Policy, pricing and consumption: pricing signals and economic efficiency

Efficient water networks benefit users, providers and overall economic productivity. Governments and utilities are continually seeking to achieve a more efficient water network for the public. One of the key processes available to utilities for influencing efficient water use is the setting of pricing signals. Pricing signals have a material impact on consumer water use and can drive a range of outcomes depending on the market in which they are applied. Incorrect pricing signals can have a detrimental effect on economic efficiency by creating perverse incentives that result in customer or utility behaviour that is counter to achieving economically efficient outcomes.

Aither works regularly with water utilities across Australia to drive their and their customers’ outcomes. Our experience has shown us some of the common mistakes and assumptions utilities make about pricing signals. We’d like to share some of the key features of water pricing and a practical example from one of our clients where a tariff structure has been imposed that demonstrates the potential impacts that pricing for water can have on efficiency across the industry.

Pricing and economic efficiency

In monopoly environments like the water industry, the service provider sets the price of the service and consumers have no viable alternative options. The water industry is regulated as an essential service and this regulatory oversight provides the main control over price setting. In the absence of competitive pressure these regulatory frameworks seek to ensure that prices are set that reflect those that would likely eventuate in a competitive market. Within this context, the setting of prices is an integral component in ensuring customers receive a service that they consider to be value for money.

One of the key drivers in price setting for monopoly service providers such as water utilities is to achieve economic efficiency through effective tariff structure design. There are three different types of economic efficiency, driven by different factors:

• Productive efficiency recovers only the efficient costs of investing in regulated services. It is driven by the level at which the prices are set and the overall expenditure that the tariffs are designed to recover. It is important to ensure that only efficient costs are to be recovered through prices.
• Allocative efficiency is reflective of forward-looking costs of providing services, thereby ensuring consumption only occurs where the benefit to the consumer outweighs the costs to society of providing those services. It is primarily impacted by tariff structures which provide signals to customers regarding the forward-looking service costs, and therefore encourage customers to consume water when it is economically efficient to do so.
• Dynamic efficiency occurs where businesses are incentivised to seek out efficiency gains over time. It is impacted by the broader governance and regulatory frameworks, such as price control. These elements determine the strength of the incentives placed on the service provider to seek out efficiency gains within the business.

Tariff structures and economic efficiency

Tariff structures can have a significant impact on economic efficiency. Inefficient tariff structures can decrease economic efficiency through the creation of a deadweight loss to the economy. Deadweight losses arise when usage prices are set above (or below) the long-run marginal costs (i.e. when they are not cost reflective), resulting in less (more) demand than is economically efficient.

In the case of water utilities, inefficient tariff structures that pass additional costs on to consumers (i.e. prices above the long-run marginal cost) mean that customers are likely to use less water than they would if prices were cost-reflective.

Customer behaviour around water consumption considers not only the personal cost communicated through pricing signals, but also other factors such as social expectations in drought conditions and environmental concerns. These factors are also impacted by cost, as price signals convey information about availability and value which in turn informs customer behaviour. These factors and other non-market values are important considerations when making decisions around tariff structures, however the incorporation of non-market values (both benefits and costs) is not currently undertaken well by either the industry or the regulators and is an area of improvement for the industry going forward. If greater effort is placed on understanding and quantifying these non-market values it will result in more informed decisions regarding investments and more efficient tariff structures.

Through these messages, tariff structure inefficiencies influence customers to make decisions to consume less water than they would if the marginal price was lower and more reflective of the marginal cost. Such decisions can involve using less water for health and sanitation (such as showering and cleaning), restricted food preparation, and less watering of gardens, with negative impacts on health, wellbeing, environmental impact, social behaviour, and consumer satisfaction. Customers need to be enabled to make decisions regarding their consumption of water based on the price and what they value from the use of the water.

Customer preferences aren’t always economically efficient

Australian regulators and utilities have recently shifted away from the theoretical position of pricing based on marginal costs and towards incorporating customer preferences. This move has been informed by increased engagement with customers to improve their understanding of the water industry and determine their preferences with regard to pricing. From this, utilities have gathered that customers largely prefer to have a utility bill that has a higher proportion of variable charges than fixed charges. This means that if customers change their consumption behaviour they are more likely to realise an impact through their bills.

This has resulted in most Australian utilities adopting a tariff structure where the variable charge for water consumption is higher than the long-run marginal cost of supplying the water to the customer. The resulting structure does not appear to be based on the incorporation of non-market values but rather a perception of how much ‘control’ customers want over their water bills. While this appears to be the current preference of the customer, it is important to consider the implications of this approach and question whether this preference is fully informed by an understanding of the water industry and potential subsequent cost impacts.

So, what happens when prices don’t equal marginal costs?

When marginal prices are set above the marginal cost to the service provider this can impact the cost of providing the service to customers.

For example, various social, economic and environmental factors (such as water restrictions, industry decline, and access to water-efficient appliances and fixtures) may result in a reduction in service consumption. When this happens, reductions in consumption will result in a loss of revenue within the period of reduced use that is greater than the cost savings through the lower level of consumption. The service provider, such as a water utility, will therefore experience a shortfall in revenue for the period.

