternative approach to water and wastewater service provision. Adoption of the regional alliance model is more appropriately regarded as an organisational reform, and is considered in section 13.3.

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Motivation

Horizontal aggregation involves increasing the operating scale of regional water utilities (that is, the number of properties served by the utility), and may involve a pair of neighbouring water utilities, or a large groups of utilities within a defined geographic region. Aggregated utilities may elect to operate as a water corporation or as a county council (box 13.1).

Unlike the reform options proposed in chapter 12, aggregation is not motivated by the achievement of competition or contestability in water and wastewater service provision. Rather, the primary rationale for contemplating aggregation of regional water utilities rests on the ‘non-competition’ related efficiency benefits that might follow (section 12.1). These benefits include economies of scale efficiencies, better access to skilled staff, greater regulatory compliance and more effective water system planning and resource management.

However, structural reform is not without costs. The precise benefits and costs of aggregation in regional areas depends on the way in which aggregation is undertaken, and the size and compositions of the aggregations that result. There are no hard and fast rules around how regional water utilities should be aggregated to realise the greatest benefits from structural reform. Rather, this will depend on the location, characteristics and circumstances of affected regional water utilities.

Approaches to aggregation — the evidence

In the case of New South Wales, Armstrong and Gellatly (2008) were guided by six criteria in determining the appropriate size and composition of utility aggregations:

• there should be at least one major regional centre per aggregation

• aggregated utilities should have annual revenue of at least $10 million

• aggregated utilities should have at least 10 000 connected properties

• the boundaries of the aggregated utility should be sensitive to catchment boundaries

• consideration should be given to existing alliances between local water utilities

• aggregations should reflect the views of respondents to the inquiry process to the fullest extent possible.

The criteria that drove the reform process in Victoria (and the identification of appropriate regional groupings in particular) included (Gleeson 1999):

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• commercial viability (including a minimum revenue base of $10 million per annum, debt servicing of less than 30 per cent of revenue and capability to self-fund future capital works)

• ability to meet the requirements of operating licences (including water and wastewater quality standards and customer service guarantees)

• capacity to provide a commercial return to the State Government as the shareholder (via licence fees, tax equivalents and commercially-based dividends)

• water systems (consideration of natural water catchments and regional water infrastructure).

Similar criteria informed the Tasmanian urban water reform process. In particular, better coordination of water and sewerage infrastructure provision with land-use planning decisions was regarded as a key driver of reform in Tasmania (MWST 2006).

These factors are all highly relevant considerations in determining the most efficient approach to aggregation of regional water utilities. In particular, it is critical that decisions about how to aggregate take explicit account of matters other than scale, and do not rely too heavily on the presumption that bigger is better. Despite the multitude of ways that aggregation might be pursued in regional areas, there are a number of generic benefits and costs that are likely to materialise in varying degrees. These benefits and costs are identified below.

Benefits of aggregation

Economies of scale efficiencies

By definition, the aggregated water utility will serve more customers relative to the stand-alone water utilities it comprises. This may allow the utility to earn more revenue, with a less than proportionate increase in costs. Where this is the case, aggregation is considered to have revealed ‘economies of scale efficiencies’ (section 12.1).

For example, an aggregated businesses may be able to service all customers using one wastewater treatment plant in place of multiple plants, or deal with all customer complaints via a single complaints department. An aggregated utility may also realise economies of scale in procurement, administration and training (Armstrong and Gellatly 2008). Likewise, there may be scale benefits with regard to accessing funding for capital projects and servicing debt, with flow-on benefits for asset

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management. For example, larger utilities are more likely to have the appropriate financial strength to access debt funding to undertake efficient investment.

It is common for industry participants to anticipate efficiency gains from aggregation of smaller utilities, all else equal, For example, the NSW Office of Water (2010a, p. 22) note ‘there are significant economies of scale for large utilities, particularly the capital cost of infrastructure and the operating cost of water treatment works’.

Evidence of scale efficiencies is provided by the recent Tasmanian urban water reform experience: Reform has provided the scope for the rationalisation of overloaded and ageing assets that were previously constrained by lines on a map. Combining existing systems and decommissioning assets which are either antiquated or surplus to requirements offers potential to make more efficient use of existing facilities and in doing so, realise significant capital, maintenance and operational cost savings. (Tasmania Water and Sewerage Corporations, sub. 43, p. 5).

The reform process in Tasmania provides some important insights with regard to the benefits, costs and risks of pursuing aggregation, as detailed in box 13.2.

The reform process undertaken in Victoria also provides evidence of cost savings from aggregation. For example, Gleeson (1999) suggests that reform lead to reductions in operating costs across the industry of between 20 and 35 per cent. Dollery, Keogh and Crase (2005) found more modest cost savings, suggesting amalgamations delivered an 8.5 per cent reduction in costs. The AECOM report (2010) also points to evidence of economies of scale in water supply, noting that larger water utilities service their regional communities at relatively lower cost, with the annual water bill in Victoria being approximately 20 per cent cheaper than the annual bill in regional New South Wales, and nearly 30 per cent cheaper than in regional Queensland.

However, it is important to recognise that urban water reform in Victoria coincided with local council amalgamations and corporatisation of regional water businesses. In this context, it would be misleading to attribute all of the efficiency benefits of this reform process to an increase in operating scale alone, or to expect that the same sorts of benefits will materialise in other regions where local councils are not amalgamated simultaneously, or a corporation structure is not adopted.

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Box 13.2 Lessons from Tasmanian reform The Tasmania Water and Sewerage Corporations (sub. 43) identify a series of ‘lessons learned’ from the recent reform process.

Government interference Government intervention should be limited to rebates for disadvantaged customers, and independent economic regulation should be allowed to work. In Tasmania, the Government has imposed blanket bans/caps on price increases, which is constraining the ability of corporations to generate sufficient revenue for necessary capital investment and service improvements.

Managing council expectations Effective consultation and communication with member councils during the reform process is crucial. Following reform in Tasmania there were high expectations amongst the corporation’s council owners regarding the return they would earn. At the same time, the corporations were (and are) encountering high costs, which is limiting the return paid to councils. This has led to some tension between councils and the corporations, which might have been avoided if the councils better understood how the corporatised model would work. Government should fund uneconomic service provision Some Tasmanian customers assumed that reform and corporatisation would mean existing un-serviced areas would begin to receive reticulated services. Introduction of services to these areas would impose significant capital costs on water corporations. Any government commitment to roll out reticulated water supply to un-serviced areas that are otherwise uneconomic for the corporation to supply must be aided by gap funding by government.

Source: Tasmania Water and Sewerage Corporations (sub. 43).

Where aggregation does move utilities closer towards minimum efficient operating scale (section 12.1) (and therefore give rise to scale efficiencies), the financial position of the water utility will improve, with flow-on benefits for consumers — including lower prices and improved service quality. In addition, as more utilities become financially independent, reliance on government funding will subside, reducing pressure on consolidated revenue. Gleeson considered that urban water reform in Victoria led to significant savings for the State Government: During the 1997/98 year the non-metropolitan water industry paid a dividend to the State Treasury of $20.6 million. This is a $50 million turn-around in the impact of water supply on Treasury. (Gleeson 1999, p. 9)

In practice, the extent to which aggregation leads to scale economies will depend on a range of factors. For example, LGAQ (sub. 20, p. 8) caution ‘economies are not easily achieved where a large number of small communities are spread at great

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distance’. For this reason, the magnitude of scale benefits (if any) from horizontal aggregation must be assessed on a case-by-case basis, with due regard to the specific circumstances of the region (chapter 12).

Aggregation should also be undertaken with due regard to the limitations of economies of scale in mind. That is, there is a point (beyond minimum efficient scale) where there is a net cost from increasing scale further (or put another way, where decreasing returns to scale set in) (figure 12.1 — chapter 12). Where utilities operate above minimum efficient scale, there may be a net benefit from breaking up the utility. For example, in South Australia, Western Australia and the Northern Territory a single utility currently provides water and wastewater services to virtually the entire jurisdiction. It is worth investigating whether these services would be more efficiently provided if multiple regional utilities were established to service discrete geographic areas, as in Victoria. This is discussed further in section 13.4.

As discussed in chapter 12, structural reform has the potential to improve the productive and technical efficiency of regional water utilities, holding scale impacts constant. That is, structural reform may move utilities closer towards the efficiency frontier (figure 12.1, chapter 12) by reducing other costs or revealing additional opportunities for efficiency gains. The various non-scale related efficiency benefits that horizontal aggregation might give rise to are described below.

Skills shortages

The potential benefits of aggregation for alleviating skill shortage problems are two-fold — larger organisations may:

• have greater capacity to attract and retain skilled staff

• be able to rationalise their workforce (relative to the predecessor stand-alone utilities).

A number of respondents considered that larger regional water utilities (formed via aggregation) will be more capable of attracting and retaining skilled staff (including financial and asset management planners) relative to small, stand-alone utilities. Kempsey Shire Council (sub. 30, p. 10) commented ‘larger utilities will offer the benefits of providing greater opportunities for training, career paths and progression’. Likewise, LGAQ (sub. 20, p. 8) noted ‘group access to specialised senior staff is seen as a strong benefit for regional collaboration’. However, LGAQ also cautioned that skills shortages at the operational level will not necessarily be solved via amalgamation.

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Armstrong and Gellatly reached a similar finding: Larger organisations serve to provide staff with opportunities to move professionally up through the organisation. This can be very attractive to prospective employees, and may serve to reduce the degree of industry ‘churn’. (Armstrong and Gellatly 2008, p. 91)

In Tasmania, the MWST identified greater skills availability as a key benefit for structural reform: Increased scale would improve the ability to attract and retain key staff. This is of particular importance given the skill shortages for engineering and technical expertise that exists nationwide. Career opportunities for key staff would also increase, which would assist in retaining essential skills in Tasmania. (MWST 2006, p. 11)

Aggregated utilities may also be able to reduce the size of their workforce overall, for example, if there is capacity to allocate skilled labour resources more efficiently. The extent to which this is possible will depend on a range of factors, such as the distances that staff have to travel to carry out their functions, and the number (and type) of assets (including networks) managed by the utility. Armstrong and Gellatly indicated that aggregation will provide less scope for rationalisation of operational staff relative to non-operational staff: Councils that are proposing the transfer of water supply and sewerage assets and operations to another entity do not expect an impact on operational staff because customer service levels would need to be at least maintained following the transfer. The impact of the transfer is more likely to affect some managerial and administrative staff. (Armstrong and Gellatly 2008, p. 47)

On balance, aggregation may reduce the skilled labour problem facing many regional water utilities (but it is not expected to solve it entirely). Specifically, aggregation may provide regional water utilities with greater capacity to:

• develop and implement asset management plans

• comply with relevant regulations

• improve financial planning processes

• plan for and manage complex issues such as drought and climate change.

Notwithstanding these benefits, the issue of insufficient skilled labour in the water industry is a much broader problem, and should be addressed directly.

Asset management and compliance with regulatory standards

A common definition of asset management is ‘the systematic and coordinated activities and practices through which an organisation optimally manages its

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physical assets and their associated performance, risks and expenditures over their lifecycles for the purpose of achieving its organisational strategic plan’ (Hooper, Gallagher and Armitage 2009, p. 6). The water utility industry is one that faces numerous asset management issues due to large inventories of different asset types including mechanical equipment, electrical equipment and civil infrastructure (Mathew, Zhang, Ma and Hargreaves 2006).

Appropriate asset management is a critical pre-requirement for regional utilities to deliver efficient services and achieve compliance with regulatory standards. Under the current arrangements, the relative expense of investing in and maintaining water supply infrastructure for small towns often means that capital projects are unviable for the water utility. This poses serious risks for public health. For example, AECOM (2010) observe that many small towns are currently without water treatment because the increase in residential bills required to recover the cost would be substantial.

To the extent that regional water utilities do realise economies of scale efficiencies following aggregation, the consequent improvement in the financial position of these businesses will provide utilities with greater capacity to invest in water system infrastructure, leading to direct asset management benefits. Greater access to skilled labour by aggregated utilities will also be important in driving better asset management outcomes. This will improve the quality of water and wastewater services, and utility compliance with water quality and environmental standards. Higher standards of services may also have economic and social benefits, for example, as a community becomes more attractive to live in, this will boost regional development and employment.

In sum, better asset management (and the efficiency gains that flow from this) is a direct and significant benefit of achieving scale economies and greater access to skilled labour.

Transaction costs

Water resource management and water system planning

Aggregation will reduce the costs of regional water utilities collaborating on issues that are common to the region. In particular, water resource management and water system planning may be more efficient and effective under the aggregated model. For example, where multiple regional water utilities share a common bulk water source, such as a dam or river, aggregation will remove the coordination and transaction costs involved with management of that resource. Likewise, where a

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single utility is responsible for a water asset, the risks associated with individual utilities having inconsistent or conflicting asset management plans and policies is avoided.

The aggregated utility is also expected to take a more region-wide approach to water system planning relative to the predecessor local council utilities. In assessing the case for urban water reform in Tasmania, the MWST noted: Under the current arrangements, decisions on land-use planning and the provision of water and sewerage infrastructure lies in the hands of … Local Government. There are examples in some municipalities where there appears to be a disconnection between land-use decisions and water and sewerage infrastructure provision and, as a result, serious issues have emerged .… planning may also be inhibited by a narrow (but arguably legitimate) focus of council activities to their own discrete geographical areas within their municipalities. (MWST 2006, pp. 10–11)

AECOM (2010) suggested that it is inefficient for water planning to be defined by local government boundaries when water resources are managed on a catchment- basis. Armstrong and Gellatly (2008, p. 29) considered that aggregation will support ‘increased ability to coordinate integrated water cycle management across whole catchments’, relative to the status quo. The Institute for Sustainable Futures noted: Each interface between one entity and another in the whole spectrum of planning for and providing community services and activities creates a potential barrier to achieving fully integrated service provision, IWCM [integrated water cycle management], holistic planning, including land-use planning and strategic community planning, and all the other desirable goals associated with Fourth Generation Urban Water Management. (Institute for Sustainable Futures 2008, p. 11)

More efficient and cost-effective resource and environmental management was a key motivation for the recent horizontal aggregation of water utility businesses in Auckland (appendix C).

Other coordination costs

Aggregation may also reduce the transaction costs associated with regional utilities interfacing with State and Territory Government departments. In particular, the administration and regulatory costs of coordination with government agencies (for example, with regard to administering public health and environmental regulations, performance reporting, licensing arrangements and policy development), are likely to fall following aggregation, due to the smaller number of water utilities in regional areas that government agencies must engage with.

Although aggregation might reduce total transaction costs in some circumstances, it is important to recognise that organisations can become ‘too big’, and that there is a

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natural limit to what can be efficiently undertaken within one organisation. This point is best made by Ronald Coase: As a firm gets larger, there may be decreasing returns to the entrepreneur function, that is, the costs of organising additional transactions within the firm may rise. Naturally, a point must be reached where the costs of organising an extra transaction are equal to the costs involved in carrying out the transaction in the open market. (Coase 1937, p. 394)

In circumstances where utilities are inefficiently large, the costs and complexities of internalised operations and decision making become significant, and the most appropriate remedy may in fact be to disaggregate the integrated entity (section 13.4). If aggregation is expected to produce a utility that is at risk of decreasing returns, the case for structural reform becomes considerably weaker.

Yardstick competition

Consolidation of regional water utilities is not motivated by the pursuit of competition, and does not provide opportunities for competitive pressure to develop in the same way that vertical and horizontal separation does (chapter 12). However, aggregation may provide scope for some form of comparative performance reporting, or ‘yardstick competition’, between aggregated regional water utilities (section 12.1).

To the extent that two or more of these regional water utilities face broadly similar supply and demand conditions, there may be an opportunity to use data and information about their individual performance to drive efficiency gains across the sector. This has been one of the benefits of urban water reform in Tasmania, as pointed out by Southern Water (trans., p. 403), ‘comparative competition has been very good and an important part of our start-up’. Kempsey Shire Council (sub. 30, p. 14) considered that aggregation will ‘provide for a level of soft competition … in relation to pricing and financial performance’.

Yardstick competition also provides strong incentives for innovation by regional water utilities. A number of respondents to this inquiry suggested that this has been a significant benefit of establishing yardstick competition between the three metropolitan Melbourne retailers (section 12.1). Greater scope to meaningfully compare the performance of larger-scale regional water utilities is also expected to generate rivalry between utility managers, with corresponding benefits for utility performance.

Currently, there is no comprehensive performance reporting or benchmarking of all Australian regional water utilities, although significant inroads have been made in

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recent years. For example, the ESC and the NSW Office of Water report on the relative performance of regional water utilities in Victoria and New South Wales respectively. The WSAA and NWC National Performance Report series has been important in driving improvements in utility performance, and building the case for further reform of the urban water sector. However this reporting is limited to utilities that serve more than 10 000 properties and therefore excludes a large number of regional water utilities.

Benchmarking the performance of all Australian urban water utilities is unlikely to be a cost-effective or particularly informative exercise under the current arrangements due to the (large) number and (small) size of some regional water utilities, and the sensitivity of individual utility performance to respective local conditions. As discussed in chapter 12, the value of performance benchmarking is highly dependent on the extent to which utilities can be meaningfully compared on a common set of metrics. To the extent that aggregation produces fewer utilities of larger scale, the case for undertaking comprehensive national benchmarking of regional water utilities is likely to improve.

Other efficiency benefits

There is potential for aggregation of regional water utilities to give rise to a number of additional efficiency benefits. These benefits are not expected to rival those stemming from economies of scale, or the increased capacity of utilities to attract skilled resources, but may be important nonetheless.

Economies of scope

Aggregation may lead to economies of scope efficiencies if, for example, water and wastewater services receive more focus when they are delivered via a specialised water body (such as a water corporation) following aggregation, compared to where these services are provided by general purpose local councils. Kempsey Shire Council considered: Most water utilities in New South Wales are managed by general purpose Councils whose major focus is on issues other than water and sewer. This situation often leads to water and sewer issues only receiving secondary consideration. This situation is exacerbated in smaller Councils where management and technical staff also share general purpose roles. In these situations the level of focus on water issues is often minimal due to external pressures, rather than the needs of the water utility operation. (sub. 30, p. 14)

Some commentators view this as a key benefit of urban water reform in Victoria. Gleeson considered:

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In Victoria, many local councils viewed their water supply functions as just another municipal department, ranking alongside rubbish collection and parks and gardens in importance. This approach … stifled initiative and creativity, resulted in inadequate funding of infrastructure investment, replacement and maintenance, and a failure to embrace new technologies and strategies. (Gleeson 1999, p. 4)

Competitive outsourcing

Aggregation may lead to greater use of competitive procurement and outsourcing practices, with associated efficiency benefits. For example, larger utilities, due to their increased buying power, may have greater capacity to secure goods or services from the private sector at more cost-competitive levels. The Tasmanian Water and Sewerage Corporations (sub. 43, p. 6) note that reform has ‘provided the ability to combine like capital projects to provide a more attractive package of work to external providers’ and consider there may be further gains in this area: There is an opportunity for this to be done between the corporations such that larger national companies might also be attracted into the market. Similarly there are opportunities to look outside our own sector, possibly in combination with utilities such as electricity and gas, to leverage longer-term maintenance contracts with larger national firms. (Tasmanian Water and Sewerage Corporations, sub. 43, p. 6)

Notwithstanding the range of potential benefits from aggregation, opponents of such reform have identified a number of potential costs and risks. These are considered below.

Costs of aggregation

Financial implications for local councils

Assets and revenue

A number of inquiry participants (mainly local governments and their representative organisations) expressed serious concerns about the impact of water utility aggregation on local council revenue and overall financial viability. The Local Government and Shires Associations of New South Wales (LGSA NSW) noted: The provision of water supply and sewerage services is a significant responsibility, often making up a quarter or more of councils’ annual budget and employing a significant number of their workforce … institutional reform, particularly reform that would remove water supply and sewerage functions from Local Government, needs to be thoroughly assessed against the impacts it might have on the financial sustainability of councils and on local and regional economies and employment. (sub. 63, p. 4)

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Similarly, Dollery warned against regionalisation of non-metropolitan water authorities: One predictable consequence (of aggregation in Tasmania) has been a sharp deterioration in the fiscal viability of the affected councils. This suggests that claims centred on the efficiency gains from ‘regionalisation’ of municipal water authorities should be tested carefully. In general, it would appear that the ‘regionalisation’ of local water authorities will inflict economic and social damage … this should be carefully considered since water revenue often represents a high proportion of total council income. (Dollery, B, sub. 1, p. 1) A number of respondents to the Armstrong and Gellatly inquiry strongly advocated retaining Local Government ownership of water system infrastructure to preserve the financial sustainability of councils: The adverse impact on general fund functions from removing water supply and sewerage functions from the ambit of direct local council responsibility is a major determinant to the organisational structure model that councils prefer to operate under. About 90 per cent of councils have opted for ‘no change’ or binding alliance, both of which ensure that assets and operations remain in the ownership and control of councils. (Armstrong and Gellatly 2008, p. 45)

Despite these concerns, some local councils that responded to this inquiry supported aggregation of regional water utilities, including the transfer of assets out of local councils. Midcoast Water (sub. 51) proposed that the New South Wales Government reduce the number of water authorities in regional New South Wales to 14. Kempsey Shire Council (sub. 30) also supported the aggregation of regional water utilities, with appropriate transitional arrangements to minimise the financial impact on local councils (box 13.3).

The Commission recognises that aggregation may have important implications for the way councils do business. While revenue and assets will be lost, so will the current and future operating and capital cost obligations of the water utility. The Commission is not convinced that the financial sustainability of councils is necessarily dependent on the net or gross income from water and wastewater services. Rather, the Commission considers that factors such as the population (and rates base) of the council region, rate capping policies, the governance arrangements and financial management of the council, and the cost of reporting requirements imposed by State and Territory Governments are more critical drivers of council revenue, costs and financial sustainability.

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INFORMATION REQUEST

Do local government financing policies, including restrictions on rate increases, directly or indirectly influence the price setting or investment behaviour of council-owned utilities, and if so how?

In the case of Tasmania, the MWST noted that aggregation could actually benefit local councils: Reducing Local Government’s direct involvement in the delivery of water and sewerage services would mean that councils would assume less financial and political risk associated with maintaining increasingly expensive infrastructure from a small revenue base. They would be able to focus on providing service requirements in other areas that are truly unique to their municipality. (MWST 2006, p. 13)

Economies of scope

The financial implications for local councils are not limited to the loss of water related assets and revenue. A number of respondents referred to the significant synergies within general purposes local councils that would be lost as a consequence of aggregation, with corresponding cost implications. These synergies arise via the sharing of inputs (administrative, managerial, plant and equipment) between the water and sewerage functions undertaken by councils, and other council activities such as roads provision.

The LGSA NSW anticipates that aggregation will lead to significant economies of scale losses: In council-owned and operated water utilities technical and managerial synergies arise from the integration of engineering, asset management and corporate planning systems for water supply and sewerage, roads and transport, communication, waste management, or recreational services. Economies of scope also arise from the ability to effectively and efficiently coordinate strategic land use planning and land use development control with infrastructure intensive services such as water supply and sewerage services as well as private commercial and residential related investment into water solutions… Large, stand-alone water supply and sewerage providers may well achieve some economies of scale, however cannot capture the identified economies of scope. (sub. 63, p. 7)

The issue of scope efficiencies across council activities was also raised by several respondents to the Armstrong and Gellatly inquiry: Economies of scope are an important consideration for general purpose councils. Overhead costs are able to be spread across all functions and this generates cost efficiencies. The water supply and sewerage functions of councils are deeply

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interwoven with the other functions of councils. Billing, customer interface, accounting and finance, human resource management services and other such services are shared by all council functions and the water and sewerage function as a revenue generating arm contributes substantially to the cost of these functions. Councils reported that their water and supply and sewerage revenue can represent up to 35 per cent of total revenue … it is clear from most council submissions that the benefits of economies of scope will be severely diminished with the transfer of water supply and sewerage functions to another entity. (Armstrong and Gellatly 2008, p. 12)

An important synergy for general purpose local councils relates to staff. In many cases, it is the broad range of services provided by general purpose councils that allows councils to attract highly professional staff, and justify the cost of these staff. A number of inquiry respondents suggested that aggregation will make it more costly and difficult to attract skilled staff to local government councils once responsibility for water supply is transferred: The work interest for an engineer in a small council is enhanced by having water as part of the service. Loss of a water service function makes the council vulnerable to loss of key staff for more challenging roles. Similar issues face other professional and trades staff in small councils. (Institute for Sustainable Futures 2008, p. 10)

Similar concerns were conveyed by the LGSA NSW: Water supply and sewerage services contribute to a critical mass of responsibilities that make council viable and attractive for skilled professionals. Especially in smaller councils, these services are a significant part of engineers’ and senior officers’ workload. Employees are often multi-skilled and shared between general purpose functions and water, providing efficient workforce flexibility. Removal of water would eliminate these synergies and result in loss of staff due to insufficient workload, or because their services become unaffordable for councils. (sub. 63, p. 4)

The economies of scope efficiencies between stormwater services, and water supply and wastewater services (including integrated water cycle management), was also raised by inquiry participants. Under the current arrangements, all of these services are provided by local councils (at least in most cases), providing for more integrated, whole-of-water system management and planning. Following aggregation, stormwater services will likely remain the responsibility of local councils, while water and sewerage services will rest with the aggregated utility. This could mean any economies of scope efficiencies between these services are diminished if water supply, sewerage and stormwater services are not well coordinated by separate agencies. The Armstrong and Gellatly inquiry received a number of submissions that suggested ‘the full benefits of integrated water planning will be lost if the water supply and sewerage function is excised from local councils’ (2008, p. 43).

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Job losses and other community impacts

The water supply and wastewater functions of Local Government councils often make a significant contribution to employment in regional areas. The transfer of these assets and services is likely to result in the loss of jobs in areas as new utilities seek to exploit the benefits of greater scale. This impact is expected to be most significant for managerial and administrative staff (Armstrong and Gellatly 2008).

A number of submitting parties to this inquiry suggested that a transitional strategy be developed to minimise any adverse impact on regional employment as a consequence of aggregation. Most of these participants indicated that this should be funded by the relevant state governments (box 13.3).

The impacts of structural reform in regional areas may extend beyond job losses. As local employment opportunities reduce, families may be forced to leave regional areas in search of work, with ensuing impacts for the local community, for example a reduction in school enrolments. These impacts will be further exacerbated if local councils become less viable, or deliver fewer, poorer quality services following the loss of water supply and wastewater functions.

The United Services Union stated: Since the ‘regionalisation’ of water and the forcible removal of local water utilities will have deleterious effects on the economies of small affected communities, setting into play negative multiplier effects and reducing the local population base it will obviously adversely impact upon broader local council sustainability and local community sustainability. (Armstrong and Gellatly 2008, p. 26)

Amalgamation will inevitably mean that service providers are located further away from (at least some of) their customers, relative to the current arrangements. Some participants fear that aggregated regional utilities will be less focused on — and accommodating of — the particular circumstances of individual communities, leading to a deterioration in service quality. The issue of how accountable larger regional utilities will be to local communities was also raised. Respondents expressed a specific concern that drinking water quality could be reduced following aggregation, and that utilities will be less responsive to customer complaints on these matters.

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Box 13.3 Minimising the financial and employment impacts of aggregation on councils Several respondents to this inquiry considered that any adverse financial impacts on councils as a consequence of aggregation should be mitigated by measures such as the receipt of dividends, transitional assistance funding (for structural adjustment) and employment protection provisions.

Dividends Most advocates of structural reform considered that aggregated utilities should be required to return dividends to the legacy Local Government councils (or the state government, as relevant) when they become profitable, to compensate local councils for the loss of water revenue and economies of scope. This is consistent with the current arrangements in Tasmania. The precise approach to dividend payments will depend on the organisational structure of the aggregated entity (regional water corporation or a county council). Financial assistance for affected councils Some parties suggest that State Government funding will also be required to offset short-term impacts for affected Local Government councils, particularly for smaller councils. Transitional funding support was also recommended by several respondents to the Armstrong and Gellatly inquiry: The councils that seek the formation of a council-owned regional water supply and sewerage entity … suggest that State Government transitional funding is required over 3-5 years to bed-in any new arrangements. Dividends and tax equivalent payments to shareholding or member councils would complement the transitional payments. (Armstrong and Gellatly 2008, p. 46)

Employment provisions Centralisation of water functions in a aggregated utility may result in employment redundancies in some councils. This risk is most pronounced for managerial and administrative staff. Staff transfers (where staff are kept on following aggregation but are required to move locations as a consequence) may also be an issue if there are adverse impacts on regional communities from the exodus of staff and their families. Kempsey Shire Council (sub. 30) recommended that transitional employment provisions be made to protect affected employees for up to three years. A similar conclusion was reached by Armstrong and Gellatly: To mitigate the impacts on employment … a transitional strategy needs to be developed and this may need to be funded, in whole or in part, by the State Government as part of an assistance package predicated on reform. (Armstrong and Gellatly 2008, p. 47)

For example, Shoalhaven City Council commented ‘council, as the tier of government that is closest to its customers, is very conscious of the need to balance the competing demand of communities’ (sub. 15, p. 5). The LGSA NSW (sub. 63, p. 5) refer to the geographic, demographic, climate related and socio-economic

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diversity in regional areas, and claim ‘Local Government is best placed to identify local requirements and community preferences and should therefore have the autonomy to establish solutions that suit their local/regional circumstances’. Likewise, the LGAQ (sub. 20, p. 8) warn that ‘combining small and struggling water businesses in the name of economies of scale can result in an amalgamated struggling water business that has the additional burden of cultural issues and poor on-ground links with its dispersed communities’.

The costs of decision makers (utilities) being located further away from their customers is particularly relevant in South Australia, Western Australia and the Northern Territory (where jurisdiction-wide utilities supply virtually all customers). This is considered further in section 13.4.

Concerns about adverse community impacts were also evident in the lead up to reform in Victoria. Gleeson (1999, p. 8) notes ‘the biggest impediment to rationalisation of the industry was the issue of local representation’. However, Gleeson argues that such opposition should not derail the reform process: There is no doubt that replacement of local political representatives with skills based boards has delivered substantial benefits to customers not previously possible — improvements in efficiencies, quality, service and costs. Five years down the track the regional communities at large are very comfortable with the arrangement. Clearly what is important to the customer is the quality of water product, the quality of water services they receive and the price they are required to pay. Our experience is that if you deliver on all these key aspects of utility services, then local representation will not be an issue. (Gleeson 1999, p. 8)

Conclusion

There is considerable scope for (appropriate) aggregation of regional water utilities to give rise to material productive efficiencies for a significant number of local council water utilities in regional New South Wales and Queensland, relative to the current arrangements.

Such reform may improve the financial performance of affected regional water businesses and reduce the impact of water industry skills shortages (all else equal), with corresponding benefits for investment in — and operation of — water supply and wastewater infrastructure, the incidence of utility compliance with a range of public health and environmental regulations and the standards of services delivered to customers.

The precise benefits and costs of aggregation will depend on the characteristics of the affected local council utilities, and should be assessed on a case-by-case basis.

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In particular, it is critical that factors such as network costs, the geography and topology of the area, coordination of water service provision with planning and resource management and distances between urban centres of demand are considered. This work should take full account of the costs imposed on legacy local governments and their communities as a consequence of aggregation, and consider whether there is merit in developing arrangements for mitigating these impacts.

The Commission recognises that New South Wales has already dedicated significant resources towards this type of analysis, culminating in a series of recommendations for aggregation of regional water utilities throughout non-metropolitan New South Wales. The Commission endorses the large majority of the findings and recommendations of the Armstrong and Gellatly inquiry, and urges the New South Wales Government to progress this work as soon as possible.

Specifically, the Commission:

• Fully endorses recommendations 2, 3, 5, 6 and 7 of the Armstrong and Gellatly inquiry report.

• Agrees that amalgamation of regional water utilities will lead to efficiency gains (as implied by recommendation 1) but does not necessarily support grouping these utilities into 32 regional aggregations. Rather, the precise approach to aggregation should be determined by jurisdictions following a comprehensive cost–benefit analysis of aggregation options (including catchment-based groupings, corporatisation of utilities and the establishment of alliances).

• Does not endorse recommendation 4, as the Commission does not consider that it is efficient for water utility prices (regional or otherwise) to be approved by an independent body (chapter 11).

Queensland has also made significant progress toward utility consolidation in recent years (as part of a broader local government reform program), particularly in south-east Queensland. Notwithstanding this, the Commission expects that additional aggregations in other areas of Queensland would be efficient. The Queensland Government should consider the costs and benefits of further consolidation of water businesses in more detail as a matter of priority.

There will be a number of regional water utilities for whom aggregation is not an efficient option. In this circumstance there may be merit in corporatising the stand-alone utility, or conversely, adopting a more informal approach to resource sharing, such as a regional alliance (section 13.3). Alternatively, the best solution may be to retain the current local council water utility model, pending implementation of the various reforms set out in chapter 11. In extreme cases, direct funding from relevant State and Territory Governments may be necessary to ensure

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adequate provision of services, especially in relation to drinking water quality (section 13.4).

13.3 Options for organisational structure

The large majority of regional water utilities in New South Wales and Queensland currently operate as general purpose Local Government councils (section 13.1). However, section 13.2 indicates that there are likely to be efficiency benefits from pursuing aggregation of these regional water utilities in some areas. This means that individual Local Government councils will no longer be directly responsible for providing water supply and wastewater services to their local communities.

In this context, it is necessary to determine how aggregated utilities will actually operate following structural reform, that is, the appropriate organisational model that the aggregated utility should adopt. This section sets out a high-level assessment of options for the organisation of aggregated regional water utilities. In some instances, the case for aggregation will be unclear, but there may be benefit from councils participating in a regional alliance. The relative merits of this model are also discussed.

Organisation of the aggregated utility

Armstrong and Gellatly suggested two structural options for an aggregated water utility that would improve efficiency: a council-owned regional water corporation and a (asset-owning) county council. The common, defining feature of these two models is the transfer of ownership of all water supply and wastewater assets (and related staff), and responsibility for all water and wastewater service provision, from local councils to the aggregated utility.

Regional water corporation

A regional water corporation would be established by legislation as a distinct legal entity and may be owned by the constituent local councils (as in Tasmania) or by the State Government as the single shareholder (as in Victoria). The Commission is not proposing the United Kingdom model of private ownership of regional water companies. The corporations board of directors would be appointed by the shareholders, and the corporation would be able to make dividend and tax equivalent payments to the shareholders.

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Armstrong and Gellatly (2008) regard the Central Coast Water Corporation Act 2006 (NSW) (the legislative mechanism that allowed Gosford and Wyong councils to establish the Central Coast Water Corporation) as an appropriate blueprint for designing future regional water corporations. The Commission does not dispute this finding, but notes that the process the councils went through to establish this corporation was exhaustive and time consuming, and considers that there would be benefits from expediting these processes where appropriate.

Many of the benefits of establishing a water corporation arise as a consequence of the commercial focus and discipline the model implies. For example, a regional water corporation would set and report against a clearly defined set of objectives and targets related to the efficient and effective management of the corporation, and would be accountable for its performance. These arrangements are widely considered to create strong incentives for efficient investment and operation of assets: The larger corporate structure is likely to give rise to increased efficiency. Recent evidence suggests that this (efficiency gain) was the result of governance reform implemented in Victoria during the 1990s. (AECOM 2010, p. 37)

The corporation model is considered to promote informed, independent and objective decision making. Specifically, the corporation model provides for appointment of directors that have relevant specialist skills, and sufficient authority and autonomy to make strategic and commercial decisions regarding maintenance and capital expenditure. This arrangement ensures efficient, cost-effective decisions are taken to secure future water supplies without, for example, undue influence from council politics.

This is consistent with the findings of Byrnes, Crase, Dollery and Villano: Wastewater utilities in Victoria were found to be 22 percent more pure technically efficient when compared to utilities in New South Wales of a similar size … [possible reasons for this include] first, the composition of the boards of Victorian utilities during the period was a function of relative expertise, rather than a proportional representation of the local government area each utility served … second, skilled managers may be relatively more attracted to Victorian utilities due to the prospect of reporting to a board, rather than the general manager of a council, and dealing with a broader set of stakeholders, rather than simply within local government. (Byrnes, Crase, Dollery and Villano 2009, p. 167)

Byrnes, Crase, Dollery and Villano (2010) found that water utilities in Victoria were 13 per cent more efficient when compared to utilities in New South Wales of a similar size. The authors argued that this was largely due to the governance arrangements in place in Victoria since the 1990s, which were thought to permit a greater degree of professional managerial competence, largely due to the ability to

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attract skilled managers to larger water corporations as opposed to the achievement of scale economies.

A common concern associated with aggregation of regional water utilities is the risk that utilities become less accountable to local communities relative to local government council utilities, and/or that customers have less ability (real or perceived) to influence water supply and wastewater outcomes, including the quality of service delivery. Armstrong and Gellatly considered that the regional water corporation model will ensure the utility remains accountable to the individual communities it serves: Notwithstanding the transfer of assets to the corporation, the councils as shareholders will have considerable influence on the corporation’s operations and set the broad strategic direction for the corporation … The shareholding councils are accountable to their respective communities and this will ensure that the operation of the corporation broadly reflects the communities’ interests. (Armstrong and Gellatly 2008, p. 54)

A regional water corporation would operate on the same basis as private sector participants, thus promoting competitive neutrality. Kempsey Shire Council (sub. 30, p. 10) considered ‘being classed as an infrastructure corporation [means] the risk profile will be lower, thereby giving access to more competitive borrowing rates’.

Finally, there is scope for the corporation model to reduce skills shortage problems (over and above the benefits achieved via aggregation), if skilled managers are particularly attracted to utilities that follow a corporate structure. Armstrong and Gellatly (2008, p. 25) suggest that this is one of the benefits to have arisen from the Victorian reform experience. Kempsey Shire Council agree: For generation X & Y individuals, the opportunity to work in a large corporate entity in a lifestyle location in regional New South Wales, will be a significant attraction. More and more people in this demographic are looking to move from metropolitan areas but need professional career opportunities to do so. (sub. 30, p. 13)

County council

A number of asset-owning county councils currently provide water and wastewater services in New South Wales. County councils are established by proclamation under the Local Government Act 1993 (NSW), and water supply and sewerage services and assets are transferred from the councils specified in the proclamation to the county council. The county council is responsible for all service delivery, the operation and maintenance of assets, and investment. In this sense, the county council imposes many of the same benefits, costs and risks as the corporation model.

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Riverina Water County Council noted: The county council model for water utilities continues to be a very successful structure that has allowed Riverina Water to provide financially viable water supply services to a range of communities spread over four local government areas. Without the benefit of being able to share costs, as well as many other advantages such as access to professional, technical and administrative resources, many of the smaller communities could not have a financially viable water supply. (sub. 50, p. 14)

Midcoast Water also advocated the county council approach (sub. 51) but recognised that this model does present some potential disadvantages, namely, the perception that the elected members could make political decisions with little regard for sound financial management, or the inability of the constituent councils to cooperate effectively with each other. These sorts of issues would be dealt with via the universally applicable reforms set out in chapter 11. Specifically, a charter would be established between the county council and the state government that would directly address these risks. Goldenfields Water County Council (sub. 56) strongly supported the county council model, on the basis it promotes the sharing of water resources across local government boundaries, and facilitates the cost-effective utilisation of management, engineering and technical skills.

The county council model differs from the public corporation approach in that constituent councils are not compensated for the loss of assets that are transferred to the county council (under the corporation model the councils, as shareholders, earn dividends). Member councils may be paid dividends by the county council, however Armstrong and Gellatly (2008) observe that this has not been the case to date.

Despite the merits of both approaches, the Commission considers that where aggregation of regional water utilities is determined to be efficient, a corporation structure is preferable to the county council model. The commercial orientation of a corporation better complements the delivery of commercial services, and the appointment of a skills-based board is expected to deliver significant benefits for utility businesses. However, the appropriateness of adopting these approaches will ultimately depend on the circumstances of the individual utility, and should be considered in that context.

This is broadly consistent with the findings of the Armstrong and Gellatly inquiry (2008, p. 54): ‘the corporation model is widely accepted as the best-practice business model for commercial undertakings’. Armstrong and Gellatly (2008, p. 101) considered that the county council model should only be considered for future aggregations if it is the preferred model of all constituent councils and it can be demonstrated that the impact on councils’ viability, economies of scope, employment and local communities can be adequately managed.

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INFORMATION REQUEST

Alternative approach to service delivery

In some cases it may be difficult to estimate whether aggregation would deliver sufficient efficiency benefits to justify the associated costs, or alternatively, the case for aggregation may be weak. However, this does not necessarily imply maintenance of the status-quo Local Government approach to service provision.

Specifically, a regional alliance model (or a regional organisation of councils) can deliver some of the economies of scale benefits of aggregation — via organisational change — without requiring a fundamental restructure of Local Government water utilities. In this sense, a regional alliance might be an attractive alternative to aggregation of water utilities in certain circumstances.

Regional alliance model

A regional alliance allows for certain services to be provided centrally and paid for by member councils on an apportionment basis (Armstrong and Gellatly 2008). However, unlike aggregation, assets and responsibility for service delivery are retained by individual councils. The functions of the alliance are decided and agreed by member councils and may include strategic planning, price setting and identifying and funding infrastructure requirements (where funding would be obtained via member council contributions).

The functions of a regional alliance are not necessarily limited to water and wastewater service provision — these alliances may undertake a range of general purpose local council functions on behalf of member councils. For the purposes of this inquiry we have focused on the role that regional alliances play in water and wastewater service provision only.

A number of respondents to this inquiry expressed support for the regional alliance model. The LGSA NSW preferred this approach over aggregation:

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Catchment-based, regional strategic water supply and demand planning and infrastructure delivery could be achieved … without losing the economies of scope associated with the integration of water supply and sewerage functions and general purpose functions. (sub. 63, p. 7)

The LGSA NSW went on to caution that regional water corporations might be perceived as providing less accountability to the local community, but a regional alliance can achieve the goal of objective and independent decision makers without distorting the clear accountability provided through the council provision approach (sub. 63). Likewise, the LGAQ: … recognises the benefits of economies of scale but argues that they are best achieved through cooperation rather than wholesale institutional change … group access to specialised senior staff is seen as a strong benefit of regional collaboration. This is difficult under current arrangements and might be more achievable if stronger cooperative arrangements were put in place. (sub. 20, p. 8)

In weighing up the case for urban water reform in Tasmania, the MWST recognised the benefits of alliance-type models, but considered that the efficiency gains that can be achieved under this approach are limited relative to utility consolidation: Some Local Governments, such as the Derwent Valley Council, are exploring opportunities for utilising the skills and asset bases of the Bulk Water Authorities to integrate through the value chain and deliver services on their behalf. In other cases, municipalities are seeking to enter cooperative arrangements to share resources and develop consistent planning schemes and other arrangements … Such reform may eventually stagnate, as cherry picking of the best opportunities for integration will occur. (MWST 2006, p. 11)

Binding or voluntary?

Regional alliances may operate under a voluntary arrangement, or council participation may be mandated via legislation (binding).

The distinguishing feature of a binding (or mandatory) regional alliance (as described by Armstrong and Gellatly (2008)) is the presence of a binding alliance entity (BAE). The BAE is established under this model to coordinate the agreed functions of the alliance. The BAE is separate from council members and might be a distinct legal entity or a committee appointed by councils.

Although assets and responsibility for service delivery are retained by member councils, asset management is directed by the BAE and service delivery is provided in accordance with the asset management plan developed by the BAE. The binding regional alliance model requires legislation to make membership of the alliance

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compulsory (so that councils remain members of the alliance), and to compel member councils to implement the strategies and operating plans set by the BAE.

The alternative approach is the voluntary regional alliance, where member councils voluntarily elect to be part of the alliance and decisions made by the alliance are not binding. An example of this approach is provided by the Lower Macquarie Water Utilities Alliance (LMWUA). The LMWUA is a cooperative joint venture between six councils in the Lower Macquarie River Valley below Burrendong Dam.

There is no need for a BAE or associated legislative mechanisms under the voluntary alliance model. Instead, a deed of agreement specifies the structure of a board of management, the funding arrangements for a secretariat, and arrangements for sharing of data, intellectual property and so on. This agreement represents the commitment made by participating councils to the voluntary alliance.

On this basis, the binding alliance model is a more costly option (both in terms of start-up and operating costs) relative to the voluntary alliance. The quantum of costs associated with the BAE will depend on its precise functions and the number of councils that participate in the alliance. If the BAE were to undertake a wide range of functions for each member council (as proposed by Armstrong and Gellatly (2008)) such as price setting, financial planning, facilitating and procuring major capital works and so on, the cost of running the BAE could be significant.

Some participants consider that this additional expenditure is justified. For example, Armstrong and Gellatly regarded the voluntary alliance as a risky proposition: The model leaves it to members’ discretion as to the adoption of the strategic business plans developed by the Alliance’s coordinating body. In addition, members are not compelled to remain in the Alliance after the term specified in the Alliance’s deed of agreement … the benefits gained by the community from the operation of the alliance would diminish if any members left the Alliance. (Armstrong and Gellatly 2008, p. 51)

Armstrong and Gellatly conclude that because member councils are not compelled to implement the initiatives of the alliance body under these arrangements, the performance of the alliance becomes uncertain, which in turn poses risks and uncertainty around the alliance’s ability to generate revenue to fund its operations and necessary capital expenditure. A similar conclusion on the merits of the voluntary alliance model was reached by the Institute for Sustainable Futures: ‘the alliance must be binding otherwise it risks falling apart in the face of difficulties or lack of interest’ (2008, p. 17).

For this reason, Armstrong and Gellatly favour the binding alliance approach. However, the Commission considers that there are legitimate reasons to query the analysis put forward by Armstrong and Gellatly in favour of the binding alliance. In

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particular, it is not clear that sufficient consideration has been given to the possible risks (and costs) for member councils once they enter the binding alliance. Specifically, individual councils would remain entirely accountable for all water and wastewater outcomes, including compliance with customer service, public health and environmental standards. However, councils would be bound to operate water supply and wastewater systems and infrastructure in accordance with the capital expenditure and operating plans determined by the (non-risk bearing) BAE.

The risks and costs of this arrangement for member councils are potentially significant. The Commission considers that this approach could leave member councils highly exposed to a centralised decision making process. Once councils join the alliance they would be legally required to carry out all capital investment and operating decisions made by the BAE, and would be entirely accountable for the financial costs of these decisions, including the public health and environmental implications. If member councils choose to manage this risk by retaining an excessive amount of internal resources, many of the scale benefits of cooperation across utilities would be eroded.

The Commission recognises that there are outstanding concerns about the operation of the voluntary alliance model. However, the LMWUA appears to be functioning well, and participating councils intend to continue with this organisational structure. This suggests that member councils are genuinely committed to the success of the alliance despite the absence of a formal mechanism binding councils to the alliance. Indeed, this feature of the voluntary alliance model may have benefits of itself. The threat of withdrawal from the alliance by a council may discipline the conduct and performance of the voluntary alliance’s management, and indeed the attitudes of other alliance members.

In any case, it may be possible to address any concerns about the stability of the voluntary alliance by extending the term of the deed of agreement between participating councils. This point was made by the LMWUA in response to the Armstrong and Gellatly report: Four years was a purely pragmatic decision designed to encompass the maximum likely length of the current reform process, the standard life of an elected Council between elections, and the understandable desire to not lock in a structure for the long term without any knowledge at all of what the Government’s likely future course of action was going to be. The Alliance would be more than happy to adopt a longer term of agreement now that some guidance is being provided by the Government. (LMWUA 2009, p. 6)

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Conclusion

The voluntary regional alliance model is expected to be relatively inexpensive, as there is no need to set up a BAE. In addition, member councils are not exposed to the risks associated with being compelled (via legislation) to implement operating strategies and pricing policies that are determined by the (non-accountable) BAE.

The principal concern with the voluntary alliance model is the risk it is abandoned by member councils, potentially leading to collapse of the alliance. However, there may be scope to address this (at least to some extent) if member councils were to make a longer-term commitment to the alliance from the outset. It is also important that member councils enter into voluntary alliances for the right reasons. This is regarded as one of the key reasons for the failure of the New England Strategic Alliance of Councils: The motivation needs to extend beyond staving off the prospect of amalgamation … the reasons why the New England Strategic Alliance of Councils failed are complex and interrelated. They include a flawed structure, the lack of a sound governance framework, the failure to make ongoing use of project management methodologies and ultimately, a loss of common will to make the Alliance a success … To be effective, regional collaborative partnerships need shared vision, political direction and ownership; a sound evidence base to inform strategy; a detailed business case, supported by good analysis, sound governance structures and trust. (DLG 2009, p. 3)

The case for establishing binding regional alliances is considerably weaker. This model will involve greater establishment (and ongoing) costs, and the risk-sharing arrangements between the BAE and member councils could impose significant costs and risks on member councils. Nevertheless, if local councils (in consultation with relevant State Governments) choose to adopt the binding alliance model, it is critical that the roles, responsibilities and accountabilities of the BAE and member councils are made explicit, and that the institutional and governance arrangements that define the alliance are aligned with appropriate risk and reward arrangements.

On balance, the Commission considers that establishing a voluntary regional alliance will deliver more modest benefits relative to utility aggregation and corporatisation, all else equal. However, where it is not clear that the benefits of structural reform (aggregation) will be sufficient to outweigh the costs, but there are strong possibilities for efficiency gains via resource sharing, a voluntary regional alliance model may be preferable to retaining the existing, stand-alone local council utility structure. The success or otherwise of such alliances might also help inform the case for subsequent aggregation of utilities, and can therefore serve as an interim step towards establishing a regional water corporation.

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• county council

• regional water corporation

• regional alliance (or regional organisation of councils).

DRAFT RECOMMENDATION 13.2 The New South Wales Government should provide a formal response to the recommendations of the Armstrong and Gellatly inquiry as a matter or priority. The Queensland Government should commence a similar process, in consultation with Local Governments and communities, to consider the costs and benefits of different structural reform options for the urban water sector in regional Queensland (outside of south-east Queensland).

13.4 Other issues for regional areas

This section considers a number of other regional-specific issues that have been raised by participants during the course of this inquiry, but will not necessarily be adequately addressed by the reforms proposed so far in this draft report.

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Government funding

As set out in chapter 6, the Commission considers that it is only appropriate to provide water utilities with State and Territory Government funding in a very limited and specific set of circumstances (draft recommendation 6.2).

In the case of the regional water sector, subsidy funding might be efficient in one or more of the following circumstances:

• Uneconomic regional water utilities: – This applies where it is not economically feasible (due to prevailing demand and supply conditions, rather than because the utility has set inefficient prices) for a regional water utility to provide safe and secure water supply and sewerage services without external funding assistance. This may include regional utilities that provide services to Indigenous communities. – In this circumstance, government funding for capital works and operating costs may be required.

• Capital works grants: – If significant (and urgent) capital investment is required in the short term to bring water supply and wastewater infrastructure up to an adequate standard (to ensure safe and secure water services), government funding (in the form of a ‘one-off’ subsidy payment) may be appropriate. This is a separate issue to that of uneconomic utilities (above). In some circumstances, concessional loans may be appropriate.

• Financial incentives for reform: – Where there are external (social) benefits from expediting the reform process, it may be appropriate to provide regional water utilities with a financial incentive to adopt specific reforms, subject to agreed timelines and outcomes.

• Financial assistance / compensation for reform: – There may be a case for providing Local Government councils (affected by reform) with temporary funding assistance to compensate for economies of scope losses and/or to help councils adjust to the new arrangements.

Uneconomic regional utilities

The unique characteristics of some regional water systems — such as a very small rates base or extremely remote customers — coupled with policies that limit the extent to which utility costs are passed through to individual customers, can prevent some regional water utilities from achieving financial self-sufficiency.

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The reforms set out in chapter 11 and 13 are expected to improve the financial position of many regional water utilities. However, the gap between efficient costs and revenue for some utilities is significant, and may be driven by factors that are outside of the control of the utility. Where this is the case, it is not realistic to expect that reform will be sufficient to move these businesses to complete financial self-sufficiency.

This issue was recognised by the LGSA NSW: Regional circumstances will dictate what is achievable and in some regions, particularly in rural and remote regions, communities might not be able to afford the desired level of water supply and sewerage service even from a regional perspective … To ensure local water utilities throughout the whole of regional New South Wales can provide safe secure water supply and sewerage services, the Associations support the retention of a permanent funding program to provide technical and financial assistance to local water authorities for the renewal and enhancement of water supply and sewerage infrastructure in areas of need. (sub. 63, p. 10)

The Riverina Water County Council commented: Some communities have water supply systems that will never be financially viable in their own right. Some form of subsidy will always be required for such communities if they are to retain reticulated water supply. (sub. 50, p. 4)

Likewise, Goldenfields Water County Council (sub. 56) considered that where water supply systems are financially unviable to begin with (and therefore established via government funding), they will continue to be unviable and require ongoing subsidies.

The Commission recognises the critical importance of achieving safe and secure urban water and wastewater service provision for all customers, irrespective of their location. Accordingly, subsidy payments should be made available where it has been demonstrated that a utility is unable to recover efficient costs, and there are sufficient public benefits on offer to justify government assistance. Subsidy funding should be provided for capital works to bring assets up to a safe and efficient standard and for ongoing provision of water and wastewater services, as required. Any government funding should be provided by way of an explicit Community Service Obligation, using general taxation revenue, and should be subject to periodic review.

In identifying those utilities for which a subsidy arrangement is efficient, jurisdictions should also consider the relative costs and benefits of supplying these regions with water and wastewater services via stand-alone water and wastewater systems (self-supply), rather than via the reticulated network. In the case of

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Tasmania, the MWST noted that all options should be evaluated, and ‘reticulated systems may not be the optimal solution for some communities’ (2006, p. 9).

Capital works assistance

Where urgent (and critical) capital requirements cannot be financed by (otherwise economic) regional water utilities, State and Territory Governments may choose to provide one-off subsidy payments to these utilities. This funding should only be provided if it is clear that there are sufficient public benefits (for example, with respect to public health) to justify the subsidy, and the amount of the subsidy is commensurate with these benefits. Any subsidy funding should be provided by way of an explicit Community Service Obligation payment. Alternatively, State and Territory Governments may choose to provide debt funding for required capital investments and recover this over time as utilities move to full cost recovery.

AECOM considered that subsidy funding for capital works is necessary in New South Wales and Queensland: As the reform process in Victoria demonstrated, one-off grants were required to enable some of the smallest utilities to upgrade neglected infrastructure. This is also likely to be the case in New South Wales and Queensland. This represents an ideal case for COAG to implement a National Partnership Agreement. (AECOM 2010, p. 39)

In Victoria, the State Government provided water authorities with an additional $450 million in funding for infrastructure investment at the time of reform. These funds were conditional on meeting agreed timelines and outcomes, including improvements in water quality and effluent standards (Martin 2004). In Tasmania, a $1 billion capital expenditure program is currently being rolled out over 10 years to bring infrastructure up to an efficient operating standard.

The case for providing utilities with incentive payments for undertaking structural reform, and/or short-term financial assistance for affected local councils, should be considered by State and Territory Governments in the context of devising a urban water reform program.

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State and Territory Governments should subsidise the provision of water supply and wastewater services in regional areas where it is uneconomic for the utility to provide these services safely and efficiently. This funding should be granted via an explicit Community Service Obligation, and subject to periodic review. The case for providing subsidy funding for capital works, financial incentives for reform and assistance for affected local councils should be determined by State and Territory Governments.

Indigenous communities

The challenges associated with providing adequate water and wastewater services to remote Indigenous communities are well recognised. Although there is little data or information on water supply outcomes in Indigenous communities, there are genuine concerns about the quality of water and wastewater services in some areas (over and above the sorts of problems identified in non-Indigenous regional communities).

For example, the Armstrong and Gellatly (2008, p. 96) inquiry, drawing on advice from the NSW Department of Energy and Water, concluded that ‘the current situation of managing water and sewerage services in Aboriginal communities is not currently effective due to a number of challenges’. These were identified as staff/skills, water quality standards, revenue and the relationship between Aboriginal communities and the local water utility. This is consistent with the findings of the Department of Water (WA): Access to appropriate water and wastewater services in Western Australia’s remote (Aboriginal) settlements is a significant challenge due to labour constraints and the high cost of service delivery to small, geographically dispersed and very remote communities. (sub. 38, p. 4)

COAG has recognised that the quality of water services provided to some Indigenous communities is of considerably lower standard than for the wider community. This is reflected in the 2009 COAG National Partnership Agreement on Remote Service Delivery, which includes a principle that remote Indigenous communities, and remote communities with significant Indigenous populations, are entitled to standards of services and infrastructure broadly comparable with that in non-Indigenous communities of similar size, location and need elsewhere in Australia.

The Commission strongly endorses this principle, and considers that the standards of water and wastewater services provided to all Indigenous communities should be provided at comparable (in terms of location and scale) standards to the rest of the

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Australian community, as a matter of priority. State and Territory Government funding should be provided for this purpose, as per draft recommendation 13.3.

There would be benefit from State and Territory Governments undertaking regular reviews of water supply and sewerage outcomes in Indigenous communities, and publicly reporting on these findings. This will facilitate more timely progress towards achieving equitable standards of water services between Indigenous and non-Indigenous areas, and will improve the availability of data and information on water supply outcomes in Indigenous communities.

It is essential that water supply and wastewater outcomes in Indigenous communities are assessed on the same metrics that are used for non-Indigenous communities (and likewise, that public reporting on water and wastewater outcomes is consistent across both groups). This point was made by the Commission in the Overcoming Indigenous Disadvantage 2009 report (which relied on Australian Bureau of Statistics (ABS) data, and the 2006 Community Housing and Infrastructure Needs Survey (CHINS) specifically): ABS CHINS data used in this chapter to report on drinking water, sewerage and electricity services are limited to discrete Indigenous communities and definitions are not comparable to those used for performance reporting by major water, sewerage and electricity utilities. It would be useful if data could be collected for discrete Indigenous communities using standard industry indicators, definitions and guidelines. (PC 2009a, p. 9.30)

The Commission’s position on this issue has not changed, and it is critical that any assessments of water supply and wastewater outcomes in Indigenous communities are based on the same metrics, parameters and performance targets as apply in non-Indigenous communities. This includes reporting by the ABS, the WSAA and NWC (via the National Performance Report series) and State and Territory Governments.

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Compliance with the Australian Drinking Water Guidelines

As discussed in section 13.1 a number of water utilities across all states do not fully comply with all elements of the ADWG.4 The various challenges facing regional water utilities, such as skills shortages, ageing assets, insufficient access to capital and drought go some way towards explaining this non-compliance. To the extent that aggregation will address these issues, there are expected to be improvements in the quality of drinking water following structural reform, and an increase in the rate of utility compliance.

Notwithstanding this, non-compliance is not confined to financially unviable utilities, or even to small regional water utilities. This suggests that the current arrangements are not adequate to guarantee drinking water delivered to customers meets the quality standards set out in the ADWG. In this context, and in light of the significant potential costs and consequences for public health of a breach of drinking water quality standards, it is necessary that specific arrangements are developed to ensure all utilities deliver safe drinking water, that is compliant with all elements of the ADWG.

Armstrong and Gellatly considered this issue: In terms of public health, compliance with microbiological requirements is imperative. Therefore, it is of concern that approximately 20 per cent of utilities are consistently not complying. The number of boil water alerts issued in the last year also signals that poor water quality is not an isolated issue. (Armstrong and Gellatly 2008, p. 65)

The inquiry panel ultimately recommended that regulation of regional water utilities be strengthened to make it a statutory requirement that utilities implement all relevant plans, guidelines and standards, including the ADWG. This would be complemented by an adequate reporting and monitoring framework.

The AECOM (2010, p. 35) review also considered drinking water quality issues and concluded that ‘states that have not already mandated compliance with all elements of the ADWG via legislation or regulatory instruments such as operating licences, should do so’. AECOM recognised that compliance with these guidelines may not always be feasible in some smaller communities, and considered that exemption applications should be introduced to allow for flexibility in regulation where required.

4 The ADWG include standards for (1) microbial quality of drinking water (the microorganisms found in drinking water that can be harmful to health), (2) physical and chemical quality of drinking water (including colour, turbidity, odour), (3) radiological quality of drinking water (acceptable levels of radioactive material) and (4) drinking water treatment chemicals (used to treat or remove algae, pesticides, pollutants and so on).

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In view of the potentially catastrophic consequences for public health of a breach of drinking water quality standards, the Commission recommends that compliance with the ‘health critical’ elements of the ADWG be made mandatory. The Commission notes that the National Health and Medical Research Council (NHMRC) expects to release a revised version of the ADWG during 2011. It would be appropriate for the NHMRC, alongside the release of these guidelines or shortly thereafter, to identify those elements of the ADWG that are critical for human health, and should be met by all water and wastewater utilities.

Serious sanctions, including financial penalties and dismissal, should apply in the event water utilities do not comply with the mandatory elements of the ADWG. Managers and directors of utility businesses, or other accountable persons such as councillors, would be personally liable for the full risks associated with non-compliance. This is consistent with the penalties that apply for non-compliance with Occupational Health and Safety legislation.

Where utilities fail to meet the non-health critical elements of the guidelines, they should be required to develop and implement a risk management plan that sets out clear outcomes and timelines for moving towards full compliance with the ADWG. This plan should be approved and monitored by the relevant State or Territory Government health department. Utilities would be required to notify the public about non-compliance with any element of the ADWG.

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Disaggregating jurisdiction-wide public water corporations

As set out in chapter 2, water customers in regional areas of South Australia, Western Australia (outside of Bunbury and Busselton — table 13.1), and the Northern Territory are served by the respective jurisdiction-wide public water corporation.5 This contrasts with Victoria and Tasmania, where multiple regional water corporations — each servicing a defined geographic area — have been established.

The primary motivations for horizontally disaggregating large, jurisdiction-wide water utilities include to:

• better align water system planning and water resource management with provision of services

• remove diseconomies of scale (where the large utility is operating above an efficient scale) (section 12.1)

• open up opportunities for yardstick competition between regional water utilities

• put customers in closer proximity to their water service provider, in turn making utilities more accountable to their local communities, and providing customers with greater scope to influence the activities and performance of the utility

• support more ‘region-specific’ water and wastewater outcomes

• implement more location-specific pricing arrangements (chapter 7). Although there is scope for statewide utilities to set water prices on a location-specific basis, this has not been the case historically. The Water Corporation in Western Australia has moved towards more differential pricing arrangements in recent years, but these arrangements do not constitute location-specific pricing at this stage.

Very few inquiry respondents considered this issue explicitly. However, the Institute for Sustainable Futures considered: This option would represent the option most divorced from local inputs; while the sheer size of the organisation would create a risk of it wielding too much political control over water matters, pushing local concerns further into the background. Also at risk would be integration efforts. (Institute for Sustainable Futures 2008, p. 23)

The Commission recognises that the Economic Regulation Authority in Western Australia (ERA) has undertaken work that considers the merits of alternative structural arrangements for Western Australia. This includes a piece of work

5 ACT is also supplied by a single state wide corporation but is not regarded as a potential candidate for disaggregation due to its size / geographic coverage.

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undertaken by the Allen Consulting Group (ACG), Water Industry Structure Study Analysis of Alternative Reconfiguration Options in the South-West of Western Australia. ACG found that there would be economies of scale benefits from merging Aqwest (Bunbury) and Busselton Water with the Water Corporation, relative to the existing arrangements (Water Corporation, sub. 78, p. 3).

However, this analysis does not explicitly assess the full range of costs and benefits (including the prospects for competition and other dynamic efficiencies) associated with breaking up the Water Corporation such that regional areas are serviced by separate stand-alone utilities. The study is also limited to areas relatively close to Perth, and that may have some capacity to share water resources. Likewise, the Commission is not aware of any work that has considered the merits of alternative structural arrangements in South Australia and the Northern Territory.

The Commission considers there would be benefit in relevant State and Territory Governments commissioning an independent review of the prospects for achieving a more efficient water supply and wastewater industry through structural separation. In some cases structural reform may not be efficient. However, the merits of re-defining the boundaries of ‘postage stamps’ used for pricing purposes in these jurisdictions should also be considered, with a view to achieving more efficient — and more location-specific — pricing arrangements for water and wastewater services (chapter 7).

INFORMATION REQUEST

What are the likely sources of costs and benefits of undertaking structural reform of the urban water sectors in Western Australia, South Australia and the Northern Territory?

REFORM IN 429 REGIONAL AREAS

Integration of water supply and wastewater services

As set out in chapter 12, existing evidence on economies of scope between water supply and wastewater service provision is mixed, suggesting there is no case for establishing separate water supply and wastewater utilities.

However, the Commission notes that there are a number of standalone water supply and wastewater businesses in various parts of regional Australia. For example, in New South Wales there are ten utilities that provide wastewater services only, and four utilities that provide water supply services only (NSW Office of Water 2010a).

In Western Australia, Aqwest and Busselton Water supply Bunbury and Busselton respectively, yet the Water Corporation provides sewerage services for these regions. In other areas the Water Corporation provides water supply services but wastewater is managed separately (for example, in Kalgoorlie-Boulder). The ERA also licences 20 small suppliers (less than 1000 connected properties) of wastewater services in Western Australia, including 18 Local Government authorities, Rottnest Island Authority and Hamersley Iron (ERA 2011c).

Few inquiry respondents commented on the merits of separating or integrating the water supply and wastewater functions. Wagga Wagga City Council supported reintegrating the two services, and noted (sub. 54, p. 6) ‘water supply and sewerage services are currently spread across two organisations making integrated water cycle management less effective’. In Tasmania, the MWST concluded: A lack of effective planning means that water supply and wastewater management are often considered in isolation of each other. This can, and does, lead to problems such as overlooking the impact that changes in one may have on the other. (MWST 2006, p. 11)

The Commission expects that, in some regional areas, there are likely to be scale and scope economies from a single utility providing water supply and wastewater services to a group of customers, rather than these services being provided by two separate agencies. As opportunities for wastewater reuse and integrated water cycle management expand, scope economies between these services might also increase. As part of the above assessment of reform options, jurisdictions should consider the costs and benefits of re-integrating these services in regional areas where they are currently provided separately.

430 AUSTRALIA'S URBAN WATER SECTOR

INFORMATION REQUEST

REFORM IN 431 REGIONAL AREAS

14 Implementing reform and monitoring progress

Key points

• The ‘universally applicable’ reforms should be the highest priority for reform of Australia’s urban water sector. These include setting an overarching objective for government policy, developing appropriate policies that align with this objective, and putting in place best practice institutional, regulatory and governance arrangements.

• An intergovernmental agreement could be formulated through the COAG process, by the end of 2012, on a reform program that commits each jurisdiction to implementing the universally applicable reforms identified by the Commission, and to implementing structural reform, with agreed deadlines for progress.

• Agreement across all jurisdictions is not necessary for the State and Territory Governments to implement the Commission’s recommendations. The State and Territory Governments should immediately commence enacting reforms unilaterally.

• The universally applicable reforms could be completed by no later than the end of 2013. Where a case in favour of reform is identified, the reform process could begin no later than 2014.

• There might be a need for specific transitional assistance from State and Territory Governments to those individuals and local authorities in regional urban areas disadvantaged by urban water reform.

• Progress in implementing reforms should be monitored and reported. The National Water Commission could perform this role.

• An independent public review of the reform package should take place after five years.

Chapters 3–8 of this report set out the scope for achieving efficiency gains from reforming Australia’s urban water sector. Chapters 11–13 outline institutional, regulatory and structural reform options for achieving these efficiency gains. The terms of reference for this inquiry ask the Commission to report on a proposed work program, including implementation plans, for the outlined options, identifying:

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• practical actions that the Commonwealth, State and Territory and Local Governments can undertake to implement options for reforms, including any transitional arrangements

• priority areas where greatest efficiency gains are evident and where early action is practicable

• quantitative and qualitative indicators for efficiency gains in the urban water and wastewater sectors.

Section 14.1 of this chapter summarises the recommended reforms put forward by the Commission and identifies the priorities for reform where greatest efficiency gains are evident. In section 14.2, the practical steps that governments can take to implement these reforms and deal with transitional issues. In doing so, it also outlines a timetable for reform. A monitoring and review framework for assessing the efficiency gains from reform is outlined in section 14.3.

14.1 The reform package

In this draft report the Commission has made many recommendations for reform of Australia’s urban water sector. This section summarises the universally applicable reforms and optional structural reforms identified by the Commission, and identifies the highest priority reforms.

Highest priority reforms — universally applicable reforms

Some of the recommended reforms put forward by the Commission have been identified as being applicable to all states and territories, and all urban water systems within those states and territories, irrespective of their individual geographic or structural characteristics (chapter 11). These are referred to as the ‘universally applicable’ reforms, and are summarised in table 14.1. Some jurisdictions have already implemented elements of this reform package.

It is the Commission’s view that implementing the universally applicable reforms should be the highest priority for reforming Australia’s urban water sector. These reforms to policy, governance and institutions present the greatest scope for efficiency gains, and are an essential prerequisite to pursuing any structural reforms.

The universally applicable reforms can generally be accommodated within existing structural arrangements and some should be able to start without delay, especially those that draw on well established reform principles and do not require legislative change.

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Table 14.1 Universally applicable reforms

Set overarching objective for government policy in the sector

Provision of water, wastewater and storm water services in an economically efficient manner to maximise net benefits to the community Develop appropriate policies and principles that align with overarching objective Consider the costs and benefits of all supply augmentation options using a real options approach Remove ‘policy bans’ on sources of supply augmentation, and consider supply augmentation and demand management options together Provide consumers with information on costs, benefits, and risks of supply augmentation options Restrict provision of subsidies to the limited set of circumstances identified by the Commission Phase out water restrictions and mandated water use efficiency and conservation measures Allow retailers to offer a variety of price/service options to suit consumer preferences, subject to policy guidelines that promote efficient pricing Provide consumers with information on costs and benefits of water saving activities, and using price and non-price demand management measures Clearly define property rights Use universal assistance measures to ensure that social objectives are met at least cost to efficiency. Where specific measures are required, use a rebate or concession that is independent of consumption levels and fully funded as a Community Service Obligation (CSO) Put in place best practice institutional, regulatory and governance arrangements Clearly define the objectives, roles and responsibilities of elected representatives, utilities and regulators (economic, health and environmental), and those decisions best made by consumers Assign the role of procurement of supply augmentation to retailer–distributors Ensure best practice governance of GTEs by devising a charter that provides guidance to utilities on: • obligations to serve (security, reliability, procurement) • processes and procedures for choosing supply augmentation • principles, processes and procedures for setting prices • borrowings and dividends policies • customer service standard/hardship policies • risk allocation • nature and funding of CSOs Monitor performance of GTEs against the charter subject to review by a suitable body Further apply corporatisation model to GTEs and appoint an independent skills based board Phase out price setting, and allow utilities to set their own prices subject to guidance in the charter. Adopt price monitoring where necessary Regularly review CSO payments Clearly define objectives for regulation and provide regulators with greater guidance (less discretion) Ensure best practice regulatory processes and procedures (independence, transparency and accountability) Establish a consumer representative body with a formal consultative role in supply augmentation and pricing/service issues, funded by a surcharge on water bills Mandate compliance with Australian Drinking Water Guidelines Provide Indigenous communities with water and wastewater services that are of the same standard as those provided to comparable non-Indigenous communities

IMPLEMENTATION 435 AND MONITORING

Not only is it feasible to begin implementing these reforms immediately, but it is also highly desirable in the current environment where it is unlikely that a water shortage will materialise for several years (with the possible exception of south-west Western Australia). This gives policy makers the opportunity to implement reforms without the pressure of major demand management or supply augmentation measures needing to take place.

The first and most crucial step for reform is to set an overarching objective for government policy that focuses on the provision of water, wastewater and stormwater services in an economically efficient manner to maximise net benefits to the community. As noted in chapter 3, the concept of ‘economic efficiency’ encapsulates many of the more specific objectives that should be pursued in the urban water sector, including those related to water security, water quality and the environment, and can be used to guide the tradeoffs that need to be made between these objectives. Setting this overarching objective will set the context for all other reforms to follow (where they are not already in place).

Secondary reform priorities — structural reform

A further set of optional reforms focus on the efficiency gains available from making changes to the structural arrangements of urban water systems (table 14.2).

It is the Commission’s view that the optional structural reforms are of secondary importance. Once the universally applicable reforms have been introduced, however, there are further efficiency gains to be had from implementing structural reform. Some of these reforms have already occurred in some jurisdictions.

In metropolitan areas in general, structural reforms are aimed at achieving efficiency gains by introducing (progressively more) contestability into elements of the supply chain (chapter 12). In general, it is the Commission’s view that where these reforms are not already in place, State and Territory Governments should assess the case for introducing contestability in bulk water supply (option 2) and wastewater treatment (option 3) in large urban cities. The case for introducing yardstick competition at the retail–distribution level (option 4) should also be assessed. For some jurisdictions, there will be costs associated with undertaking horizontal separation of the retail–distribution function and it is not clear that these will be outweighed by the benefits. In others, these costs are either not relevant (where yardstick competition in retail–distribution already exists), or might be justified by the potential efficiency gains.

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Table 14.2 Optional structural reforms

Reform Detail

Metropolitan areas

Regional urban areas in NSW and Qld (outside of south-east Qld) Aggregate small utilities to exploit Options include: economies of scale • County councils • Regional water corporations • Regional organisation of councils / alliances

In regional urban areas, there is less scope for contestability and so structural reforms are, in general, aimed at achieving efficiency gains by establishing more efficiently-scaled utilities (chapter 13). However, there is no ‘one size fits all’ approach to structural reform — decisions need to be made on an assessment of the costs and benefits. Furthermore, the range of feasible options in not limited to the proposals put forward by the Commission in this report.

IMPLEMENTATION 437 AND MONITORING

It is the Commission’s view that there is a strong case for aggregating utilities in regional urban areas of New South Wales and Queensland to take advantage of economies of scale and other opportunities for efficiency gains. Further examination of the costs and benefits of disaggregating the jurisdiction-wide monopolies in Western Australia, South Australia and the Northern Territory should also be undertaken.

• developing appropriate policies and principles that align with this objective

• putting in place best practice institutional, regulatory and governance arrangements.

14.2 The role of governments in implementing reform

This section identifies a role for COAG in the reform process, and then outlines the actions to be taken by State and Territory Governments.

A nationally coordinated approach — a role for COAG

Effective arrangements for integrating and coordinating policy and its administration are fundamental for successful reform of the urban water sector. The COAG process can facilitate this, and ensure a nationally consistent approach to reform, supported by a standardised framework for monitoring the progress of reform.

The Commission suggests that COAG could secure agreement from jurisdictions on a reform program that deals explicitly with the universally applicable reforms, according to an agreed timetable. Such an agreement would specify the desired outcomes and priorities and, where appropriate, provide for interim targets and for adjustment to targets as new information emerges or where circumstances change. It

438 AUSTRALIA'S URBAN WATER SECTOR

would also recognise that some of these reforms are already in place in some jurisdictions (see below).

The intergovernmental agreement would also express commitment to implementing structural reform, with agreed deadlines for progress. However, it would provide considerable flexibility for the State and Territory Governments to determine which structural reforms best suit their individual circumstances. This is because each State and Territory is characterised by different structural arrangements, which often vary between metropolitan and regional urban areas. Furthermore, the issues facing regional urban areas are different from those facing metropolitan areas, meaning that the appropriate structural reform options will differ. Jurisdictions therefore need considerable flexibility to determine the most appropriate way forward. Determining the preferred option will require assessment on a case-by-case basis, negotiations between State and Local governments, and consultation with the industry and consumers.

Given the strong case for reform of the urban water sector, it should be a priority for COAG. The Commission suggests that the new intergovernmental agreement could be in place by the end of 2012.

State and Local Government action

Agreement across all jurisdictions is not necessary for the State and Territory Governments to pursue the bulk of the recommendations put forward by the Commission. The State and Territory Governments should act unilaterally to immediately commence the reform process.

Some elements of the universally applicable reforms are already in place to differing degrees in the states and territories. For example, many jurisdictions have already moved towards greater commercialisation of water utilities and implemented some pricing reforms. Therefore, implementation requirements will vary considerably within and between jurisdictions.

The Commission suggests that the State and Territory Governments could implement all of the universally applicable reforms by the end of 2013. Where public consultation and legislative change is not required, a number of the universally applicable reforms could be implemented right away, and be completed before this deadline.

The structural reform process should get underway concurrently with the universally applicable reforms, especially in light of the long lead time that might be required to implement such reforms.

IMPLEMENTATION 439 AND MONITORING

The first step is for each State and Territory Government to do further work on assessing the scope and desirability of introducing structural reforms in large urban cities and regional urban areas.

Some states and territories are better placed to introduce contestability into bulk water supply and wastewater treatment in large urban areas more quickly than others, because some vertical separation of the supply chain has already occurred (such as in Sydney, Melbourne and Brisbane).

Furthermore, some states and territories — including Victoria and Tasmania — have already reformed the structure of their regional urban utilities and therefore less work is required. Some progress has been made in Queensland and New South Wales, but further work is required. Comparatively little investigation into the scope for structural reform in regional urban areas has been undertaken in Western Australia, South Australia and the Northern Territory.

Where a case in favour of structural reform is identified by a jurisdiction, it is the view of the Commission that the process could begin no later than the end of 2014.

INFORMATION REQUEST

The Commission is seeking feedback on its suggested timetable for reform.

440 AUSTRALIA'S URBAN WATER SECTOR

Transitional issues

Although the Commission expects urban water reform to have beneficial effects on national income overall, inevitably these benefits will not be distributed uniformly throughout the community, and there will be some people disadvantaged by reform (particularly in the short term). Retrenched workers, for example, might be unable to find new work or might need to retrain or relocate to find new work.

The Commission has previously discussed that governments have often failed to deal with the social dislocation that can occur with economic reform, particularly in regional areas: In many areas, governments have failed to address adequately the social dislocation that can accompany change. Managing reform — including the provision of adjustment assistance — is a legitimate concern for many people in country Australia, as country areas often have borne the brunt of adjustment from, for example, employment losses associated with reform of government electricity and rail businesses, many of which pre-date NCP. (PC 1999, p. 320)

The Commission considers that it is important to recognise up front any adjustment or distributional consequences of reform, and to agree up front about the general principles that should apply to the provision of any transitional assistance that might be provided to those affected. This is likely to improve the efficiency and effectiveness of the transitional assistance, and lessen perceptions that assistance is provided in an ad hoc manner (PC 2005c).

The most appropriate mechanism for dealing with transitional assistance is likely to be the taxation and transfer systems. These measures do not, however, deal with all contingencies and therefore there might be a need for additional measures in certain circumstances (PC 2005c).

The Commission envisages any such transitional assistance would be temporary, and does not consider that the proposed reforms would have large labour market effects. Moreover, with regard to local water utilities the employment effects of reform would not always be negative. Some pricing reforms might enable greater investment and promote improvements in water quality and in the services provided by utilities. This could have employment benefits in the urban water sector.

IMPLEMENTATION 441 AND MONITORING

Although the Commission considers it is important to deal with issues of transitional assistance, these should not be overstated, and they should not overshadow the fundamental imperative of commencing urban water reform. The economic and social costs of current arrangements, and the extent of potential benefits from reform, mean that the case for reform is strong.

INFORMATION REQUEST

The Commission is seeking feedback on what the major transitional issues might be if the urban water sector were reformed in line with the recommendations contained in this draft report, particularly for low income households and regional urban areas.

In view of the potential pay-off from urban water reform, the Commission recognises that in the past the Australian Government has provided financial incentives to states and territories in order to facilitate national reforms. Such payments were widely seen as successful in garnering support for the National Competition Policy (NCP) reforms beginning in the mid-1990s.

The logic behind the NCP-related payments was that the reforms would have a significant pay-off in terms of gross domestic product, leading to additional tax revenue which, because of vertical fiscal imbalance, would flow disproportionately to the Commonwealth Government. The pool of available funding was developed with reference to modelling by the Industry Commission, while the National Competition Council made recommendations on competition payments.

The NCP-related payments therefore provided both a mechanism for sharing the benefits of reform, and an accountability mechanism, with states and territories ‘penalised’ where reform commitments were not satisfactorily implemented.

With regard to the urban water reforms recommended in this report, the Commission considers that State, Territory and Local Governments are likely to be major beneficiaries, with reforms likely to lead to better investment decisions and

442 AUSTRALIA'S URBAN WATER SECTOR

more cost-reflective pricing. This will in turn reduce the need for assistance provided to utilities by State and Territory Governments to ensure cost recovery, and will lead to increased dividend payments and tax-equivalent improvements.

Therefore, the Commission does not see a case for the Australian Government providing funding to the states and territories to facilitate urban water reform.

14.3 Monitoring progress of reform

To be effective and prevent backsliding, the reform program needs to be backed up by performance monitoring. As such, the reform program should be supported by independent monitoring and reporting of progress made in implementing reforms.

The Commission considers that the National Water Commission would be the most obvious body to monitor the progress of reform. Alternatively, the COAG Reform Council or the National Competition Council could perform such a task.

Currently, the National Water Commission does biannual assessments of progress in implementing the National Water Initiative. It could be appropriate for this frequency of assessment to continue.

DRAFT RECOMMENDATION 14.3 Progress against COAG agreed water reforms should be subject to monitoring. The National Water Commission would be the most logical body to undertake such monitoring.

Reviewing the reform package

This draft inquiry report contains a series of recommendations to improve the efficiency of Australia’s urban water sector from the point of view of the community as a whole. The Commission acknowledges that the outcomes of the proposed changes are not known with certainty and circumstances can change over time. This is especially so in light of the fact that there is no ‘one size fits all’

IMPLEMENTATION 443 AND MONITORING

approach to reform, and there is limited international experience to draw upon with some of the proposed reforms.

Moreover, given the other reviews of Australia’s urban water sector that are currently underway (chapter 1), additional reforms and adjustments are likely to be made to the framework in coming years. Such changes could have implications for the sector, over and above the changes proposed by the Commission.

The Commission therefore considers that, after a sufficient time period, there should be an independent public review of the impact of the proposed new arrangements.

The Commission considers that five years would be an appropriate time period after which this review should take place. This would give the sector a realistic opportunity to respond to the changed environment before the effectiveness of the new arrangements are examined and consideration is given to any further changes that might be required.

DRAFT RECOMMENDATION 14.4 An independent public review of the reform package should take place after five years.

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A Public consultation

Outlined in this appendix are details relating to consultations through:

• submissions (table A.1)

• visits (table A.2)

• public hearings (table A.3)

• roundtables (table A.4)

• a modelling workshop (table A.5).

The Commission received the terms of reference for this inquiry on 22 July 2010. Following receipt of the terms of reference, the Commission placed notices in the press and on its website inviting public participation in the inquiry. Information about the inquiry was also circulated to people and organisations likely to have an interest in it. The Commission released an issues paper on 27 September 2010 to assist inquiry participants in preparing their submissions. The Commission received 88 submissions.

The Commission has conducted meetings with a range of organisations and individuals.

Public hearings were held in Sydney, Canberra, Melbourne, Adelaide, Perth and Hobart in November and December 2010, which attracted 35 participants. In addition, roundtables were held in Perth, Sydney and Melbourne, and a modelling workshop was held in Melbourne.

PUBLIC 445 CONSULTATION

Table A.1 Submissions received

Individual or organisation Submission number Academy of the Social Sciences in Australia 41 ACTEW Corporation 45, 69 Anglicare Tasmania 44 Aqua Piovana Pty Ltd 2 AquaNet 49 Australian Academy of Technological Sciences and Engineering 34 Australian Building Codes Board 23 Australian Council of Social Service 32 Australian Water Association 42 Barry Trembath Consultant Pty Ltd 82 Burdekin Shire Council 27 Business Council of Australia 66 Centre for Water Sensitive Cities 75 City of Salisbury 10 City of Wanneroo 55, 76 Coliban Water 73 Consumer Utilities Advocacy Centre 46, 67 Cooper, B., Crase, L. and Burton, M 28 Council of Mayors (SEQ) Pty Ltd 77 Crase, L. and O’Keefe, S 5 Department for Water (SA) 79 Department of Environment and Resource Management (Qld) 60 Department of Health (Vic) 16 Department of Water (WA) 38 Dollery, B 1 Dubbo City Council 86 Dwyer, T 57, 74 Economic Regulation Authority 36 Engineers Australia 4 Environmental Defenders Office (SA) Inc 39 Gladstone Area Water Board 87 Goldenfields Water County Council 56 Grafton, Q 22 Head, B 8 Independent Pricing and Regulatory Tribunal 58, 72 Infrastructure Australia 6, 62 Irrigation Australia 14 Jones, L 35 Joseph, A 40 Kempsey Shire Council 30 Koerner, R 7, 25, 81, 84

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446 AUSTRALIA'S URBAN WATER SECTOR

Table A.1 (continued)

Individual or organisation Submission number Local Government and Shires Associations of NSW 63, 85 Local Government Association of Queensland 20 Local Government Association of Tasmania 64 Midcoast Water 51 National Competition Council 12 National Water Commission 53 New South Wales Government 65 Nubian Water Systems 11 Nicholas, N 88 Public Interest Advocacy Centre 61 Quiggin, J 26 Riverina Water County Council 50 Rockhampton Regional Council 33 Ruff, L E. and Swier, G 47 Shoalhaven City Council 15 South Australian Government 52 Sydney Water Corporation 21, 68, 83 Tasmanian Council of Social Service 13 Tasmanian Government 70 Tasmanian Water and Sewerage Corporations 43 T Bowring and Associates Pty Ltd 17 Wagga Wagga City Council 54 Water and Carbon Group 31 Water Corporation 78 Water Factory Company 48 Water Quality Research Australia Ltd 37 Water Services Association of Australia 29 Waterplus (Aust) Pty Ltd 3 West, A 9, 59, 80 Wyong Shire Council 24 Yarra Valley Water 19

Table A.2 Visits

Individual or organisation

ACT ACTEW Corporation Australian Bureau of Agricultural and Resource Economics and Sciences Department of Sustainability, Environment, Water, Population and Communities (Cwlth) Department of Finance (Cwlth) Department of Prime Minister and Cabinet (Cwlth) National Water Commission

(continued next page)

PUBLIC 447 CONSULTATION

Table A.2 (continued)

Individual or organisation

ACT (continued) The Treasury New South Wales Australian Council of Social Service Department of Premier and Cabinet (NSW) Independent Pricing and Regulatory Tribunal Infrastructure Australia Local Government and Shires Associations of NSW NSW Office of Water NSW Treasury Sydney Water Corporation Northern Territory Department of Housing, Local Government and Regional Services (NT) Department of Natural Resources, Environment, The Arts and Sport (NT) Northern Territory Council of Social Service Northern Territory Treasury Northern Territory Utilities Commission Power and Water Corporation Queensland Department of Environment and Resource Management (Qld) Department of Premier and Cabinet (Qld) Local Government Association of Queensland Queensland Competition Authority Queensland Treasury Queensland Water Commission Queensland Water Directorate Seqwater South East Queensland Water Grid Manager South Australia Department for Water (SA) Department of Treasury and Finance (SA) Essential Services Commission of South Australia SA Water South Australian Council of Social Service United Water Tasmania Anglicare Tasmania Department of Premier and Cabinet (Tas) Department of Primary Industries, Parks, Water and Environment (Tas) Department of Treasury and Finance (Tas) Office of the Tasmanian Economic Regulator

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448 AUSTRALIA'S URBAN WATER SECTOR

Table A.2 (continued)

Individual or organisation

Tasmania (continued) Southern Water Tasmanian Council of Social Service Victoria City West Water Committee for Economic Development of Australia Consumer Utilities Advocacy Centre Department of Sustainability and Environment (Vic) Department of Treasury and Finance (Vic) Essential Services Commission Melbourne Water South East Water Water Services Association of Australia Yarra Valley Water Western Australia Department of Treasury and Finance (WA) Department of Water (WA) Economic Regulation Authority Syme, G., Edith Cowan University Water Corporation

Table A.3 Public hearings

Individual or organisation Transcript page numbers

Sydney — 9 November 2010 Local Government and Shires Associations of NSW 2–22 Independent Pricing and Regulatory Tribunal 23–39 Australian Council of Social Service 40–48 Nubian Water Systems 49–58 Public Interest Advocacy Centre 59–67 Jones, L 68–73 T Bowring and Associates Pty Ltd 74–78 Canberra — 29 November 2010 ACTEW Corporation 80–91 Sydney Water Corporation 92–114 Infrastructure Australia 115–127 Water Services Association of Australia 128–142 National Water Commission 143–155 Grafton, Q., Australian National University 156–165 Dwyer, T 166–174

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PUBLIC 449 CONSULTATION

Table A.3 (continued)

Individual or organisation Transcript page numbers

Melbourne — 30 November 2010 Local Government Association of Queensland 176–188 National Competition Council 189–196 Coliban Water 197–208 Joseph, A 209–216 Yarra Valley Water 217–231 Consumer Utilities Advocacy Centre 232–242 Adelaide — 7 December 2010 City of Salisbury 244–258 Australian Academy of Technological Sciences and Engineering 259–270 Water Quality Research Australia 271–281 Department for Water (SA) 282–305 CSIRO Land and Water 306–313 Perth — 8 December 2010 Water Corporation 315–333, 343, 354, 357–358, 366, 369–370 Department of Water (WA) 327 Economic Regulation Authority 334–346 Resource Economics Unit 346–354 City of Wanneroo 355–361 , 368–369 Hall, D 362–370 Marsden Jacob Associates 366, 371–373 Hobart — 13 December 2010 Local Government Association of Tasmania 374–399 Southern Water 400–418 Thorley, D 419–431

Table A.4 Roundtables

Individual or organisation

Perth — 18 October 2010 Aqwest Australian Water Association (WA Branch) Brennan, D., University of Western Australia Compost Western Australia Department of Treasury and Finance (WA) Department of Water (WA) Economic Regulation Authority GHD McLeod, P., University of Western Australia Resource Economics Unit Water Corporation

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Table A.4 (continued)

Individual or organisation

Sydney — 20 October 2010 ACIL Tasman Australian Council of Social Service Centre for International Economics Department of Premier and Cabinet (NSW) Independent Competition and Regulatory Commission Independent Pricing and Regulatory Commission LECG (now Sapere Research Group) Local Government and Shires Associations of NSW NSW Office of Water NSW Treasury NSW Water Directorate South East Queensland Water Grid Manager Sydney Catchment Authority Sydney Water Corporation Water Services Association of Australia Yarra Valley Water Melbourne — 27 October 2010 Australian Competition and Consumer Commission Australian Water Association Business Council of Australia City West Water Coliban Water Committee for Economic Development of Australia Crase, L., La Trobe University Department for Sustainability, Environment, Water, Population and Communities (Cwlth) Department of Environment and Resource Management (Qld) Department of Primary Industries, Parks, Water and Environment (Tas) Department of Sustainability and Environment (Vic) Department of Treasury and Finance (Vic) Edwards, G Essential Services Commission Essential Services Commission of South Australia Farrier Swier Consulting Freebairn, J., University of Melbourne Frontier Economics Grattan Institute Infrastructure Australia Langford, J., University of Melbourne Marsden Jacob Associates Melbourne Water National Water Commission

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PUBLIC 451 CONSULTATION

Table A.4 (continued)

Individual or organisation

Melbourne — 27 October 2010 (continued) PriceWaterhouseCoopers Queensland Water Commission Ruff, L Sibly, H., University of Tasmania South East Water Southern Water Victorian Competition and Efficiency Commission Victorian Water Industry Association Watson, A Sydney — 2 December 2010 Barwon Water Wagga Wagga City Council Local Government and Shires Associations of NSW Lower Macquarie Water Utilities Alliance Midcoast Water NSW Water Directorate Orange City Council Queensland Water Directorate Riverina and Murray Regional Organisation of Councils Townsville City Council Unitywater

Table A.5 Modelling Workshop

Individual or organisation

Melbourne — 2 February 2011 ActewAGL Centre for International Economics City West Water Department of Sustainability and Environment (Vic) Economic Regulation Authority Freebairn, J., University of Melbourne Marsden Jacob Associates Melbourne Water Sapere Research Group South East Water Smith, O., University of Melbourne Yarra Valley Water Ward, M., Australian National University Water Corporation Water Services Association of Australia

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Table A.5 (continued)

Individual or organisation

Melbourne — 2 February 2011 (continued) Watson, A Woodland, A., University of New South Wales

PUBLIC 453 CONSULTATION

B Further information on Australia's urban water sector

This appendix provides more detail on some of the material presented in chapter 2, in particular, on recent rainfall and inflows in select places around Australia, and more information on the structural, institutional, governance and regulatory arrangements of each jurisdiction. The information provided on arrangements includes the key legislation and stakeholders involved in the urban water sector, the supply arrangements, the key policies and strategies, the economic regulatory arrangements, health regulatory arrangements and environment regulatory arrangements, for each jurisdiction.

B.1 Rainfall and inflows

Chapter 2 highlighted that Australia experiences high variability in rainfall and inflows, and that some places have experienced reduced rainfall and inflows in recent years, using Melbourne as an example. Here, the experience in Perth and south-east Queensland is discussed.

Perth

Rainfall in south-west Western Australia undertook a downward step in the 1970s with lower rainfall in the years following (CSIRO 2007). Very low rainfall has occurred in recent years, and south-west Western Australia experienced its driest year on record in 2010 (Raphael 2011).

This reduced rainfall has led to an even greater reduction in inflows (figure B.1). Average annual inflow into Perth’s dams decreased from 338 GL in the period 1911 to 1974, to 173 GL in the period 1975 to 2000, and further to 92 GL in the period 2001 to 2009. Unlike other states, there has not been an increase in rainfall and inflows more recently. As of January 2011, dam storages for south-west Western Australia were about 25 per cent (Water Corporation 2011c).

FURTHER 455 INFORMATION ON THE WATER SECTOR

Figure B.1 Annual inflows into Perth’s dams 1911–2010a

1000

800 Average (1911–1974) 338 GL 600 Average Average (1975–2000) (2001–2009) GL 173 GL 92 GL 400

200

0 1911 1916 1921 1926 1931 1936 1941 1946 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006

a Year is May to April the following year. Inflows for 2010 are not for the full year. Source: Water Corporation (2011d).

Sydney

Sydney, like other parts of Australia, has experienced water shortages in recent years. Average annual inflows into Warragamba Dam, Sydney’s largest dam, have been much lower than for the preceding century (figure B.2). Average annual inflow for the period 2000 to 2010 was 341 GL, compared with 1487 GL for the period 1950–1999. Rainfall and inflows improved in 2010, and available storage in Sydney’s dams was at about 75 per cent in March 2011 (Sydney Catchment Authority 2011a).

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Figure B.2 Annual inflows into Warragamba Dam 1909–2010

8000

6000 Average Average (1909–1949) (1950–1999) 736 GL 1487 GL 4000 GL Average (2000–2010) 341 GL 2000

0 1909 1914 1919 1924 1929 1934 1939 1944 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009

Source: Sydney Catchment Authority (unpublished data).

South-east Queensland

In south-east Queensland, average rainfall over the past decade has been substantially lower than for the preceding century. Average yearly rainfall at the Wivenhoe dam, south-east Queensland’s largest dam, over the period 2001 to 2009 was 685 mm, substantially lower than for the period 1949 to 2001 (at 1069 mm) (QWC 2010b).

Annual inflows over the period 2001 to 2009 were also low compared with previous years. Average annual inflow into the Wivenhoe Dam over the period 2001-02 to 2009-10 was 126 GL, much lower than for the period 1988-89 to 2000-01, when average annual inflow was 437 GL (figure B.3).

However, there has been a turnaround in rainfall in the past couple of years in south-east Queensland and by the end of 2010, south-east Queensland’s dams were considered to be full. This pattern has continued and flooding occurred in January 2011.

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Figure B.3 Annual Inflows into Wivenhoe Dam 1989–2009a

1600

1200

Average Average (1988–2000) (2001–2009) 437 GL 126 GL 800 GL

400

0 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

a Year is July to June the following year. Source: Queensland Water Commission (unpublished data).

B.2 New South Wales’ structural, institutional, governance and regulatory arrangements

Information on the structural, institutional, governance and regulatory arrangements of the New South Wales urban water sector is provided in this section.

Structural arrangements

Metropolitan arrangements

In Sydney, the provision of water and wastewater is vertically separated. The Sydney Catchment Authority is responsible for bulk water services (except the desalination plant), and water treatment. Water treatment plants are generally owned and operated by private companies. Sydney Water is responsible for the water distribution and retail functions, and treatment and transmission of wastewater. A subsidiary of Sydney Water, Sydney Desalination Pty Ltd, owns the

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desalination plant. Sydney Water also provides stormwater services (NWC 2009b; Sydney Water Corporation, sub. 21).

In Newcastle and other local government areas in the Hunter region, bulk and retail water, wastewater, and stormwater services are provided by Hunter Water, a State Government-owned, vertically-integrated utility (PWC 2010; NWC 2009b).

In the Gosford and Wyong Council areas, the Gosford/Wyong Councils’ Water Authority provides bulk and retail water, wastewater, and stormwater services (PWC 2010).

Regional urban arrangements

In regional urban New South Wales, water and wastewater services are provided by Local Government-owned water utilities. In the 1980s, 126 local water utilities provided water and wastewater services. By June 2004, following a number of council amalgamations, the number was reduced to 107. As of July 2008, the number was 106. This includes the Gosford-Wyong Joint Water Authority (discussed above) (Armstrong and Gellatly 2008).

These 106 local water utilities have a number of different service delivery models (Armstrong and Gellatly 2008):

• Ninety-six are general purpose Local Government Councils — local water utilities operated by general purpose councils are not separate legal entities.

• Four are water supply county councils and one is a water supply and sewerage county council — these are single-purpose organisations that operate independently of local councils. The boards of management (councillors) are appointed by the constituent councils.

• Five are water supply authorities — these are designated under the Water Management Act 2000 (NSW). These are (Armstrong and Gellatly 2008): – Gosford City Council — a general purpose council – Wyong Shire Council — a general purpose council – Country Energy — a State Government-owned corporation – Fish River Water Scheme (State Water) — a State Government-owned corporation – Cobar Water Board — a board established by the Water Management Act comprising membership from three mining companies and Cobar Shire Council with responsibility for ensuring water supply to each member of the Board.

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The Sydney Catchment Authority and State Water provide bulk water services to some local water utilities (PWC 2010). Stormwater services are provided by Local Governments (NWC 2009b).

Institutions and governance arrangements

The New South Wales institutional and governance arrangements discussed below include the key urban water sector legislation, institutions, and policies and plans for the sector.

Legislation

The key legislation related to the urban water sector in New South Wales are:

• Water Management Act 2000 — provides the basis for the sustainable management of water, including the legal basis for water planning, the allocation of water resources and water access entitlements (NWC 2009b).

• Water Industry Competition Act 2006 — establishes a third party access regime for water and sewerage infrastructure and a licensing regime for private sector service providers (NSW Government nd).

• Sydney Water Act 1994 — establishes the Sydney Water Corporation and its functions.

• Sydney Water Catchment Management Act 1998 — establishes the Sydney Catchment Authority and its functions.

• Hunter Water Act 1991 — establishes the Hunter Water Corporation and its functions.

• Independent Pricing and Regulatory Tribunal Act 1992 — establishes the Independent Pricing and Regulatory Tribunal (IPART) and its functions.

• Local Government Act 1993 — establishes local council responsibilities for water, wastewater and stormwater services (NWC 2009b).

• Public Health Act 1991 — drinking water quality is regulated under this Act (NWC 2009B).

• Protection of the Environment Operations Act 1997 — provides a statutory framework for preventing pollution and licensing waste discharges (NWC 2009b).

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Institutions

Key institutions in the New South Wales urban water sector include State Government entities, the metropolitan and regional urban water utilities, IPART, the Energy and Water Ombudsman, and the national-level Murray Darling Basin Authority.

NSW Office of Water

The NSW Office of Water (within the Department of Environment, Climate Change and Water) is responsible for managing New South Wales’ surfacewater and groundwater resources. Key responsibilities include determining allocation volumes, developing statutory water sharing plans, negotiating interstate and national water agreements, approving the extraction and use of water, the policies and procedures for water trading, coordinating metropolitan and regional urban water policy, and monitoring the quantity, quality and health of water sources and extractions (New South Wales Government, sub. 65).

Department of Environment, Climate Change and Water

The Department of Environment, Climate Change and Water’s (and within this department, the Environmental Protection Authority’s (NSW)) key responsibilities include protecting and caring for the environment, managing water resources, and developing and coordinating programs to address the impacts of climate change. The Department is also responsible for environmental regulation of water utilities, and oversees some water efficiency and conservation measures (New South Wales Government, sub. 65).

NSW Health

NSW Health plays a role in ensuring drinking water quality in both metropolitan and regional urban New South Wales. It is involved in developing standards for drinking water quality, and undertakes a drinking water monitoring program for local utilities (New South Wales Government, sub. 65).

Division of Local Government

The Division of Local Government (within the Department of Premier and Cabinet) is responsible for overseeing Local Government Councils in New South Wales (DLG 2010).

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Independent Pricing and Regulatory Tribunal

The Independent Pricing and Regulatory Tribunal is the independent economic regulator for New South Wales. Its water related responsibilities mostly relate to the metropolitan sector, and include price setting, licensing of water utilities and providing advice to the Minister for Water regarding the issuing of licences under the Water Industry Competition Act (New South Wales Government, sub. 65)

Energy and Water Ombudsman

The Energy and Water Ombudsman New South Wales is an industry-based ombudsman which is funded by members. Water utilities that are members include Sydney Water, Hunter Water, Gosford City Council, Wyong City Council, Essential Water (Country Energy), Shoalhaven Water and State Water (EWON 2011a).

Murray Darling Basin Authority

The Murray Darling Basin Authority is a national-level body responsible for planning and management of water resources in the Murray-Darling Basin (Engineers Australia 2010c).

Key policies and plans

Key metropolitan policies and plans include the Metropolitan Water Plan, the H250 plan and the Water Plan 2050, which all aim to secure long-term water supplies for greater Sydney, Hunter and Gosford and Wyong respectively. For example, Sydney’s Metropolitan Water Plan (2010) focuses on four main areas to secure water including dams, recycling, desalination and water efficiency (NSW Government 2010b).

The Best-Practice Management of Water Supply and Sewerage Guidelines have been developed to encourage best practice management in local water utilities in regional urban areas. They aim to encourage the effective and efficient delivery of services, and to promote sustainable water conservation practices and water demand management. Demonstrating best practice management is a requirement for a Local Government’s water utility to pay a dividend (Department of Water and Energy 2007).

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Economic regulation

Economic regulation in the New South Wales urban water sector includes pricing, licensing of water utilities and third party access arrangements.

Pricing

The Independent Pricing and Regulatory Tribunal is responsible for setting the prices that the metropolitan water utilities — Sydney Catchment Authority, Sydney Water, Hunter Water, Gosford City Council and Wyong City Council — can charge. It also sets the prices that Country Energy can charge to water customers in Broken Hill and surrounding areas.

Prices are determined by IPART via a public process that includes publishing a draft and final determination, receiving submissions and holding public hearings. The metropolitan water utilities provide pricing submissions to IPART detailing expected capital and operating expenditure. These are examined by IPART and an independent consultant (NWC 2009b).

Local Government utilities are responsible for setting their own water prices. Guidance is given to local water utilities in the Best-Practice Management of Water Supply and Sewerage Guidelines (Department of Water and Energy 2007).

Licensing

The metropolitan water utilities — Sydney Water, Sydney Catchment Authority and Hunter Water — are required to be licensed to provide water and wastewater services. Licences set out a range of requirements including drinking water requirements, infrastructure performance requirements, customer and consumer rights, system performance standards, water efficiency, demand management and recycling requirements, and environmental indicators and management. IPART audits performance against the operating licences, with the results provided to the Minister for Water (Sydney Water ndb).

The Water Industry Competition Act provides a framework for the licensing of private water service providers. A private corporation must obtain a licence from IPART to construct, maintain or operate any water industry infrastructure or to provide water or wastewater services by means of water industry infrastructure (IPART nd).

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Third party access

In 2006, New South Wales introduced third party access arrangements for water through the Water Industry Competition Act. The arrangements cover the areas of operation of Sydney Water and Hunter Water. To gain access to Sydney Water or Hunter Water’s network, an application must be made to IPART. IPART makes a recommendation to the Premier on whether the infrastructure should be declared, with the Premier making the final decision (IPART nd).

Health regulation

Drinking water management

The quality of drinking water provided by Sydney Water and Hunter Water is regulated through their operating licences, which are overseen by IPART. The licences set the standards of service they must meet, including providing a reliable supply of safe drinking water (NWC 2009b).

NSW Health, under the Public Health Act plays a role in managing drinking water quality, which includes having a memorandum of understanding with each water supplier. These define the roles that NSW Health and the water supplier play in protecting public health. Sydney Water and Hunter Water must also develop a Drinking Water Quality Management Plan every five years, which outlines its strategy for managing water quality issues associated with water supply and catchment management, and the public health aspects of wastewater disposal and reuse (NWC 2009b).

Sydney Water and Hunter Water are also required to produce annual drinking water quality reports which outline performance in meeting the Australian Drinking Water Guidelines. The Sydney Catchment Authority is required to publish an Annual Water Quality Monitoring Report containing water quality data collected from its catchments and storages. These reports are provided to NSW Health and are made public (NWC 2009b).

In regional urban areas, drinking water quality is monitored by NSW Health under the Public Health Act 1991. It undertakes a drinking water monitoring program, which involves testing the quality of water provided by local water utilities to verify that consumers are receiving safe drinking water. Local water utilities are notified if they are not meeting the Australian Drinking Water Guidelines. Local water utilities also monitor water quality against the guidelines (NWC 2009b).

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Recycled water management

Recycled water schemes managed by Sydney Water and Hunter Water are regulated through their operating licence, which requires them to operate schemes according to relevant guidelines specified by a number of government departments, including NSW Health (Power 2010).

Recycled Water schemes run by other utilities require approval from the Minister for Water under either the Local Government Act or the Water Management Act, depending on the type of utility. NSW Health plays an advisory role in relation to potential public health risk and the final use of water (Power 2010).

Private sector recycled water schemes are licensed under the Water Industry Competition Act. Licence applications to IPART are passed onto NSW Health and the NSW Office of Water for comment and potential conditions of approval. They might also need approval to install and operate from the local council under the Local Government Act (Power 2010).

Environmental health regulation

Environmental health as it relates to water is regulated the by Department of Environment, Climate Change and Water and the Environmental Protection Authority under the Protection of the Environment Operations Act and the supporting Protection of the Environment Operations (General) Regulations 1998. The Protection of the Environment Operations Act provides the framework for preventing pollution and licensing waste discharges. The Environmental Protection Authority issues environmental protection licences that set out operating and waste discharge limits, and other conditions such as monitoring requirements, providing certification of compliance with the licences and compliance with a mandatory environmental audit program (NWC 2009b).

B.3 Victoria’s structural, institutional, governance and regulatory arrangements

Information on the structural, institutional, governance and regulatory arrangements of Victoria’s urban water sector is provided in this section.

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Structural arrangements

The structural arrangements in both the metropolitan and regional urban water sector have undergone significant reform in Victoria in recent years.

Metropolitan arrangements

Victoria’s metropolitan water supply arrangements have undergone significant reform, including vertically separating bulk and retail services. Prior to reform, Melbourne Water was the vertically-integrated State Government-owned utility providing water and wastewater services. In 1995, Melbourne Water became the provider of bulk water and stormwater services, and three retailer-distributors, Yarra Valley Water, South East Water and City West Water, were established to provide retail water and wastewater services in their own geographic area (Yarra Valley Water 2010). Local councils also play a role in stormwater, being responsible for the local drains, road networks and street and property drainage (Melbourne Water 2011a).

Regional urban arrangements

Prior to structural reforms in Victoria’s regional urban water sector, water, wastewater and stormwater services were provided by vertically-integrated Local Government-owned utilities. In 1994, as part of wider Local Government reforms, these suppliers were amalgamated to create 15 catchment-based State Government-owned vertically-integrated utilities providing water and wastewater services. Catchment Management Authorities were also established to coordinate the management of catchments in their area. In 2005, the utilities were further merged reducing the number to 13 (Armstrong and Gellatly 2008; DSE 2011a).

Although these regional urban utilities are vertically-integrated, some source some of their bulk water from Melbourne Water, and rural water providers such as Southern Rural Water and Goulburn Murray Water (NWC 2009b).

Local Governments are responsible for providing stormwater services in regional urban areas (NWC 2009b).

Institutions and governance arrangements

The Victorian institutional and governance arrangements discussed below include the key urban water sector regulation, institutions, and policies and plans for the sector.

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Legislation

The key legislation related to Victoria’s urban water sector include (VCEC 2008):

• Water Act 1989 — the principle water-related Act in Victoria, with purposes related to integrated water resource management, promoting the orderly, equitable, efficient and sustainable use of water. It details the objectives and governance arrangements for the regional urban water corporations and Melbourne Water.

• Water Industry Act 1994 — enabled the separation of Melbourne Water and established a licensing system for service providers.

• State Owned Enterprises Act 1992 — establishes the Melbourne retailer-distributors as State Government-owned companies under the Act.

• Catchment and Land Protection Act 1994 — provides a framework for management and protection of catchments (NWC 2009b). Establishes Catchment Management Authorities and their functions.

• Safe Drinking Water Act 2003 — provides a regulatory framework for managing drinking water quality.

• Food Act 1984 — plays a role in regulating drinking water quality by prohibiting the supply or sale of water for human consumption that is unsafe or unsuitable.

• Environmental Protection Act 1970 — provides a framework for the protection of the environment. Establishes the Environmental Protection Authority (Vic) (EPA) and its functions.

• Melbourne Water Corporation Act 1992 — establishes Melbourne Water and its functions.

• Essential Services Commission Act 2001 — provides an economic regulatory framework for regulated industries, and establishes the Essential Services Commission (ESC) and its functions.

Institutions

The key institutions involved in Victoria’s urban water sector include State Government department and ministers, water utilities, the EPA, the ESC, the Energy and Water Ombudsman Victoria, the Consumer Utilities Advocacy Centre and the national-level Murray Darling Basin Authority (section B.2).

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Department of Sustainability and Environment

The Department of Sustainability and Environment is the lead agency that manages water resources in Victoria. It is responsible for developing and implementing water policy, including looking after water resource policy issues, developing and managing appropriate operational and governance frameworks, and coordinating the conduct of the water sector intergovernmental policy and program obligations (DSE 2011a).

Environmental Protection Authority

The EPA is responsible for regulating recycled water quality and environmental health (NWC 2009b).

Department of Human Services

The Victorian Department of Human Services is responsible for regulating drinking water quality, and plays a role in managing recycled water quality (NWC 2009b).

Essential Services Commission

The ESC is the independent economic regulator for Victoria. Its roles relating to water are set out in the Essential Services Commission Act and the Water Industry Regulatory Order (2003) which is made by the Governor in Council. Its roles include setting and regulating water prices, regulating the standards and conditions of service of water utilities, publishing customer service codes and publishing performance reports (DSE 2011a; ESC 2009e).

Energy and Water Ombudsman Victoria

The Energy and Water Ombudsman Victoria (EWOV) can investigate and resolve disputes related to electricity, gas and water companies. EWOV is a fully member-funded industry service that companies are required to participate in as part of their licence obligations. It is independent from Government (EWOV 2011).

Consumer Utilities Advocacy Centre

The Consumer Utilities Advocacy Centre is a Victorian Government-funded, independent advocacy organisation established under the Corporations Act. It was established to promote fair, equitable and balanced regulatory outcomes in the

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electricity, gas and water industries, with a particular focus on low income, disadvantaged and rural and regional consumers (CUAC 2011b).

Key policies and plans

Key policies and plans of Victoria’s urban water sector include Our Water, Our Future, sustainable water strategies and water utilities’ Water plans.

Our Water Our Future

Victoria’s key water policy statement is Our Water, Our Future, published in 2004. It sets out 110 different initiatives that aimed to secure water supplies over the next 50 years. The follow up document Our Water, Our Future: The Next Stage of the Government’s Water Plan published in 2007 set out long-term solutions to secure water supply, including building the desalination plant and expanding the water grid (Victorian Government 2009; 2010b).

Sustainable Water Strategies

Sustainable water strategies are being developed by the Department of Sustainability and Environment. They set out a long-term regional plan to secure water for local growth, while maintaining the balance of the area’s water system and safeguarding the future of its rivers and other natural water sources (Engineers Australia 2010h).

Water plans

Water utilities are required to develop water plans under their Statement of Obligations. They feed into the price setting process, and set out how the organisation will deliver on service standards, costs, revenue requirements, and the prices proposed to meet these revenue requirements. These plans are reviewed by the ESC and independent consultants (Engineers Australia 2010h).

Economic regulation

Economic regulation in Victoria’s urban water sector includes price setting and regulating utilities through their statements of obligations.

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Pricing

The ESC sets both bulk and retail water and wastewater prices for urban water businesses. Water utilities are required to submit water plans to the ESC before it makes its determination. These water plans include costs and revenue requirements and the prices proposed to meet these revenue requirements. These plans are examined by an independent consultant. Based on these water plans, the ESC makes both draft and final price determinations. Public consultation is undertaken before and after the draft determination (DSE 2011a; NWC 2009b).

Statement of obligations

The main regulatory instrument used to regulate water utilities is the statement of obligations. Statements of obligations are issued to Victoria’s water utilities by the Minister for Water, Environment and Climate Change under the Water Industry Act 1994. They impose obligations on the water businesses in relation to their performance and the exercise of their powers (DSE 2011a).

Health regulation

Drinking water management

Drinking water quality is regulated in Victoria by the Department of Human Services under the Safe Drinking Water Act. This Act requires drinking water providers to comply with drinking water standards, prepare risk management plans, and publicly disclose relevant water quality information. The risk management plans are audited by the Department of Human Services and the results published in annual safe drinking water reports. Supporting the Safe Drinking Water Act, the Safe Drinking Water Regulations 2005 set out the requirements and procedures for the preparation and auditing of the risk management plans, including specifying quality standards, testing requirements and reporting schedules. Standards are based on the Australian Drinking Water Guidelines 2004 (DSE 2011a; NWC 2009b).

Along with the risk management plans, water providers are also required to submit monthly water quality testing results and annual drinking water quality reports. The Department of Human Services prepares the Annual Report on Drinking Water Quality, which includes a summary of compliance by water businesses to drinking water standards and water quality incidents (DSE 2011a; NWC 2009b).

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Recycled water management

Recycled water quality in Victoria is regulated by the EPA, under the Environmental Protection Act. Approval and a licence must be obtained to operate a recycled water scheme, except where schemes are deemed large enough that they can be exempt from licensing provisions, and the scheme meets EPA guidelines. Class A schemes require both EPA approval and Department of Human Services endorsement. All schemes require a risk management plan, which includes monitoring and reporting to be undertaken. This framework for managing recycled water quality is set out in the EPA's Guidelines for environmental management: use of reclaimed water (NWC 2009b).

Environmental health regulation

Environmental health regulation as it relates to water is undertaken by the EPA under the Environmental Protection Act. The EPA is responsible for regulating the discharge of wastewater to the environment. Water suppliers are required to obtain a license from the EPA to discharge wastewater. These set out a number of requirements, including a joint commitment by the water business and the EPA to increase sustainability of the water business, and performance requirements for the water business to meet, including submitting an Annual Performance Statement to the EPA (DSE 2011a; NWC 2009b).

B.4 Queensland’s structural, institutional, governance and regulatory arrangements

Information on the structural, institutional, governance and regulatory arrangements of Queensland’s urban water sector is provided in this section.

Structural arrangements

South-east Queensland

The structural arrangements of south-east Queensland’s urban water sector have undergone significant reform in recent years. Prior to reform, Seqwater provided bulk water services, and city councils provided retail water and wastewater services. As of July 2008, the bulk water arrangements changed, and bulk water and transmission services became the responsibility of four entities (QWC 2010b):

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• Two bulk water utilities, Seqwater, which owns all the dams, groundwater infrastructure and water treatment plants, and WaterSecure, which owns the Tugun desalination plant and the Western Corridor Recycled Water Scheme. Seqwater and WaterSecure will merge on 1 July 2011 (Fraser and Robertson 2010).

• Linkwater, which owns all the major pipelines in south-east Queensland.

• The South East Queensland Water Grid Manager, which owns the water entitlements, and manages the strategic operations of the water grid by selling treated water bought from the bulk suppliers to retailers and other customers (SEQ Water Grid Manager 2011).

As of July 2010, the city council utilities were amalgamated in three Local Government-owned retailer-distributors — Unity Water, Queensland Urban Utilities and Allconnex Water — each serving a different area of south-east Queensland (QWC 2010b).

Stormwater services are provided by Local Government (NWC 2009b).

Outside of south-east Queensland

Outside of south-east Queensland, vertically-integrated Local Government-owned utilities provide water and wastewater services. This sector has also undergone recent reform, with local council amalgamations in 2008 resulting in a reduction of the number of regional urban water utilities to 71. The majority of these are local council utilities, although there are two commercialised water boards, the Gladstone Area Water Board and the Mount Isa Water Board, and a corporatised utility, the Local Government-owned Wide Bay Water Corporation. Some utilities source bulk water from the rural water utility SunWater. Stormwater services are also provided by local government (Department of Environment and Resource Management (Qld), sub. 60; Local Government Association of Queensland, sub. 20; NWC 2009b).

Institutions and governance arrangements

The Queensland institutional and governance arrangements discussed below include the key urban water sector regulation, institutions and policies and plans for the sector.

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Legislation

The key legislation related to Queensland’s urban water sector include:

• Water Supply (Safety and Reliability) Act 2008 — regulates infrastructure management and service provision by water and sewerage service providers, the supply of drinking water and recycled water, and dam safety (DERM 2009b).

• Water Act 2000 — provides a system for the planning, allocation and use of water, as well as establishing the regulatory framework for the provision of water and wastewater services, and sets out the Queensland Water Commission’s roles (Department of Environment and Resource Management (Qld), sub. 60; Engineers Australia 2010e, NWC 2009b).

• Environmental Protection Act 1994 — provides the regulatory framework for the protection of the environment (NWC 2009b).

• Public Health Act 2005 and the Public Health Regulation 2005 — sets standards for drinking water and recycled water (DERM, sub. 60).

• Local Government Act 2009 —includes provisions for Local Government utilities setting water prices.

• Queensland Competition Authority Act 1997 — establishes the Queensland Competition Authority (QCA) and its functions.

Institutions

The key institutions involved in Queensland’s urban water sector include State Government entities, water utilities, the Queensland Water Commission and the QCA.

Department of Environment and Resource Management

The Department of Environment and Resource Management (DERM) is the key State Government department in urban water. It was formed in May 2009 with the integration of the Department of Natural Resources and Water and the Environmental Protection Agency (DERM, sub. 60).

Its responsibilities include setting and leading overall water policy and reform, water supply planning, water resource allocation, regulation and monitoring, and assessment. It administers the Water Supply (Safety and Reliability) Act 2008, the Water Act 2000 and the Environmental Protection Act 1994 and its associated regulations and policies (DERM, sub. 60).

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Queensland Health

Queensland Health plays a role in drinking water and recycled water management (DERM 2011).

Water and wastewater service providers

Along with providing water and wastewater services, urban water service providers are also responsible for planning for current and future growth, maintaining assets, establishing customer service protocols, processes and standards, ensuring adequate workforce skills and capacity, and outside of south-east Queensland, setting prices (DERM, sub. 60).

Queensland Water Commission

The Queensland Water Commission was established in 2006 under the Water Act 2000. It is an independent body that is responsible for achieving safe, secure and sustainable water supplies in south-east Queensland and other designated areas. Its main functions are to advise the Minister on matters relating to water supply and demand management, delivery of level of service objectives, implementation and management of regional water security programs, and ensuring compliance with these programs and water restrictions (DERM, sub. 60).

Queensland Competition Authority

The QCA is Queensland’s independent economic regulator. Its water related roles include the oversight of monopoly business activities. Specifically, its roles include investigating and reporting on pricing practices of water utilities, and mediating on access and water supply disputes (QCA 2010c).

Queensland Ombudsman

The Queensland Ombudsman is an independent complaints agency that aims to ensure that public agencies (such as State Government departments and bodies and Local Councils) act fairly (Queensland Ombudsman 2008).

Key policies and plans

Key Queensland water policies and plans include regional plans, water resource plans, regional water supply strategies and total water cycle management plans.

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Regional Plans

Regional plans aim to help different areas in Queensland meet challenges associated with managing growth, population change, economic development, protecting the environment, and infrastructure provision. Water management is one of the topics covered. Currently, statutory and non-statutory regional plans are in place for south-east Queensland and other areas (DERM, sub. 60).

Water resource plans

Water resource plans are developed on a catchment basis and provide a framework for the allocation and management of water in a specified area. They define the availability of water, provide a framework for managing and taking water, identify priorities and mechanisms for dealing with future water requirements, and provide a framework for reversing degradation in natural ecosystems. The majority of Queensland has water resource plans in place at this stage (DERM, sub. 60; QWC 2010b).

A resource operations plan is developed to implement the water resource plan by setting out the day-to-day arrangements used to put the strategies into effect (DERM, sub. 60).

Regional water supply strategies

Regional water supply strategies are used to ensure that water supply security is met on a regional basis in the short and long term. They balance the water demand and supply requirements, and provide regional water supply solutions for the next 50 years. Regional water supply strategies have been completed for south-east Queensland, central Queensland and far north Queensland. Strategies for north Queensland, Mackay, Whitsunday, Wide Bay Burnett and north-west Queensland are expected to be released in 2011 (DERM 2010b; sub. 60).

Total water cycle management plans

Under the Environmental Protection (Water) Policy 2009, local governments with populations of greater than 25 000 are required to develop total water cycle management plans. These consider all the elements of the water cycle to deliver community needs while optimising social and environmental benefits, and minimising costs (DERM, sub. 60).

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Other key south-east Queensland plans

Other key south-east Queensland plans include the South East Queensland Regional Water Security Program, which is a statutory program that provides a greater level of water security, and the South East Queensland Healthy Waterways Strategy 2007–2012, which includes 500 actions to maintain and improve waterway health (DERM, sub. 60; QWC 2010b).

Economic regulation

Economic regulation in the Queensland urban water sector includes pricing, licensing and third party access arrangements.

Pricing

In south-east Queensland, bulk water prices are set by the State Government, with it recently setting a 10 year bulk water price path in 2008. This was adjusted downwards in December 2010. Retail prices are set by the three retailer-distributors. The QCA can be requested to monitor or investigate the pricing practices of utilities by the State Government. It has been proposed that retail prices will be subject to full price regulation by the QCA from 2013. Until then, there is currently an interim price monitoring framework in place, develop by the QCA (Council of Mayors (SEQ), sub. 77; DERM, sub. 60; NWC 2009b; QCA 2010c).

In regional urban areas, water utilities set prices, in accordance with the Local Government Act 2009, which sets out a framework for water charges. The QCA has developed the Statement of Regulatory Pricing Principles for the Water Sector to assist Local Governments in setting prices (DERM, sub. 60, NWC 2009b).

Licensing

Water licences are required in order for water to be taken or interfered with. They are issued by DERM under the Water Act. Licences contain conditions such as requirements to monitor how much water is taken, threshold flow conditions that must be met before water is taken, the volume of and rate at which water can be taken, and the locations water can be taken from (DERM 2009a).

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Third party access

The Queensland Competition Authority Act includes a third party access regime that covers water, as well as other utilities and transport infrastructure. It is overseen by the QCA.

Health regulation

Drinking water management

Drinking water in Queensland is regulated under the Water Supply (Safety and Reliability) Act. The Act is administered by DERM, who is also the regulator. Drinking water is regulated using a phased approach with two stages. In the first stage, the regulator issues a notice requiring water quality criteria to be met, along with the monitoring and reporting of drinking water quality. The drinking water provider must report monitoring results on a quarterly basis, and notify the regulator when water quality criteria are not met. The notice continues to apply until an approved Drinking Water Quality Management Plan is in place (DERM 2011; sub. 60).

Under stage two, water providers develop and implement a Drinking Water Quality Management Plan. This documents the risks to the drinking water service, as well as the steps taken to manage these risks, and the operational and monitoring requirements for managing the drinking water service. This approach is based on the Australian Drinking Water Guidelines 2004. Drinking water must meet the requirements for drinking water quality that are set under the Public Health Act and the Public Health Regulation 2005. The Drinking Water Quality Management Plan must be submitted to the regulator for approval. If water quality criteria are not met the regulator must be notified, and Queensland Health can become involved where there are public health risks (DERM 2011; sub. 60).

Recycled water management

Recycled water in Queensland is regulated by the Water Supply (Safety and Reliability) Act. This legislation requires recycled water providers to either have an approved recycled water management plan, or an exemption from having a plan, or be covered by transitional arrangements that stage the introduction of requirements over time. Recycled water management plans provide a risk-based system for managing recycled water and aim to protect public health. All recycled water providers, including those with exemptions, are required to report to the regulator,

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DERM, including submitting annual reports (except those under transitional arrangements) and reporting on non-compliance with water quality criteria. A number of guidelines have been prepared to ensure compliance with the requirements of the Act (DERM 2010d; NWC 2009b)

Environmental health regulation

Environmental health, as it relates to water, is regulated through the Environmental Protection Act, the Environmental Protection (Water) Policy 2009 and Environmental Protection Regulation 2008. The environmental health regulator in Queensland is DERM. The Environmental Protection Act sets out the framework for the protection of the environment and regulates environmentally relevant activities, which are set out in the Environmental Protection Regulation 2008. DERM and local councils are responsible for the administration and enforcement of these activities, and DERM is responsible for licensing these activities, through the issuing of environmental authorities, development approvals or registration certificates, which regulate discharge to waterways (NWC 2009b).

The Environmental Protection (Water) Policy 2009 provides a framework for the development of environmental values and water quality objectives for Queensland waters (including water for drinking, water supply and water for industry). These are developed in accordance with the National Water Quality Management Strategy and the Queensland Water Quality Guidelines. These values and objectives must be considered when developing plans such as water resource plans. DERM is responsible for monitoring water quality and it makes the results publicly available (DERM 2010a; NWC 2009b).

B.5 South Australia’s structural, institutional, governance and regulatory arrangements

Information on the structural, institutional, governance and regulatory arrangements of South Australia’s urban water sector is provided in this section.

Structural arrangements

In South Australia, urban water and wastewater services are predominantly provided by SA Water, a State-Government-owned, vertically-integrated utility. In addition to SA Water, there are some small Local Government service providers, such as Coober Pedy Council. Currently the provision of water and wastewater

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services to Adelaide is contracted out to United Water, a private company. Whilst this contract expires in June 2011, water and wastewater services in Adelaide will continue to be provided by the private sector (Emmerson 2010; United Water 2009). Stormwater and drainage services are provided by Local Government and Natural Resource Management Boards (PWC 2010).

Institutions and governance arrangements

The South Australian institutional arrangements discussed below include the key urban water sector regulation, institutions, and policies and plans for the sector.

Legislation

The key legislation related to the urban water sector in South Australia are:

• Natural Resources Management Act 2004 — provides the framework for managing South Australia’s natural resources, including natural resource planning and water allocation and management, with the aim of promoting sustainable use of water resources (NWC 2009b). Establishes the National Resource Management Boards and their functions.

• South Australian Water Corporation Act 1994 — establishes SA Water and its functions.

• Sewerage Act 1929 — empowers SA Water to construct and operate sewerage systems (Engineers Australia 2010f).

• Waterworks Act 1932 — empowers SA Water to construct and operate water supply systems (Engineers Australia 2010f).

• Environment Protection Act 1993 — provides the regulatory framework to protect South Australia’s environment. It provides for the development of environmental protection policies and the issuing of licences (NWC 2009b). Establishes the Environmental Protection Authority (EPA) (SA) and its functions. – Environmental Protection (Water Quality) Policy 2003 — subordinate legislation of the Act that allows for the development of environmental values and water quality objectives for South Australian waters (NWC 2009b).

• Food Act 2001 — establishes a framework for regulating drinking water (NWC 2009b).

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• Public and Environmental Health Act 1987 and the Public and Environmental (Waste Control) Regulations 1995 — play a role in regulating recycled water.

• Essential Services Commission Act 2002 — establishes the Essential Services Commission of South Australia (ESCOSA) and its functions.

• Proposed Water Industry Act — This will replace some of the existing legislative arrangements and will cover water demand and supply planning arrangements, appointing ESCOSA as the independent economic regulator, licensing arrangements for service providers and technical regulation (South Australian Government, sub. 52).

Institutions

The key institutions in the South Australia urban water sector include State Government entities, SA Water, Natural Resource Management Boards, ESCOSA and the national-level Murray Darling Basin Authority (section B.2).

Department for Water

The Department for Water is the key Government department that is responsible for water. Its responsibilities in the urban water sector include leading urban water policy, water planning and management, water allocation planning, research, monitoring and evaluation, and overseeing major water programs (South Australian Government, sub. 52).

Commissioner for Water Security

The Commissioner for Water Security is responsible for advising Government on water security policy and options, and overseeing the implementation of Water for Good (South Australian Government, sub. 52).

Department of Environment and Natural Resources

The Department of Environment and Natural Resources is responsible for administering the Natural Resources Management Act 2004 and overseeing the Natural Resource Management Boards (South Australia Government, sub. 52).

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Department of Treasury and Finance

The Department of Treasury and Finance plays a role in setting water and wastewater prices (NWC 2009b).

Department of Health

The Department of Health plays a role in regulating drinking water and recycled water quality (NWC 2009b).

Environmental Protection Authority

The EPA plays a role in regulating recycled water quality and regulates environmental health (NWC 2009b).

SA Water

Along with providing water and wastewater services, SA Water also maintains and invests in the water and wastewater infrastructure, carries out research, provides consultancy, develops and markets commercial products within its area of expertise, advises water users in the efficient and effective use of water, and encourages and facilitates public and private sector participation in the provision of water and wastewater services (Engineers Australia 2010f; South Australian Government, sub. 52)

Natural Resource Management Boards

Natural Resource Management Boards are responsible for the management of natural resources in their respective areas. This includes developing and implementing natural resource management and water allocation plans, and ongoing monitoring and evaluation of water resources and dependent ecosystems (NWC 2009b).

Essential Services Commission of South Australia

ESCOSA currently can undertake inquiries into the processes that the Government undertakes to determine water and wastewater prices (NWC 2009b).

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Under the proposed Water Industry Act, ESCOSA will take on the role of independent economic regulator for the industry, including setting prices from July 2012 (South Australian Government, sub. 52).

Ombudsman SA

The Ombudsman SA can investigate complaints relating to South Australian Government and Local Government agencies, and make recommendations to correct any identified problems (Ombudsman South Australia 2011).

Key policies and plans

The South Australian urban water sector’s major policy document is Water for Good (2009). It sets out broad objectives for the urban water sector and water security over the coming years. It outlines the key objectives and 94 actions to ensure that water supplies are safe, secure and reliable until 2050. The key elements of Water for Good cover a number of topics including establishing new regulatory arrangements (including economic regulation), adaptive management approaches to supply and demand, introducing independent planning processes where needed, water sensitive urban design, and water restrictions and water conservation measures (South Australian Government 2009; sub. 52).

Economic regulation

Economic regulation in South Australia includes price setting, and soon will include licensing of service providers.

Pricing

Up until July 2012, water and wastewater prices in South Australia are set by the South Australian Cabinet. The prices are set out in Part A of the Transparency Statement for Metropolitan and Regional Water and Wastewater Prices in Metropolitan and Regional South Australia, which is prepared by the Department of Treasury and Finance. This statement allows for public scrutiny of the process undertaken by Government, including the Government's compliance with the COAG principles, to determine prices (DTF 2010; NWC 2009b).

The Treasurer can give ESCOSA directions to undertake an inquiry into the processes that the State Government undertakes to determine water and wastewater prices. ESCOSA’s final report on its inquiry is published as Part B of the

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Transparency Statement. Part C of the Transparency Statement is the Government’s response to ESCOSA’s inquiry (DTF 2010; NWC 2009b).

From July 2012, ESCOSA will be responsible for setting water and wastewater prices (South Australia Government, sub. 52).

Licensing

Under the new arrangements, licensing of water service providers, including private operators, will be introduced. Licenses will be issued by ESCOSA, which will oversee the regime (Department for Water 2010).

Third party access

The South Australian Government has committed to developing a state-based third party access regime by 2015 under Water for Good. There are currently some voluntary access arrangements that SA Water has negotiated within its rural water supply network (Department for Water 2010).

Health regulation

Drinking water management

Drinking water in South Australia in managed under the Food Act, which ensures that food (and water, which is defined as a food under this Act) is safe for human consumption. The Department of Health is responsible for ensuring drinking water is safe. SA Water has developed a Drinking Water Quality Management Framework and undertakes testing and reporting according to the Australian Drinking Water Guidelines. It produces an annual report detailing its performance, which is provided to the Department of Health and is made available to the public (NWC 2009b).

Recycled water management

Recycled water in South Australia is managed under the Public Health and Environmental Act and the Public and Environmental Health (Waste Control) Regulation 1995. The Department of Health and the EPA are the main bodies in charge of regulating recycled water quality. The Department of Health must approve any recycled water schemes, and once they reach a certain size, the EPA also plays a role in overseeing the scheme (NWC 2009b; Power 2010).

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These bodies also produce the South Australian Reclaimed Water Guidelines (treated effluent), which describe methods for the use of reclaimed water from sewage treatment plants that minimise risks to public health and the environment (NWC 2009b).

Environmental health regulation

Environmental health management, as it relates to water, is regulated by the Environmental Protection Act and its subordinate legislation the Environmental Protection (Water Quality) Policy 2003. Under the Environmental Protection Act, the EPA is responsible for protection of water quality and management of pollution. The EPA issues environmental authorisations that are required to undertake certain activities under the Act. These authorisations can also spell out conditions in relation to a licence to ensure compliance (NWC 2009b).

The Environmental Protection (Water Quality) Policy 2003 supports these by providing the environmental values and water quality objectives that feed into these notices and licences. The EPA can require monitoring and reporting as part of licence conditions. The requirements are described in the Environmental Protection Authority Guidelines for Monitoring Plan Requirements and Reporting Requirements (NWC 2009b).

B.6 Western Australia’s structural, institutional, governance and regulatory arrangements

Information on the structural, institutional, governance and regulatory arrangements of Western Australia’s urban water sector is provided in this section.

Structural arrangements

In Western Australia, the Water Corporation, a State Government-owned vertically-integrated utility, provides bulk and retail water and wastewater services to most of urban Western Australia, except in Bunbury, Busselton, Rottnest Island and Dampier, Paraburdoo and Tom Price. In Bunbury, Busselton and Rottnest Island, the Government statutory authorities, Aqwest, Busselton Water and Rottnest Island Authority provide retail water services, and in Dampier, Paraburdoo and Tom Price, Hamersley Iron Pty Ltd, a private company, supplies water and wastewater services. In addition, some Local Governments provide sewerage services.

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Stormwater services are provided by the Water Corporation and Local Governments (PWC 2010; NWC 2009b).

Institutions and governance arrangements

The Western Australian institutional and governance arrangements discussed below include the key urban water sector regulation, institutions and policies and plans for the sector.

Legislation

The key legislation relating to the urban water sector in Western Australia include:

• Water Services Licensing Act 1995 — establishes the regulatory framework for the water services industry including the licensing of water service providers.

• Health Act 1911 — plays a role in the regulation of drinking water and recycled water quality (NWC 2009b).

• Environmental Protection Act 1986 — establishes the Environmental Protection Authority and its roles, including the prevention, control and abatement of pollution and environmental harm, for the conservation, preservation, protection, enhancement and management of the environment (EPA 2011).

• Water Corporation Act 1995 — establishes the Water Corporation and its functions.

• Water Agencies (Powers) Act 1984 — gives the Minister for Water the power to determine water charges for the Water Corporation (NWC 2009b).

• Water Boards Act 1904 — gives the Minister for Water the power to determine water charges for Aqwest and Busselton Water (NWC 2009b).

Institutions

The key institutions involved in Western Australia’s urban water sector include State Government departments and entities, the water and wastewater service providers and the Economic Regulation Authority.

Department of Water

The Western Australian Department of Water is the lead Government agency on water. Its responsibilities related to urban water include (Department of Water 2011):

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• high level strategy and policy, including developing water policies and plans, advising the Minister for Water, implementing and monitoring water reform and legislative change, and developing community education and engagement strategies

• water resource management, including monitoring and protecting surfacewater sources, playing a role in protecting and recharging underground aquifers, assisting state and industry in engineering and technical solutions to protect catchment areas and waterways, and identifying and assessing water resources suitable for new drinking water supplies.

Western Australian Treasurer

The Western Australian Treasurer is responsible for setting water and wastewater prices (NWC 2009b).

Department of Health

The Department of Health and the Minister for Health regulate drinking water quality, and are involved in managing recycled water quality (NWC 2009b).

Department of Environment and Conservation

The Department of Environment and Conservation plays a role in managing recycled water and environmental health (NWC 2009b).

Environmental Protection Authority

The Environmental Protection Authority plays a role in managing recycled water and environmental health, through conducting environmental impact assessments and initiating measures to protect the environment from environmental harm and pollution (NWC 2009b).

Water Corporation

Along with providing water and wastewater services, the Water Corporation also plays a role in planning and developing future water sources (Water Corporation ndc).

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Economic Regulation Authority

The Economic Regulation Authority (ERA) is the independent economic regulator for Western Australia. Its main functions include licensing water service providers and conducting inquiries into water and wastewater prices which the Treasurer uses to set final prices (ERA 2011b, NWC 2009b).

Ombudsman Western Australia

The Western Australian Ombudsman is an independent entity that can investigate and resolve complaints relating to public authorities (Ombudsman Western Australia nd).

Key policies and plans

Key water plans in the Western Australian urban water sector include the Water Corporation’s Water Forever, the State Water Plan and regional water plans.

Water Forever

Water Forever is the Water Corporation’s 50 year plan to deliver water and wastewater services to Perth and surrounding areas including the Goldfields. It includes a number of plans which set out actions and goals, in the hope of achieving targets around reducing consumption, increasing water recycling and developing new water sources (Water Corporation 2009).

State Water Plan

The State Water Plan was released in 2007. It provides a strategic policy and planning framework for meeting the State’s water demands until 2030, and builds on the State Water Strategy 2003, the 2004 National Water Initiative and the Blueprint for Water Reform in Western Australia 2006. It is a whole-of-Government initiative with 11 Government agencies sharing over 100 priority actions that are to be completed by 2011 (Department of Water nd).

Regional water plans

Regional water plans are currently being developed by the Department of Water. They assess current resource management and service delivery, identify current and future water availability and demand, and set priority actions to implement water

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policy and planning, improve water resource management and establish water management plans (Engineers Australia 2010i).

There are a number of other water management plans, including drinking water source protection plans, water allocation plans, drainage plans, floodplain plans and waterways plans (Engineers Australia 2010i).

Economic regulation

Economic regulation of the Western Australian urban water sector includes price setting and licensing of service providers.

Pricing

The Western Australian Minister for Water sets water and wastewater prices for the Water Corporation, through a by-law process under the Water Agencies (Powers) Act. The water and wastewater prices of other water service providers (for example, Aqwest and Busselton Water) are set by their boards and approved by the Minister for Water (NWC 2009b).

The Western Australian Treasurer can request the ERA to undertake investigations into water and wastewater prices of any water provider in Western Australia, to assist the Government in setting prices. The ERA also has an ongoing reference to provide an annual review of the Water Corporation's prices. Outside of regular price determination procedures, water service providers can request the Minister for Water to approve changes to prices (NWC 2009b).

Licensing

Under the Water Services Licensing Act, entities providing potable water, non-potable water, sewerage and drainage services are required to hold a licence that is issued by the ERA. Licence holders are required to meet service standards, including water quality and water quality service standards, and customer service and complaints handling standards. Performance against licence conditions is monitored through a compliance and performance reporting regime, and through regular operational audits and asset management reviews (ERA 2011b).

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Health regulation

Drinking water management

Drinking water quality is regulated in Western Australia under the Health Act and the Water Services Licensing Act. Under the Health Act, the Minister for Health, supported by the Department of Health, is responsible for ensuring public health. The Minister and Department are supported by the Advisory Committee for the Purity of Water, which advises on issues associated with protecting public drinking water (NWC 2009b).

Under the Water Services Licensing Act 2005, the operating licences that water service providers must obtain from the ERA specify drinking water quality standards, which are also set out in a memorandum of understanding between the water provider and the Department of Health. These memoranda define the Department of Health as the regulator of drinking water quality. Under the operating licence, a water service provider is required to report quarterly to the ERA and the Department of Health on their compliance with drinking water standards (NWC 2009b).

Recycled water management

The regulation of recycled water quality occurs in a similar way to drinking water regulation with operating licences setting standards. The Department of Health also plays a role. In addition, the Environmental Protection Authority undertakes impact assessments to determine if the scheme should go ahead, and under what conditions. The Department of Environment and Conservation is required to grant approvals to schemes with a high capacity and issue a licence for discharges. This licence ensures that the impact of discharges on the environment is acceptable and includes monitoring and reporting requirements (NWC 2009b).

Environmental health regulation

Environmental health is regulated under the Environmental Protection Act and the Environmental Protection Regulations 1987. Under this legislation the Department of Environment and Conservation is responsible for licensing certain activities that can impact on environmental health. Conditions of these licences can include regular audits, monitoring and reporting on compliance with a standard or code of practice. The Environmental Protection Authority undertakes environmental impact

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assessments to determine if the activity will significantly impact on the environment, and if so, under what conditions it should go ahead (NWC 2009b).

B.7 Tasmania’s structural, institutional, governance and regulatory arrangements

Information on the structural, institutional, governance and regulatory arrangements of Tasmania’s urban water sector is provided in this section.

Structural arrangements

The structure of Tasmania's water sector has undergone significant reform in recent years. Prior to reform, much of Tasmania’s water sector was vertically separated. Twenty-eight of the State’s 29 Local Government Councils provided retail, and sometimes bulk, water services, and 27 of them provided wastewater services, in their geographical area. Many also sourced bulk water from three bulk water utilities, Hobart Water, Esk Water and Cradle Coast Water (Tasmanian Government, sub. 70).

From 1 July 2009, water and wastewater services are no longer provided by Local Government utilities, but three vertically-integrated Local Government-owned trading enterprises, Southern Water, Ben Lomond Water and Cradle Mountain Water, each servicing a different geographic area of Tasmania (Tasmanian Government, sub. 70). A common service provider owned by the three corporations, Onstream, was established to provide such services as information technology, finance and billing (Onstream 2010). Local government provides stormwater and drainage services (NWC 2009b).

Institutions and governance arrangements

The Tasmanian institutional and governance arrangements discussed below include the key urban water sector regulation and institutions.

Legislation

The key legislation related to the urban water sector in Tasmania are:

• Water and Sewerage Industry Act 2008 — establishes an economic regulatory framework for the water and sewerage industry, including the establishment of a

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licensing regime, provisions for price regulation, customer service standards and performance monitoring of the industry (DPIPWE 2010; NWC 2009b).

• Water and Sewerage Corporations Act 2008 — establishes the three water and sewerage corporations and the common services provider (Onstream).

• Water Management Act 1999 — provides the basis for the management of Tasmania’s freshwater resources (NWC 2009b).

• Environmental Management and Pollution Control Act 1994 — provides the regulatory framework to protect Tasmania's environment from pollution and waste management (NWC 2009b). Established the Environmental Protection Authority (EPA) (Tas) and its functions.

• Public Health Act 1997 — provides the framework for regulating drinking water and recycled water quality (NWC 2009b).

Institutions

The key institutions involved in Tasmania’s urban water sector include State Government departments, the EPA, utilities, and the economic regulator.

Department of Primary Industries, Parks, Water and Environment

The Department of Primary Industries, Parks, Water and Environment is the lead Sate Gvernment agency in the water sector. Along with administering the Water Management Act 1999, it is responsible for overall water policy, planning and management (NWC 2009b).

Department of Health and Human Services and the Director of Public Health

The Director of Public Health, supported by the Department of Health and Human Services, is responsible for regulating drinking water quality (NWC 2009b).

Office of the Tasmanian Economic Regulator

The Office of the Tasmanian Economic Regulator (OTTER) is Tasmania’s independent economic regulator. Its roles include, and will eventually include, regulating prices, licensing service providers, establishing and administering the customer service code, and monitoring and reporting on the performance of the service providers (OTTER 2010b).

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Environmental Protection Authority

The EPA is responsible for regulating a number of activities under the Environmental Management and Pollution Control Act 1994, including activities that relate to wastewater disposal (EPA Tasmania 2010).

Ombudsman Tasmania

The Ombudsman is an independent entity that can investigate complaints relating to public authorities, including the water and sewerage corporations (Ombudsman Tasmania 2011).

Economic regulation

Economic regulation of the Tasmanian urban water sector will include price setting and licensing of utilities.

Pricing

The pricing of water and wastewater services is going through a transitional phase and will eventually move to price setting by the independent economic regulator, OTTER. Under the Water and Sewerage Act, the Treasurer was responsible for issuing an Interim Price Order (IPO) in July 2009. The economic regulator was required to conduct an inquiry and report back to the Treasurer. This report formed the basis for the IPO (NWC 2009b; Tasmanian Government, sub. 70).

From July 2012, OTTER will be responsible for determining water and wastewater prices. The service providers will be required to submit to OTTER a Price and Service Plan submission which will set out proposed prices for the services to be provided, as well as compliance improvement paths. OTTER will prepare draft and final determinations, based on these submissions, and consult publicly (NWC 2009b; Tasmanian Government, sub. 70).

Licensing

Like pricing, the licensing of water and wastewater service providers is currently going through a transitional phase. An interim licensing scheme is in place. In July 2009, the Minister for Primary Industries and Water issued interim operating licences to the three corporations so they are licensed and subject to performance

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obligations while the new licensing scheme is being developed (Tasmanian Government, sub. 70).

The interim licences include a number of requirements, including complying with the codes and guidelines issued by the regulators and customer service code issued by OTTER, and the performance monitoring framework under the Water and Sewerage Industry Act. Licensees must also develop a number of plans, including a Compliance Implementation Plan, and provide information where appropriate (DPIPWE 2009).

OTTER will be responsible for the licensing of the water corporations from July 2011.

Health regulation

Drinking water management

Drinking water quality in Tasmania is managed under the Public Health Act. It requires all parties that are involved in providing water to ensure it does not pose a risk to public health. The Department of Health and Human Services, and in particular, the Director of Public Health, is responsible for regulating drinking water under the Act. The Director of Public Health issued the Drinking Water Quality Guidelines (2005), which are based on the Australian Drinking Water Guidelines (2004) and contain information, recommendations and requirements relating to the provision of drinking water. Under these guidelines, water suppliers are required to prepare and implement drinking water quality managements plans, monitor drinking water quality and provide an annual drinking water quality report to the Director of Public Health (NWC 2009b).

Recycled water management

The State Government does not directly regulate recycled water quality in Tasmania. The Water and Sewerage Industry Act 2008 covers the treatment process for recycled water schemes, but not the delivery infrastructure. However, the State Government has developed the Environmental Guidelines for the Use of Recycled Water in Tasmania (2002) which provides guidance on the planning, design, operation and monitoring of wastewater reuse systems, and defines the required procedures for environmental assessment and approval of a recycling system (Engineers Australia 2010g; Power 2010).

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However, the State Government does regulate wastewater discharge under the Environmental Management and Pollution Control Act. Under this Act, wastewater treatment schemes greater than a certain capacity require a licence. If discharge is going to be to the environment, then a development proposal and environmental management plan is required. Approval for schemes is given by the EPA. The requirements of the licence include regulator reporting to the Director of the EPA (Power 2010).

Environmental health regulation

Environmental health, as it relates to water, is regulated under the Environmental Management and Pollution Control Act. The Board of the EPA is the main body responsible for regulating environmental health. The EPA can issue Environmental Protection Notices to entities that are undertaking activities that might be causing environmental harm. These specify the conditions under which an activity can operate. These conditions must be consistent with the State Policy on Water Quality Management 1997, which provides a framework for water quality management through the determination of environmental values and the setting of water quality objectives. The Tasmanian Surface Water Quality Monitoring Strategy 2003 supports this policy through identifying the need for a standard and consistent water quality monitoring strategy, including regular baseline monitoring, creation of a centralised database and a review of regulatory reporting (NWC 2009b).

Regulation of discharge as it relates to environmental health is discussed above.

B.8 Northern Territory’s structural, institutional, governance and regulatory arrangements

Information on the structural, institutional, governance and regulatory arrangements of the Northern Territory’s urban water sector is provided in this section.

Structural arrangements

In the Northern Territory, urban water and wastewater services, in both metropolitan and regional urban areas, are provided by the Power and Water Corporation, a State Government-owned vertically-integrated utility. In remote Indigenous communities, a subsidiary of the Power and Water Corporation, Indigenous Essential Services Pty Ltd, provides water and wastewater services (NT

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Power and Water Corporation 2010). Stormwater services are provided by Local Government (Engineers Australia 2010d).

Institutions and governance arrangements

The key legislation governing the Northern Territory’s urban water sector, the institutions involved, and their responsibilities in managing and planning for the sector are discussed below.

Key legislation

The key Northern Territory water legislation includes:

• Water Act 1992 — provides for the investigation, allocation, use, control, protection, management and administration of water resources. (NRETAS nda).

• Water Supply and Sewerage Services Act — provides a system of licensing for water supply services by the Utilities Commission. Plays a key role in establishing guidelines for the protection of public health by setting minimum drinking water quality standards (Engineers Australia 2010d; NWC 2009b).

• Public Health Act 2005 — plays a key role in setting guidelines for the protection of public health (Engineers Australia 2010d).

• Power and Water Corporation Act 2002 — establishes the Power and Water Corporation and its functions.

• Utilities Commission Act 2000 — establishes the Utilities Commission and its functions.

• Environmental Protection Act — requires the referral of major projects undertaken by the Power and Water Corporation to the Environment Protection Agency for assessment (Engineers Australia 2010d).

• Waste Management and Pollution Act 1998 — regulates the discharge of sewage or effluent.

• Local Government Act — states that Local Government is specifically responsible for stormwater drainage (Engineers Australia 2010d).

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Institutions

The main institutions involved in the urban water sector include State Government departments, the Power and Water Corporation and its subsidiary, Indigenous Essential Services Pty Ltd and the Utilities Commission.

Department of Natural Resources, Environment, the Arts and Sport

The Department of Natural Resources, Environment, the Arts and Sport (NRETAS) is the main State Government body responsible for urban water in the Northern Territory. It is responsible for the assessment, monitoring, management, planning, protection and sustainable utilisation of water resources. It is responsible for administering the Water Act 1992 (NRETAS 2007b; nda).

Department of Health and Families

The Department of Health and Families plays a role in regulating drinking water and recycled water quality, through setting standards and monitoring compliance with standards.

Treasurer

The Northern Territory Treasurer is responsible for setting prices.

Power and Water Corporation

As discussed above, the Power and Water Corporation is the Northern Territory’s State Government-owned vertically-integrated utility that provides water and wastewater services. It also investigates and develops water related infrastructure (NWC 2009b).

Utilities Commission

The Utilities Commission is the independent economic regulator for the Northern Territory. Under the Water Supply and Sewerage Services Act the Utilities Commission is responsible for licensing of water service providers, advising on price setting and monitoring and enforcing compliance with set prices (NWC 2009b; Utilities Commission nd).

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Ombudsman NT

The Ombudsman for the Northern Territory can investigate complaints relating to the Power and Water Corporation (Ombudsman Northern Territory 2011).

Key policies and plans

The NRETAS’s main tool for managing water resources are water allocation plans. The Water Act allows for the development of these plans to enhance water resource management. Water allocation plans include allocations for towns, agriculture, industry and the environment, strategies to achieve water use efficiency, information about the reliability of water allocations, and a monitoring and reporting program (NRETAS ndb).

Water allocation plans have been prepared for three geographic areas — Tindall Limestone Aquifer (Katherine), Alice Springs and Ti Tree. Water allocation plans are under development for another seven areas.

Economic regulation

Economic regulation of the Northern Territory’s urban water sector relates to pricing and licensing of Power and Water Corporations operations.

Pricing

Water and wastewater prices in the Northern Territory are set by the Treasurer, via a Water and Sewerage Pricing Order. In setting prices the Treasurer can seek advice from the Utilities Commission. The Utilities Commission is responsible for monitoring and enforcing compliance with the pricing order, and the Treasurer can assign some price and service standard monitoring functions to the Utilities Commission under their regulatory powers (NWC 2009b).

Licensing

Under the Water Supply and Sewerage Services Act, the Power and Water Corporation requires water and sewerage operating licences to provide water and wastewater services, and under the Water Act, a waste discharge licence to discharge wastewater to the environment. The operating licences are issued to Power and Water Corporation by the Utilities Commission, which monitors and enforces compliance with the licences. They set out Power and Water Corporation’s

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requirements, including service standards it must meet, documentation that must be prepared and reporting requirements to the Utilities Commission (Utilities Commission 2009).

Power and Water’s waste discharge licence is issued by the Controller of Water Resources through NRETAS. It sets out quality and quantity requirements, standards to be met and reporting requirements (NRETAS 2007a).

Health regulation

Drinking water management

Drinking water quality in the Northern Territory is managed through licensing of water providers under the Water Supply and Sewerage Services Act. The Minister for Health can specify the minimum standards for drinking water quality that holders of a licence (the Power and Water Corporation) must meet. These minimum standards are set to the Australian Drinking Water Guidelines (2004). The Power and Water Corporation conducts routine water quality tests to ensure water quality meets the Australia Drinking Water Guidelines, and must report on its compliance with the minimum standards to the Utilities Commission, the Chief Health Officer, and other stakeholders, such as customers (NWC 2009b).

Recycled water management

Recycled water quality in the Northern Territory is managed under the Public Health Act and the Water Management and Pollution Control Act. Under these Acts, recycled water schemes require approval from the Department of Health and Families, and might require a licence from NRETAS. The framework for managing recycled water, as well as the requirements of recycled water scheme operators, including monitoring and reporting requirements, can be found in the Department of Health and Families’ Guidelines for Management of Recycled Water Systems (2009).

Environmental health regulation

Environmental health is managed under the Water Act and the Waste Management and Pollution Control Act. The Controller of Water Resources, supported by NRETAS, is responsible for overseeing environmental health. Water Discharge Licences, issued by NRETAS, specify the quality and quantity of wastewater can be discharged, and specify environmental monitoring programs that must be

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implemented to verify that discharge limits and ambient water quality objectives are being met. The results of monitoring are required to be provided to the Controller for Water Resources, and made publicly available (NWC 2009b).

B.9 ACT’s structural, institutional, governance and regulatory arrangements

Information on the structural, institutional, governance and regulatory arrangements of the ACT’s urban water sector is provided in this section.

Structural arrangements

Water and wastewater services in the ACT are supplied by ACTEW, a Government-owned vertically-integrated utility. ACTEW contracts ActewAGL Distribution to operate and maintain its water and sewerage networks. In particular, it is responsible for billing, sales, planning, design and maintenance of the network (Engineers Australia 2010a). Stormwater services are provided by Roads ACT, which maintain the stormwater infrastructure (TAMS 2009).

Institutions and governance arrangements

The key legislation governing the ACT’s urban water sector, the institutions involved, their responsibilities in managing and planning, and key policies and strategies for the sector are discussed below.

Legislation

The key ACT water legislation include:

• Water Resources Act 2007 — controls how water from the ACT’s water bodies can be used. It provides a framework for the sustainable management of water resources, including the issuing of water access entitlements and water licences, and the preparation of a water sharing plan (DECCEW 2009; NWC 200b).

• Independent Competition and Regulatory Commission Act 1997 — establishes the Independent Competition and Regulatory Commission (ICRC) and its functions.

• Utilities Act 2000 — provides the regulatory framework for the licensing of utilities (ICRC 2010a).

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• Public Health Act 1997 — provides the framework for licensing drinking water suppliers (NWC 2009b).

• Environment Protection Act 1997 — provides the framework for managing environmental health in the ACT (NWC 2009b). Establishes the Environmental Protection Authority (EPA) (ACT) and its functions.

Institutions

The institutions involved in the ACT’s water sector include the water utility, ACTEW, ACT Government departments, the ICRC and the national-level Murray Darling Basin Authority (section B.2).

Department of the Environment, Climate Change, Energy and Water

The Department of the Environment, Climate Change, Energy and Water is the main Territory Government department responsible for water in the ACT. It has responsibility for high level strategic water policy, including the national water reform agenda, and national competition issues relating to water access, pricing and trading. It is also responsible for regulating the ACT’s water resources, and monitors and reports on water quality (DECCEW 2011).

Department of Territory and Municipal Services

The Department of Territory and Municipal Services has a number of responsibilities relating to the urban water sector, including overseeing land management and planning, managing stormwater infrastructure, and investigating non-potable water supplies for priority sportsgrounds (ACTEW 2010b).

ACT Planning and Land Authority

The ACT Planning and Land Authority’s responsibilities relating to the urban water sector include administering the Utilities Act, the Water and Sewerage Act and the Water and Sewerage Regulations 2001, water and sewerage technical regulation, assisting in the design work for water services to new urban developments, implementing policies relating to urban water management and water efficiency and investigating the feasibility of non-potable water supplies (ACTEW 2010b).

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ACT Health

ACT Health is responsible for managing drinking water quality in the ACT. It administers the Public Health Act 1997, and licences drinking water providers (ACTEW) under this Act (NWC 2009b).

Environment Protection Authority

The EPA is responsible for regulating environmental health in the ACT (NWC 2009b).

ACTEW

Along with providing water and wastewater services in the ACT, ACTEW also plays a role in water planning activities (NWC 2009b).

Independent Competition and Regulatory Commission

The ICRC is the ACT’s independent economic regulator. It is responsible for setting water charges and licensing utilities, including ensuring compliance with licensing conditions (ICRC 2009; 2010b).

ACT Ombudsman

The ACT Ombudsman can investigate complaints related to ACTEW (ACT Ombudsman nd).

Key policies and plans

The ACT’s main water resource strategy is Think water, act water — a strategy for sustainable water resource management (ACT Government 2004). It provides guidance for water resource management until 2050, and defines actions to achieve sustainability objectives for water use, including to increase water use efficiency, provide a long-term water source, develop a cross-border (ACT-New South Wales) water supply agreement and to incorporate water sensitive design principles into urban, commercial and industrial development (Engineers Australia 2010a).

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Economic regulation

Economic regulation of the ACT’s urban water sector relates to pricing and licensing of ACTEW’s operations.

Pricing

The ICRC is responsible for determining water and wastewater charges, and recommending the method for setting and calculating the water abstraction charge (this charge reflects the environmental cost of extracting water and the value of water as a resource) (NWC 2009b). The ICRC receives terms of reference from the ACT Government to undertake a review and determine water and wastewater charges for a set period. ICRC undertakes a public process, including issuing a number of documents, including a draft determination, before its final determination, and stakeholders can make submissions (ICRC 2010b).

ACTEW provides the ICRC with a submission detailing its proposed capital expenditure and operating costs. The efficiency of these estimates are examined by an independent consultant (NWC 2009b).

Licensing

Under the Utilities Act, ACTEW requires a utilities services license to provide water and wastewater services. This licence is issued and enforced by the ICRC. It sets out ACTEW’s requirements, including service standard requirements and reporting requirements to the ICRC (ICRC 2002; 2009).

Under the Public Health Act, ACTEW also requires a drinking water utility licence, which is issued by ACT Health. Under the conditions of this licence, ACTEW must comply with the Drinking Water Quality Code of Practice 2007 (ACTEW 2006).

Under the Water Resources Act, and issued by the EPA, ACTEW also requires a licence for abstracting water and releasing environmental flows (ACTEW 2006).

Health regulation

Drinking water management

Drinking water quality in the ACT is managed under the Public Health Act. This Act is administered by ACT Health, which is responsible for licensing drinking water suppliers under this Act. ACT Health also prepared the Drinking Water

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Quality Code of Practice 2007, which licence holders must comply with. The Code provides a framework for reporting and water quality management, and refers to the Australian Drinking Water Guidelines (2004). Under the Code, and its licence conditions, ACTEW must undertake a performance monitoring program and report the results in an annual drinking water quality report, which it must submit to the Chief Health Officer of ACT Health, and make public (NWC 2009b).

Recycled water management

Recycled water quality in the ACT is regulated under the Environment Protection Act. Under this Act the EPA regulates recycled water schemes, and issues either environmental protection agreements or environmental authorisations, depending on the size of the scheme. Smaller schemes are class B activities, requiring an environmental protection agreement, while larger schemes are class A activities, requiring an environmental authorisation (NWC 2009b; Power 2010).

Environmental health regulation

Environmental health in the ACT is managed under the Environment Protection Act, and the supporting legislation Environment Protection Regulations 1997 (Schedule 4 Water Quality Standards), which provide more detail on the regulation of activities that might pollute waterways, and specifies water quality standards that are based on the National Water Quality Management Strategy. Under the Act, wastewater activities are a class A activity, requiring an environmental authorisation issued by the EPA (NWC 2009b).

The Department of the Environment, Climate Change, Energy and Water produces an annual report which includes the results of water quality testing in the ACT (DECCEW 2009; NWC 2009b).

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C Lessons from other water sectors

The terms of reference request the Commission to have regard in this inquiry to lessons from both reform in the rural water sector and overseas. This appendix discusses reform in Australia’s rural water sector as well as reform that has occurred, or has been proposed, in overseas urban water sectors including Scotland, Auckland, New Zealand and England and Wales. The focus is on reforms that might hold lessons for urban water reform in Australia.

C.1 Scotland

Scotland has introduced a retail market for the provision of water and wastewater services for non-domestic customers. The primary motivation for this reform was that competition could bring about lower prices, improved services, increased innovation and wider choice (WICS 2009a). This section describes Scotland’s water sector prior to reform, sets out the approach to reform, and key outcomes to date.

Prior to retail competition

Historically, the provision of water and wastewater services in Scotland was the responsibility of 12 Regional and Island Councils. In 1996, the structure of Local Government in Scotland was reorganised. As part of this process, responsibility for water and wastewater service provision was transferred to three Central Government-owned water authorities — North of Scotland, West of Scotland and East of Scotland Water Authorities (Lobina and Terhorst 2005).

In 2002, the structure of Scotland’s water supply sector was reformed further, with the three regional utilities being merged into one utility, Scottish Water. It was argued this would help avoid regional price disparities, finance capital investment, and maximise economies of scale (Lobina and Terhorst 2005). Scottish Water is a vertically-integrated utility responsible for both water and wastewater services.

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Establishment of retail competition

In 2005, the Scottish Parliament passed the Water Services etc. (Scotland) Act 2005. This Act provides the basis for the establishment of a non-household (business and public sector) retail market for water and wastewater service provision. Licensed retailers are able to purchase wholesale water and wastewater services from Scottish Water and provide retail water and wastewater services (WICS 2009b). The Water Services Act also established the Water Industry Commission for Scotland (WICS).

Governance and regulatory arrangements

WICS was assigned the responsibility of overseeing the introduction and operation of the retail market, and facilitated the development of the framework under which the market operates. In 2005, WICS established the Licensing Framework Implementation Group, which developed the agreements and codes that would form the retail market framework. They developed a series of documents setting out how licensed retailers would be required to operate. These are summarised in box C.1.

Box C.1 Market documents that govern the Scottish retail market Market Code — This sets out the duties of the market participants and details the establishment and governance of the Central Market Authority. Operational Code — This code governs the way that Scottish Water provides services to all licensed retailers, such as new connections, metering and tradewaste. Wholesale Service Agreements — A separate Wholesale Service Agreement is negotiated between Scottish Water and each retailer. It is the contract between the parties that sets out terms for which Scottish Water agrees to provide wholesale services. Disconnections document — Outlines the procedures for the industry if there is a need for services to be disconnected. Default directions — Each licensed retailer is obliged to provide, at the minimum, a default level of service at a default price. The default tariff is determined by WICS and ensures that non-household customers will pay no more than they would have if retail competition had not been introduced.

Source: WICS (2009b).

In 2007, WICS established the Central Market Authority (CMA) to administer and help oversee the operation of the market. The CMA is an independent organisation that is owned and governed by market participants. Licensed retailers are required

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to become members of the CMA. In administering the retail market, the CMA’s functions include:

• operating the computer systems that run the market

• holding information on retailers’ activities including information on which retailers are responsible for services at every connection point

• facilitating the transfer of customer information when they change retailers

• acting as a vehicle for participants’ views via a technical panel and a market participants forum

• calculating the wholesale charges that retailers must pay Scottish Water (Central Market Authority Scotland 2011; Waterwatch Scotland 2010a; WICS 2009b).

The Water Services Act also provided for establishment of a retail subsidiary of Scottish Water, Business Stream, to provide non-household retail services. This was seen as necessary to demonstrate that a level playing field existed between incumbent and new entrant retailers. Business Stream is legally separate from Scottish Water and was granted its licences in January 2008 (WICS 2009b). In recognition of Business Stream being the incumbent retail service provider, its licenses impose additional obligations, including publishing details of all its charges and ensuring its charges are cost reflective (WICS 2010d).

WICS is responsible for the administration of licences. Retailers must be licensed to provide retail services. There are three types of licences:

• General licences — These are the most common licences. Water and sewerage general licences allow retailers to compete for all non-household customers in Scotland. They must offer the default package of services and tariffs. They can also supply customers that received discounts on their wholesale charge1 (WICS 2010d; nda).

• Self-supply licences — These allow businesses to purchase wholesale water direct from Scottish Water. They receive no retail services from a retailer. The business is responsible for putting in place its own emergency and maintenance measures (WICS 2010d).

• Specialist licences — Designed for retailers that want to focus on identifying cost savings and help customers apply for reduced wholesale charges. Holders of these licences are only eligible to supply customers that are applying for, or have successfully applied for, a reduction in the wholesale charge (WICS ndc).

1 If a customer and supplier can demonstrate to Scottish Water that their actions have reduced Scottish Water’s charges, the supplier can receive a discount on the wholesale charges it pays Scottish Water (WICS 2010c).

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Water and sewerage licences are granted separately, so two licences are usually necessary. All three types of licences allow the licence holder to participate in the CMA technical panel and nominate and vote for members of the CMA board. To be granted a licence the entity must undergo a series of checks to prove their competence and reliability, and that they can meet the conditions designed to protect customers (WICS 2010b). Supplier of last resort arrangements exist for in the event that retailers cannot meet their obligations (Central Market Authority Scotland 2010).

WICS is also the economic regulator for water in Scotland. WICS sets Scottish Water’s water charges and the wholesale prices retailers pay to Scottish Water for wholesale services. WICS also sets the maximum default tariff that business retail customers can be charged. This ensures that non-household customers will pay no more than they would have if retail competition had not been introduced (WICS 2009b). Retailers can set their own prices and levels of service subject to this default tariff and the default level of service (WICS 2010c).

The retail market

The retail market began operating in April 2008 (WICS 2010d). As of February 2011, five entities had been granted water and sewerage services licences (WICS ndb):

• Satec Limited (licences granted 2 August 2007).

• Scottish Water Business Stream Limited (licences granted 11 January 2008).

• Osprey Water Services Limited (licences granted 1 April 2008).

• Aimera Limited (licences granted 20 April 2009).

• Wessex Water Enterprises Ltd (licences granted 28 October 2009).

The five entities service about 96 000 non-household customers in total. Business Stream is the largest retail service provider, servicing over 90 per cent of the market (Waterwatch Scotland 2010a).

Another retailer, Aquavitae, had its licence revoked in 2008. Customers were transferred to other licensed retailers under supplier of last resort provisions (WICS 2008).

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Evidence of the performance of the retail market

WICS, in its 2009-10 report on competition in the Scottish water industry, reported that retail competition has benefited customers, with over 45 000 customers having renegotiated the terms of their supply, receiving better prices and/or more tailored levels of service. In addition, the number of customers switching to a new retailer had increased by 40 per cent on the previous year. However, as seen in the United Kingdom gas and electricity sectors, switching does not always lead to better deals for customers (box C.2). WICS also reports that the introduction of competition has raised customer awareness of the environmental benefits and cost savings of being more water efficient (WICS 2010a).

Box C.2 Evidence on switching in the United Kingdom gas and electricity markets In Great Britain’s gas and electricity markets, customers are allowed to switch service providers. Since the markets were opened to competition in the mid 1990s, most consumers have switched gas and/or electricity service providers at least once. Switching rates in Great Britain’s gas and electricity markets are some of the highest in the world. Switching is often seen as a proxy for success of a market. However, not all of this switching has benefitted consumers. For example, a 2008 survey found that about 40 per cent of consumers had not benefitted from switching service providers. Fewer Pre-Payment Meter customers (often considered to be disadvantaged) had benefitted than more advantaged customers. Disadvantaged customers were more likely to have switched based on the information provided by door-to-door salespeople, and were less likely to compare prices of different service providers.

Sources: Ipsos MORI (2008); Ofgem (2008; 2010).

WICS has also commissioned consultants Grant Thornton to undertake a cost-benefit analysis of retail competition. Using information on the set-up costs, and data from the first full financial year of operations, Grant Thornton projected what the costs and benefits of the retail market would be over the 15 year period 2005-06 (when the first set-up costs were likely to have been incurred) to 2020-21. The costs, including set up and administration costs were estimated to be about ₤45 million (about A$73 million), for the 15 year period, however the benefits, including lower bills, return to owners and reduced carbon impact where estimated to be anywhere between ₤112 million (about A$181 million) and ₤142 million (about A$229 million), making the introduction of the market economically justifiable (Grant Thornton 2010).

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Waterwatch Scotland, the customer representative body for the Scottish water industry, published a report on retail competition in 2010. It found that there was scope for improvement in retail competition. It believed that WICS, in being both the market developer and market regulator, had a potential clash of priorities. It also found customers have had mixed experiences, with some insights from customers’ experiences including:

• The number of contacts made to Waterwatch Scotland by non-household customers far exceeded pre-competition levels. Before competition non-household customers accounted for about 25 per cent of contacts/complaints. This increased to about half. However, not all of the increase in contacts is attributable to the introduction and operation of the retail market:

• Many customers still did not know that competition existed.

• Many customers trying to switch retailers had experienced difficulties.

• Retailers were not always providing the services they were required to provide.

• Many customers were frustrated by extra bureaucracy (Waterwatch Scotland 2010b).

Lessons from the introduction of the Scottish retail market

Given that the Scottish retail market, apart from the market in England and Wales (a comparison of the two retail markets and the lessons that can be drawn from the success of each is presented in section C.3), is the only urban water retail market in the world of which the Commission is aware, the Scottish retail market could be a model on which other places could draw. However, the market is still relatively new and so it might be too early to draw strong conclusions about its success, and its potential to be replicated in other places.

The market appears to be functioning well. As a result, the governance, regulatory and administrative arrangements could provide a useful precedent for other jurisdictions that are looking at implementing a retail market. Using these arrangements as a starting point in other jurisdictions could reduce set-up costs.

The introduction of the retail market appears to have resulted in benefits to non-household customers. The market has provided consumers with the opportunity to negotiate for better prices and standards of service. This opportunity has been taken up by many, as evidenced by switching and the reduced market share of Business Stream. It appears that the benefits of introducing the retail market will outweigh the costs.

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However, although four other retailers have entered the market, Business Stream still remains the dominant retail service provider with about 90 per cent market share.

There might be a need to refine some of the arrangements, as some customers have complained that retailers were not always providing the required services, and some were having difficulty switching retailers.

C.2 Auckland, New Zealand

Auckland recently restructured its water supply industry as part of a broader restructure of Auckland’s council system. In November 2010, Auckland’s water and wastewater supply was vertically- and horizontally-integrated into one government-owned vertically-integrated monopoly utility, Watercare. This section discusses Auckland’s water supply arrangements before reintegration, the impetus and process of reforming the sector, and the post-reform situation.

Background

Prior to recent reform, Watercare was responsible for the supply of bulk water services only, and was jointly owned by the six territorial authorities to which it provided services. Watercare also provided bulk wastewater services (treatment and disposal) to four of those six councils.2 The seventh territorial authority district of Auckland, Franklin, had its own water and wastewater supply scheme. Retail water services were provided by the seven territorial authorities, through a number of different structures, including directly by councils, through council-owned organisations and via contracting out (RCAG 2009).

Impetus and lead up to reform

Reviews of Auckland’s water sector

One of the most influential reviews of the Auckland water sector was announced by the Government in 1998. All the territorial authorities (except Franklin) participated in an industry stakeholders’ forum in 2000. The authorities endorsed three possible options for reform:

2 North Shore and Rodney were responsible for their own wastewater treatment and disposal.

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• Improved status quo — no change to the organisation of the industry, but greater cooperation and coordination.

• Share network — all the pipes in the region being owned by one public entity, with the retail end of water and wastewater being opened up to competition.

• One provider — combining Auckland region’s entire water services industry into a single entity (RCAG 2009).

A public consultation process was undertaken. The ‘one provider’ option was preferred by 68 per cent of the respondents. However, the process stalled at this point. This was at least in part due to a lack of consensus among industry stakeholders (RCAG 2009).

There have been other reviews of the Auckland water sector. One review by Saha International Limited (2006, cited in RCAG 2009), which included a summary of previous reviews, highlighted a number of concerns, and areas for improvements, including:

• the industry structure was fragmented

• there was a role for regulation

• considerable scope existed for greater coordination and cooperation

• different stakeholders had different priorities and objectives

• large-scale investment was needed to deal with stormwater issues (RCAG 2009, p. 579).

However, these reviews have generally resulted in little action.

Royal Commission on Auckland Governance

The Royal Commission on Auckland Governance (Royal Commission) was established by the New Zealand Government in 2007. The Royal Commission was required to investigate the local government arrangements in the Auckland region and how they could be improved in order to maximise the well-being of the region and its communities (RCAG 2009).

The Royal Commission highlighted a number of problems in Auckland’s water sector. These included:

• The age and condition of the pipe network, which was plagued by leaks in some areas.

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• There was no detailed stormwater management and funding plan for Auckland. Runoff was degrading and polluting waterways, posing a major environmental threat.

• The industry was fragmented. The retailers each had different priorities and philosophies. For example, although one retailer was prioritising keeping water affordable, another placed greater priority on environmental concerns. This fragmentation led to poor regional planning and decision making.

• There were significant governance issues. For example, many plans and reports had been produced but there was little in the way of action, mostly due to the fragmented nature of the industry (RCAG 2009).

The Royal Commission made a number of recommendations relating to the provision of water, wastewater and stormwater services. These are presented in box C.3. The most significant recommendations related to Auckland’s water and wastewater industry being vertically and horizontally integrated so that one utility was responsible for bulk and retail water and wastewater services. The Royal Commission believed that these recommendations would lead to better demand management, better environmental management and cost savings (RCAG 2009).

The Royal Commission also recommended the dissolution of the Auckland Regional Council and the seven territorial authorities, and replacing them with one regional-wide council, Auckland Council (RCAG 2009).

The New Zealand Government accepted the recommendation of one water and wastewater service provider for the Auckland region, owned by the Auckland Council. It also made Auckland Council responsible for environmental management, including water quality management (New Zealand Government 2009).

Reform process and the new arrangements

In November 2010, Watercare became the single vertically-integrated utility providing bulk and retail water and wastewater services in six of Auckland’s seven regions. Watercare provides water and wastewater services to about 1.3 million people (Watercare 2010b). In Papakura, United Water is still contracted to provide water and wastewater retail services. Watercare provides bulk services to United Water (Watercare 2010a).

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Box C.3 Royal Commission’s recommendations relating to water, wastewater and stormwater

• The Auckland Council should have overall responsibility for setting policy in relation to the three waters (water, wastewater and stormwater).

• In urban areas, all drinking water and wastewater services should be supplied by one council-controlled organisation (Watercare Services Limited) owned by the Auckland Council. (This is subject to existing contractual arrangements in the Papakura region.)

• The water and wastewater operations (including assets and relevant staff) of all abolished local authorities should be transferred to Watercare Services Limited on the establishment date.

• No compensation should be payable for the transfer of water-related assets from the existing territorial authorities to the Auckland Council.

• All assets relating to Auckland’s water services should remain in public ownership.

• The Auckland Council should determine the extent to which responsibilities for the delivery of stormwater services are shared between local councils and Watercare Services Limited.

• The current obligation on Watercare Services Limited to maintain prices for water and wastewater services at minimum levels (subject to obligations to be an effective business and maintain its assets in the long term) should continue. So too should the prohibition on paying a dividend, to avoid potential subsidisation and high rate of return issues.

• Both water and wastewater charges should be calculated on a volumetric (or notionally volumetric) basis.

• Uniform charges for water and wastewater should apply across the region.

Source: RCAG (2009).

Watercare is now a council-controlled organisation owned by the Auckland Council. Auckland Council is responsible for appointing the Company’s board, and the board appoints the Chief Executive (Watercare 2010b). Although Watercare is independent of the council’s operations it is accountable to Auckland Council. Watercare and Auckland Council must agree to a Statement of Intent, which includes performance measures. This Statement of Intent is made public (Auckland Council 2010).

Lessons from the structural reform of Auckland’s water sector

Auckland’s water sector has only recently been restructured, so it is too early to know if the reform has/will bring significant benefits. However, lessons can be

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drawn from the problems identified, and the recommendations made, by the Royal Commission.

There appears to be scope for better resource management though having one single body, rather than several entities trying to coordinate and cooperate with each other.

There are also other efficiency benefits from integration. Better demand management could lead to deferred investment in infrastructure, and better integrated planning can result in capital being used more effectively. Elimination of duplication in many functions can also reduce costs and increase operational efficiency (RCAG 2009).

C.3 England and Wales

The water industry in England and Wales has undergone significant reform over a number of years, including privatisation, the introduction of a form of competition for the market, and the introduction of a retail business market. Currently there are calls for further reform with the release of the Independent Review of Competition and Innovation in Water Markets in 2009.

Privatisation

The water industry in England and Wales was privatised in 1989. Prior to this, the water sector comprised ten publicly-owned vertically-integrated water authorities that provided both water and wastewater services to their own geographic areas, and 28 privately-owned water authorities that provided only water services in parts of the areas serviced by the vertically-integrated utilities (Cowan 1997).

Leading up to privatisation the water sector was experiencing a number of challenges, including:

• years of underinvestment in the sector

• meeting higher European Union drinking water and environmental quality standards

• securing competitive and sustainable financing and driving down costs (Cave 2009).

The Government privatised the water industry for a number of reasons, arguing:

• privatisation would result in more efficient companies

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• private water owners would fund the investments needed to meet tighter water quality standards and make up for past underinvestment (van den Berg 1997).

Through this process the previously public and private companies were brought under the same regulatory regime. Since privatisation, many water companies have merged, significantly reducing the number of utilities (van den Berg 1997).

Along with the privatisation of utilities, the regulatory arrangements of the water industry in England and Wales were changed. These changes included the establishment of the Office of Water Services (Ofwat), which is responsible for the economic regulation of the sector (Ofwat 2011).

Views on the privatisation of England and Wales’ water industry

There are mixed views on the privatisation of England and Wales’ water industry. For example, the Cave review on competition and innovation in water markets notes: Over the last 20 years, the industry has risen to the challenges investing around ₤80 billion, often borrowed at favourable rates. This investment has delivered higher quality drinking water, with an average of 99.96 per cent compliance with European Union standards. It has also resulted in improvements to aquatic ecological quality and near universal compliance with minimum European Union standards for Britain’s beaches. However, … customer expectations, environmental standards and efficiency, remain ongoing challenges. (Cave 2009, p.17)

The Cave review also points out that privatisation might have cost consumers financially, with household charges rising in real terms by 42 per cent since privatisation (Cave 2009).

Van den Berg (1997), writing for the World Bank, also has a mixed view on how well privatisation achieved the Government’s objectives of improving the efficiency of utilities and increasing investment. Privatisation succeeded in attracting a significant amount of investment, with investment by water companies in the six years post-privatisation more than five times the level in the six years pre-privatisation. However, all of this investment might not have been efficient:

• The regulatory regime could have created incentives to gold plate assets.

• Economic and environmental regulatory responsibilities were separated during privatisation. This might have made creating the right environmental incentives difficult, especially since customers had a low willingness to pay for the water quality improvements mandated in European Union directives.

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• Ofwat’s mandate is limited to ensuring the financial viability of water utilities. As a result, it might not sufficiently take the public costs and benefits of water policies into consideration when assessing companies’ investment programs.

• Investment has generally occurred in a cycle that corresponds with the regulatory cycle. This can distort the timing of investments and weaken water utilities’ incentives to generate cost savings towards the end of the regulatory cycle.

Other indicators of performance of the sector since privatisation include (van den Berg 1997):

• The per unit operating costs of water increased during the first regulatory cycle, even though staff numbers were reduced.

• As a result of the increased investment, there have been significant increases in the prices customers face.

• The profitability of water companies increased significantly after privatisation, which resulted in serious public backlash against the reforms.

Comparative competition

As a result of privatisation, England and Wales now have privatised vertically-integrated utilities servicing distinct regional areas. Apart from the non-household retail market (discussed below) there is no direct competition between utilities for retail customers. As part of its role as the economic regulator, Ofwat uses comparative competition to place competition pressures on the utilities (Ofwat 2007b).

Ofwat benchmarks the water companies to assess their relative efficiency. This information is published in an annual report on the costs and efficiencies of the companies. This information also feeds into the price setting process (IPART 2007). In its price setting, Ofwat rewards outperforming utilities and penalises underperforming utilities (Ofwat 2003).

As discussed in chapter 11, a form of comparative competition is also used by the Essential Services Commission to compare Melbourne’s three retailers. The form of comparative competition used in England and Wales is different from that used in Melbourne. The main difference is that the Essential Services Commission does not use this information in the price setting process.

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Ofwat reports comparative competition has delivered benefits for users: comparative competition has delivered significant benefits for users over the past 18 years. It has accommodated a very large programme of capital investment, improved the quality of service for customers significantly and provided incentives for efficiency improvements worth more than ₤100 per year in bill reductions for the average customer. England and Wales scored reasonably well in international comparisons of water and sewerage quality and efficiency. (Ofwat 2007b, p.5)

The United Kingdom Department for Environment, Food and Rural Affairs has noted that comparative competition, along with the competitive pressures of having to obtain private sector finance, has been an effective incentive for reducing costs and providing higher standards of service. However, the incentives are unlikely to be as strong as those provided by direct market competition (DEFRA and Welsh Assembly Government 2002, in IPART 2007).

Inset appointments

Inset appointments allow a water company to replace the existing water service provider at a specific site. Inset appointments were first introduced in 1989, when only new water customers could be supplied by an inset appointment. In 1992, the potential customer base was extended with current water customers being eligible if they met certain criteria (Cowan 1997). To be granted an inset appointment the application must meet one of three criteria (Ofwat and DEFRA 2006):

• The customer uses (or is likely to use) at least 50 ML of water per year in England, or 250 ML in Wales.

• The existing water and/or sewerage service provider agrees to the inset.

• The site is not currently served by a water and/or wastewater service provider.

For an application to be granted, along with meeting the above criteria, the applicant has to satisfy Ofwat that it is financially, technically and operationally viable (Ofwat ndb). An inset appointee can supply the customer using its own assets or by requesting the use of the existing undertaker’s (the incumbent utility in the geographic area) assets (Ofwat and DEFRA 2006). Inset appointment service providers are subject to the comparative competition regime (Ofwat 2007c).

As at the end of 2010, 31 new appointments and appointment variations had been granted (Ofwat 2010).

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Views on inset appointments

The Department for Environment, Food and Rural Affairs and the Welsh Assembly Government believe that inset appointments have sharpened incentives for utilities to offer lower tariffs and better service for large users. However, the impact is lessened because not all potential entrants want to become appointed service providers. The Government also noted that the application process had been criticised for being onerous and slow (DEFRA and the Welsh Assembly Government 2002, in IPART 2007).

Cowan (1997) found that the introduction of inset appointments induced water companies to introduce ‘large-user tariffs’. Between 1995 and 1997, the introduction of these tariffs resulted in discounts available that varied from about 1 per cent to 30 per cent for a customer with consumption of 300 ML.

However, Cave (2009) found the current inset framework did not guarantee beneficial outcomes: While these have the potential to offer customers choice, lower prices, better service and reduced environmental impact, the current framework does not guarantee these outcomes because there are significant barriers to entry, costs may not [be] distributed appropriately and there may be inefficient entry. (Cave 2009, p. 13)

Water supply licensing and retail competition

In 2005, the Water Supply Licensing regime was introduced, which provided for retail competition in the provision of water (but not wastewater) services to non-household customers. The objective was to develop competition that would benefit consumers, through greater efficiencies, keener prices, innovation and better services, while at the same time, balancing the wider objectives of protecting public health, protecting and improving the environment, meeting the Government’s social goals, and safeguarding services to customers (DEFRA and Welsh Assembly Government 2002, in IPART 2007).

Companies can compete to supply non-household customers whose annual water consumption is likely to exceed 50 ML each year. When competition was introduced, about 2200 non-household customers would have been eligible (Ofwat and DEFRA 2006).

Prospective service providers have to obtain a licence from Ofwat to compete in the market. There are two types of licences, retail licences and combined licences (Ofwat ndc):

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• Retail licence — authorises the licensee to purchase water from an appointed water company and use its supply system to supply water to the customer’s premises.

• Combined licence — authorises the licensee to introduce water into an appointed water company’s supply system and to supply the water to the customer’s premises.

With the introduction of water supply licences, the water undertaker in each geographic area was required to develop access codes which set out the terms on which licensees can access the supply system (Ofwat and DEFRA 2006). Undertakers are also required to publish an indicative price for access to the supply system, with guidance on how to calculate these prices issued by Ofwat (Ofwat 2009a).

If a water undertaker wants to participate in the market in another undertaker’s area of operation, it must set up an associate company. This company cannot compete in the associated undertaker’s supply region (Ofwat nda).

Ofwat has expressed concern that the Water Supply Licensing regime has not been successful. In a letter to the Government, Ofwat identified two factors it believed were limiting the development of competition (Ofwat 2006, in IPART 2007):

• The threshold for contestability was limiting the size of the market.

• The application of the pricing rule (according to the costs principle) was resulting in low margins for entrants.

A review by Ofwat on market competition in the water and sewerage industries (Ofwat 2007c), recommended that the costs principle should be removed and replaced with general criteria for access pricing, and that the threshold should be reduced from 50 ML to 5 ML initially, then removed all together.

Cave review

In 2008, the United Kingdom Government and Welsh Assembly Government commissioned Professor Martin Cave to lead an independent review on competition and innovation in water markets. The aim of the review was to ‘recommend changes to the legislation and regulation of the industry in England and Wales to deliver benefits to consumers, particularly the most vulnerable, and the environment through greater competition and innovation’ (Cave 2009, p.3).

The Cave Review identified a number of new and ongoing challenges that needed addressing, including climate change, population growth, reducing water

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consumption, meeting consumer expectations, continued efficiency, environmental concerns and resource management concerns (Cave 2009).

Along with these challenges, a number of problems with the current operation of the England and Wales water industry were identified, and recommendations were made, specifically relating to, abstraction and discharge, upstream activities, retail activities and innovative capacity. The main findings and recommendations are presented in box C.4. Some of the findings and recommendations related to some of the topics presented above (comparative competition, inset appointments and the Water Supply Licensing regime) included (Cave 2009):

• The Water Supply Licensing regime was flawed in conception and implementation. Only one customer has recently been able to switch to a new service provider. The review recommended that the regime be reformed, including potentially removing the threshold (Ofwat should advise further on this) and legislating the legal separation of retail functions from water businesses.

• Currently a special merger regime is in place, under which some mergers between water companies can be referred to the Competition Commission if they could potentially impact on Ofwat’s ability to regulate prices on the basis of comparative competition. The review found that this regime had discouraged mergers and should be reformed, including removing retail only mergers from the regime on the introduction of competition.

• There are a number of significant issues with the current inset appointment framework. For example, so far appointments have only undertaken retailing activities and built new infrastructure, none have abstracted and treated water or treated and discharged wastewater directly. The review recommended changing the inset appointment framework in the short term and, in the medium term, replacing it with a reformed system for the provision of upstream and infrastructure services.

The United Kingdom Government responded to the final report of the Cave review in the 2009 Budget. It agreed with the Cave review’s conclusion that there is not a convincing case for extending competition to the household sector. In addition, it will consult with stakeholders on the implementation of legal separation of large companies’ retail operations, further reforms to the water supply regime and reforms to the mergers regime and inset appointments regime (UK Government 2009).

Ofwat also published its response to the Cave review in June 2009. Ofwat agreed with most of the recommendations, believing ‘it represents a valuable contribution

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to developing reforms that will deliver more sustainable and innovative water and sewerage sectors in England and Wales’ (Ofwat 2009b, p. 2).

Box C.4 Main findings and recommendations of the Cave review

Abstraction and discharge The abstraction licence and discharge consent regimes failed to ensure that resources were used efficiently and sustainably. The review recommended that the Environment Agency should be given new powers to tackle over-abstraction and to encourage the trading of licences. Licence conditions should also be reformed to take greater account of the impacts of abstractions and discharges on the environment.

Upstream activities The review saw benefits from introducing greater competitive pressure. Initially incumbents should be given an independent purchasing order and the water supply licensing regime should be reformed. At a later stage a contracting entity for new capacity could prove to be more effective. Ofwat should encourage greater innovation by increasing the incentives for outperformance and addressing the potential bias to capital expenditure.

Retail activities The review recognised that there could be benefits in removing the non-household threshold for retail competition on the introduction of appropriate accompanying changes and legal separation. This will allow all non-household customers to choose a service provider. The review also proposed that customers and their representatives take a greater role in determining the services provided by companies. The review found that the special merger regime represented a significant barrier to further consolidation, adversely affecting the scope for efficiency gains, financing costs and resource optimisation. The review recommended that the regime be reformed and restricted to those mergers which are likely to have a significant impact on Ofwat’s ability to undertake comparative competition. Stakeholders should also be given greater certainty about the process.

Innovative capacity The review proposed the creation of a research and development body to agree to a shared research and development vision for the industry and to co-ordinate the work of stakeholders. The organisation would be supported by funding, including revenue from customers and water companies’ shareholders.

Source: Cave (2009).

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Lessons from reform in England and Wales

The privatisation of the water industry in England and Wales appears to have increased investment however, perhaps because of the regulatory system some of this investment might not have been efficient. Prices and profits of water companies have risen in the post-privatisation period, making privatisation unpopular with some.

Comparative competition seems to have been beneficial. It appears to have been beneficial to price setting, and consumers might have benefited from reduced bills. However, stakeholders have indicated comparative competition might not provide as strong incentives as direct competition.

Inset appointments appear to have been beneficial in reducing prices and improving services, however, the current arrangements appear to be limiting the potential benefits from the regime.

The Water Supply Licensing regime appears to have not resulted in the benefits that stakeholders would have hoped. One of the main issues with the regime that Ofwat has identified is the threshold on non-household customers participating, at 50 ML consumption per year. Ofwat (2007c) and Cave (2009) have both recommended, at the minimum reducing this threshold. The Scotland retail market has no threshold limiting non-household entry.

A requirement of the introduction of the Scottish retail market was the separation of non-household retail from Scottish Water’s operations, with the establishment of a subsidiary, Business Stream. This was seen as important to show that the market was a level playing field. This has not been done in England and Wales. However, legal separation has been brought up as a potential option by Cave (2009).

C.4 Australia’s rural water sector

Australia’s rural water sector has undergone significant reform in the past couple of decades. It has been the main focus of such COAG agreements as the 1994 water reform agreement, 1995 National Competition Policy and the 2004 National Water Initiative. The focus of this section is the lessons that can be drawn upon from the successful establishment and benefits of water trading, particularly in the southern Murray-Darling Basin, and the establishment and benefits of carryover rules.

LESSONS FROM 523 OTHER WATER SECTORS

Water trading

Water trading first began in the early 1980s in response to emerging pressures on water resources. Trade was generally restricted by the location in which it could occur (for example, trading between regions in Victoria was not allowed until 1994), and its type. The main types of trade are trade in water entitlements and seasonal water allocations (Frontier Economics 2007):

• Water entitlements — An entitlement gives the holder a perpetual or ongoing entitlement to exclusive access to water in each irrigation season (seasonal allocation). It is specified in volumetric terms or as a share of a specified consumptive pool.

• Water allocations — A specified volume of water (based on percentages) allocated to a water entitlement in a given season.

For water trading to occur water rights needed to be separated from land. Before reform, in many irrigation districts allocations of water were matched to land size. To access more water irrigators had to purchase more land to gain the entitlements (Frontier Economics 2007).

The main impetus for the development of water trade came through the 1994 water reform agreement and 1995 National Competition Policy. The 1994 agreement required:

• implementation of a comprehensive system of water entitlements and seasonal allocations, backed by the separation of water rights from land, with clear specification in terms of ownership, volume, reliability, transferability, and if appropriate, quality

• cross-border trade to be facilitated and trading arrangements to be consistent

• delivery pricing reform based on user pays and the principle of full cost recovery (PC 2010a, p.36).

The reform agenda was given a further push by the 2004 National Water Initiative. Through this agreement, the Murray-Darling Basin states agreed to:

• remove barriers to trade in water and minimise transaction costs

• implement nationally-compatible characteristics for securing water entitlements

• introduce water accounting to meet the information needs of different water systems including for planning, monitoring, trading, environmental management and on-farm management (PC 2010a, p. 37).

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Water trading has been increasing since its introduction. Between the period of 1998-99 and 2007-08 the volume of trading in allocations grew from the equivalent of 6 per cent of total water allocated for consumptive use in the southern Murray-Darling Basin to 24 per cent, and trade in entitlements increased ten-fold. Trade in allocations is significantly greater than trade in entitlements (NWC 2010a).

Benefits and costs of water trading

Water trading can bring about benefits by reallocating water to ‘higher value’ uses. Studies of the impacts of water trading indicate water trading can yield substantial benefits. Frontier Economics (2007) found that water trade had resulted in significant economic benefits. Examples included:

• Without temporary trade the dairy industry would have fared much worse than it did during the past 10 years of drought.

• Even with temporary trading many dairy enterprises collapsed as a result of the extraordinarily low seasonal allocations of 2002-03 and 2006-07. Permanent trading meant that those farmers left farming with more money than they otherwise would have had.

• Without temporary trading many existing horticultural enterprises in the Goulburn system would not have survived the extraordinarily low seasonal allocations.

• Many mixed farms survived the low seasonal allocations by selling water on the temporary market, thus making more money than they would have done by growing crops. (Frontier Economics 2007, p. xiii)

However, Frontier Economics (2007) found that the social impacts can be both positive and negative, with the negative impacts including:

• Some farmers have been ostracised by their community for selling their permanent water entitlements.

• Trade in a region can lead to increased competition in production, queuing for timely irrigation water delivery, and higher water tables. Trade out of a region can lead to increased water delivery charges to remaining users (because of stranded assets), the build-up of disease and pest plants and animals, and depopulation.

• Communities in regions exporting water can experience reduced populations and less spending. Communities in regions importing water can experience increased populations without necessarily having the infrastructure and services to properly accommodate these new arrivals. (Frontier Economics 2007, p. xiv)

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The National Water Commission (NWC 2010a) also found that water trading had yielded significant benefits to individual water users, and regions. It also found that water trading had made a positive contribution to Australia’s gross domestic product, increasing it by $220 million in 2008-09.

Carryover

Carryover rules allow entitlement holders, subject to certain limits, to carry over unused allocated water to the next season. Prior to the introduction of carryover provisions, entitlement holders generally lost any water that they had not used or traded away. Carryover was introduced in the southern Murray-Darling Basin states of New South Wales in 1998-99 and Victoria in 2006-07. South Australia does not currently have carryover arrangements (Department for Water 2011a; PC 2010a).

Benefits of carryover

Carryover arrangements encourage more efficient use of water resources by allowing entitlement holders to make decisions about their own water security, by allowing them to make intertemporal decisions. Entitlement holders can use their water when it is of greater value to them and better manage their risks. Carryover arrangements are most beneficial the greater the water scarcity, the greater the variability in allocations season to season, and when options for trading and on-site storage are limited (PC 2006d).

Lessons from reform in Australia’s rural water sector

Water trading has been successfully established in the rural water sector, bringing with it significant economic benefits, including making a positive contribution to Australia’s gross domestic product. However, water trading might have also imposed some social costs.

Allowing water users to make intertemporal decisions on their water use can lead to more efficient use of water resources, allowing irrigators to use water when it is most valuable to them, and helping them to better manage risk.

C.5 Overall lessons from reform in other water sectors

The precise approach to reform varies considerably across Scotland, Auckland, England and Wales, and Australia’s rural water sector. In the case of Scotland,

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England and Wales and Australia’s rural water sector, different types and levels of competition have been established. By contrast, Auckland’s reform program has focused on integration of water and wastewater service provision. In England and Wales, there has been a shift away from government involvement in the water sector through privatisation. In Scotland similar outcomes are being pursued by encouraging competition with the government-owned, functionally separate, incumbent utility. On the other hand, in Auckland, water and wastewater services are provided by a government-owned utility, and there is no indication that these arrangements will cease.

The diverse reform paths taken by these jurisdictions reflect the different demand and supply conditions of each region, and the institutional arrangements in place prior to reform. These experiences demonstrate the range of feasible reform options available, and the importance of developing a reform program that is location (and content) specific.

Notwithstanding the diverse nature of the reforms there are some common themes. For example, separation of the natural monopoly elements of the supply chain (networks) from the contestable elements can allow competition to develop, with corresponding efficiency benefits for customers. However, evidence from reform in England and Wales demonstrates that establishing efficient and appropriate governance and regulatory arrangements is critical to realise the potential benefits of reform.

LESSONS FROM 527 OTHER WATER SECTORS

D Lessons from reform in other utility sectors

Since the 1980s, the Australian economy has been reshaped by a widespread program of microeconomic reform across many sectors, including urban water. There are a number of lessons from these programs of reform that should be considered when assessing further potential reforms for the urban water sector.

This appendix briefly outlines some of these key lessons.

Reform can have significant benefits

One overarching message from the reforms of recent years is that reform can lead to significant efficiency gains. This is particularly the case in areas of the economy that have not previously been subject to competitive pressures. These efficiency gains are likely to have benefits for consumers in terms of price, service quality or innovation (for example, reform of the telecommunications sector).

Importantly, the post-reform era in Australia has also been associated with sustained economic growth, rising real per capita incomes, relatively low rates of inflation and, following the global financial crisis, favourable employment outcomes compared to most developed world economies.

There has also been a productivity pay-off from reform. Australia’s annual multi-factor productivity growth rate averaged an extraordinary 2.3 per cent during the 1993-94 to 1998-99 productivity cycle, substantially above the rates in any of the other productivity cycles and more than twice the long-term average rate of 1.1 per cent. Australia’s international ranking increased from 12th to 2nd amongst key OECD countries. (In recent years, Australia’s multi-factor productivity performance has been below average, which the Commission largely attributes to lags between high levels of investment and subsequent output in the mining industry, increased capital investment in the utility sectors — including water — and drought conditions reducing agricultural output) (PC 2009c).

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Getting market design right is important

An important lesson from the reforms in other sectors, and particularly electricity, is that market design is important and lead times for reform are often quite long. The development of the national electricity market took many years. However, if reform is to provide anticipated benefits, it is more important to get market structure and governance arrangements ‘correct’ than to implement reforms quickly.

The reform era has also shown that more areas of the economy can be subjected to competition than might previously have been assumed to be case. Although many infrastructure areas have natural monopoly components, they also often have contestable elements. When initiating reform, it is important to define the natural monopoly elements of utility sectors, which should generally be kept as monopolies, and those that might be effectively opened to competition (chapter 12).

However, competition, although generally beneficial, should be seen as a means to an end (such as more efficient outcomes), rather than as an end in itself. Seeking to introduce competition for its own sake will sometimes be counterproductive, especially where competitive outcomes are unlikely to be achieved. For example, in the area of freight rail, the costs of vertical separation on some lightly trafficked rural rail freight routes are likely to be greater than any offsetting benefits from increased competition (PC 2006c). If competition is unlikely to emerge, the case for vertical separation is greatly diminished (although there might still be benefits from increased transparency, or potential efficiencies to be gained that might not have been discovered internally). Regardless of whether or not there is potential for competition, it is important to ensure that the benefits of vertical separation exceed the associated transaction and co-ordination costs associated with it before pursuing separation (chapter 12).

Sector dynamics change after implementing market reforms

The reform era has highlighted that once competition is introduced to a sector, the dynamics of that sector are fundamentally changed. For example, bringing new players into an industry, as has occurred in the Australian telecommunications sector, can accelerate the uptake of innovation, and help ensure that cost reductions are passed on to consumers (PC 2005c).

However, vertical separation can introduce difficulties associated with the need for coordination between sector entities. This is particularly true where there are independencies between industry players. For example, a company involved in electricity generation might be reluctant to invest if it was uncertain whether there

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would be complementary investment in transmission. Vertically-integrated operators do not have this problem.

These coordination issues can present problems even with otherwise highly successful reforms. For example, although reforms in the electricity sector have been successful in achieving efficient dispatch, they have not necessarily been as successful in encouraging investment (although uncertainty over future carbon emission reduction policies has undoubtedly contributed to this).

Governance arrangements are important

Reform in other sectors highlights the need to get governance arrangements correct if the benefits of reform are to be fully captured. The separation of policy, commercial and regulatory functions is important in order to remove conflicts of interest that are otherwise almost impossible to resolve, and to prevent the public monopoly provider from having a competitive advantage over its rivals (by effectively being both a ‘player’ and ‘umpire’ in the market).

Clear objectives, and the inclusion of objects clauses in legislation, are important. For example, the objects clause of the legislation enabling the national electricity market highlights the objective of the law as being to ‘promote efficient investment in, and efficient operation and use of, electricity services for the long term interests of consumers of electricity’ (Ruff and Swier, sub. 47, p.7). Where objectives are conflicting and guidance is not provided, accountability of both governments and government trading enterprise managers is diminished, and regulators are often given an undesirable level of discretion.

The Commission considers it important that new regulatory arrangements associated with microeconomic reforms should be well scrutinised in advance and subjected to regular review to ensure their benefits exceed their costs (PC 2005c). In particular, there is a need to be conscious of compliance and administration costs, and the need to strike the right balance between pricing decisions today and providing incentives for investment into the future.

Highlighting the benefits of regularly reviewing regulation, it can be seen that once competition has been able to develop, or if it becomes apparent that initial concerns about potential misuse of market power have been overstated, regulatory arrangements have often been eased. In a number of areas that have been subject to microeconomic reform (such as ports, airports, gas and electricity), initial levels of regulation have been ‘wound back’, either through reductions in the number of organisations subject to regulation, or by moving to more light handed forms of regulation.

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For example, in the case of ports in Victoria, over time there has been a reduction in the number of services subject to price regulation, and price monitoring has replaced potentially more heavy handed regulation for those still subject to price regulation. Following a review, several ports are no longer subject to price regulation, however a complaints mechanism is in place. The Victorian Government has also announced the repeal of the Victorian Channels Access Regime (ESC 2010).

Importantly, where regulation has been ‘wound back’, outcomes have often been found to be superior. In its 2006 report on of the regulation of airport services, the Commission found price monitoring to have delivered important benefits, and ‘preferable to a reversion to stricter price controls’ (PC 2006b, p. xii).1

Experience has taught governments that regulatory arrangements between wholesale and retail markets need to be consistent or compatible. The Californian electricity crisis of 2000 and 2001 stemmed, in part, from price capping at the retail level while wholesale prices were uncapped. The capped retail prices promoted electricity consumption, while electricity wholesalers had incentives to withhold production. As wholesale prices increased substantially, retailers were unable to recoup costs and were effectively rendered insolvent (Borenstein 2002).

Third party access arrangements can be problematic

Reform has demonstrated that third party access arrangements for infrastructure, although being potentially valuable in promoting competition, can be problematic. On one hand, by limiting potential returns they can represent a disincentive for infrastructure owners to invest. On the other, they can be ineffective in providing for competition, particularly where ‘deep pocketed’ infrastructure owners can delay access for many years.

In its 2010 report on export wheat marketing arrangements, the Commission found that an ‘access test’ designed to ensure rival exporters had access to port terminal facilities had provided benefits in the short term by allowing competition to develop, but that, were the test kept in place over time, the costs associated with the test would come to exceed the benefits (PC 2010b).

Third party access is likely to more problematic where there is a vertically-integrated infrastructure owner as there is an incentive for the infrastructure owner to favour their upstream or downstream operations. However,

1 The price monitoring regime for airport services is currently the subject of a further Commission inquiry.

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in 2001 the Commission found there are still likely to be benefits in having third party access arrangements applying potentially to all ‘bottleneck’ facilities (subject to meeting the criteria under Part IIIA of the Competition and Consumer Act 2010 (Cwlth)) rather than just vertically-integrated ones, not least because of the dangers of firms otherwise re-structuring to try to avoid being subject to them (PC 2001b).

Adjustment and distributional issues should be considered up-front

Major reform, even where creating significant net benefits, is likely to have adjustment and distributional implications associated with it. There are likely to be benefits of assessing these implications of reform at the outset (before the reforms are implemented), with decisions about transitional assistance being guided by appropriate principles.

Consideration of the adjustment and distributional impacts up-front will assist in developing principles to indicate whether transitional support is likely to be warranted, and in determining the most efficient method of providing assistance. Specifying the assistance that will be on offer can also assist in gaining support for change. Further, it will also reduce the likelihood of adjustment assistance being subsequently provided, or appearing to be provided, in an ad hoc manner (PC 2005c).

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