When marginal prices do not equal marginal cost, water utilities face revenue risks associated with changes in demand. If the marginal price is set above the marginal cost, any demand for the service above what was expected will result in a net increase in revenue for the utility, but a lower demand for the service will result in a net loss in revenue. Conversely, if the marginal price is set below the marginal cost, the water utility would be worse-off if customers used more than expected as the marginal costs will increase by more than the marginal revenue.

There are several mechanisms to assist utilities to manage this issue if the tariff structure poses a material revenue risk, particularly if the tariff structure was not the utility’s preferred option. Two of the mechanisms available to regulators are:

• ‘True-up’ mechanisms or regulatory re-openings: These are generally applied to account for risks that cannot be completely mitigated by the water utilities. Examples include force majeure events or significant investment decisions. These mechanisms have been applied in a number of jurisdictions to account for material changes in usage demand where the marginal price does not equal the marginal cost (this is generally based on a short-term perspective to account for cash flow timing issues for utilities).
• Specific allowances: Specific allowances such as a revenue volatility allowance may be provided to account for the need for the utility to manage the increased risk associated with a different tariff structure, assuming the adoption of the tariff structure was not done through choice.

Case study: Seqwater

The current case of Seqwater in Queensland highlights the potential impacts that pricing for water can have on efficiency across the industry and investment in water networks where a 100 per cent variable tariff structure has been imposed.

Seqwater is a bulk water service provider in south-east Queensland, a vertically disaggregated industry with five distributor-retailers purchasing bulk water from Seqwater to distribute to end-use customers. Seqwater is owned by the Queensland State Government, while the distributor-retailers are owned by their respective Local Governments.

As per previous State Government policy decisions, Seqwater is required to adopt a 100 per cent volumetric charge to recover its expenditure, in spite of the business’s underlying cost drivers being largely fixed. Additionally, the volumetric charge must be explicitly separated on end-use customer bills (i.e. separate to the distributor-retailer charges).

What does this mean for distributor retailers?

The 100 per cent volumetric charge results in a much higher marginal price for the distributor-retailers than the marginal cost to Seqwater of providing the water. This means that Seqwater’s customers, the distributor-retailers, invest millions of dollars each year to reduce leaks in their networks to decrease their bulk water costs to Seqwater.

For Seqwater, the reduction in demand through the reduced leaks results in a loss of revenue that is greater than the reduction in costs. This then increases the variable charge in the next regulatory period, which in turn creates an even stronger incentive to reduce leaks (assuming the 100 per cent tariff structure remains in place). The distributor-retailers’ focus on reducing network leaks is a completely rational response to an irrational tariff structure.

As a result, the supply chain of the water industry bears a higher cost incurred in delivering the water than there would be if a lower, more cost-reflective usage charge was applied. As the distributor-retailer incurs a higher marginal cost through this tariff structure, the increase in costs for the distributor-retailer in reducing network leaks will not be offset by a reduction in costs for Seqwater as the bulk water supplier. The result is a higher cost to supply water than would be the case under a more cost-reflective tariff structure.

The following figure provides a stylised example of the difference between marginal cost and marginal price for network leaks under the Seqwater example. There is a point at which it becomes no longer economic to repair network leaks – this is where the savings from the works are less than the cost of actually undertaking the work. The difference between the two columns represents the difference in costs faced by the distributor-retailer and therefore significantly changes that decision-point about when it is economic to repair network leaks.

To consider an alternative, if the water industry in South East Queensland was vertically integrated as in South Australia and Western Australia, investments in leak reduction would be primarily driven by the left-hand column. This would result in a much lower incentive to invest in leak reduction methods throughout the network as the benefits from the savings would be much lower. Therefore the increased spend on network leaks is primarily driven by an inappropriate pricing signal from the bulk service provider to the distributor-retailers.

The higher marginal cost also has impacts distributor-retailers’ decision-making in augmentation investment. This is especially prevalent where investment decisions are underpinned by avoidable costs, such as through recycled water solutions that reduce the need for future potable water supply augmentations. In this example the higher marginal cost will result in an investment bias towards options that potentially reduce the need for future potable supply augmentations.

What does it mean for end-use customers?

What this tariff structure means is that the end-use customers – that is, residential and non-residential customers – incur a higher cost for the combined water services than they should. This is because while the distributor-retailer is, very rationally, spending money to reduce its costs where it is efficient to do so, the subsequent loss of net revenue (revenue in excess of avoided costs) by Seqwater is greater. This results in an increase in Seqwater’s prices in the next period which more than offsets any decrease in the costs of the distributor-retailer.

The end result is a higher bill for the end-use customer that is solely driven by the pricing signals from Seqwater’s tariff structure. These price increases have a significant impact on customer ‘utility’ from water usage and the satisfaction of the end-use customers.

Key messages

Efficient tariff structures and pricing signals are crucial for driving economic efficiency, and the tools available for water utilities to drive efficiency are complex and contingent on the markets in which they operate. There are three key findings that we hope water utilities will carry into their pursuit of economic efficiency:

• Pricing signals can impact efficient investment evaluation. If the cost of water to the distributor is much higher than the actual cost to supply from Seqwater, this will influence the distributor’s investment decisions.
• Pricing signals can impact broader economic efficiency and customer utility. Prices can impact on customers’ ‘enjoyment’ from the use of water where they would otherwise be happy to pay if prices are cost reflective
• One of the issues for regulators (and utilities) is valuing those non-financial impacts of reducing water consumption. Currently it is generally driven by a view that there is broader benefits in conserving water that go beyond the costs to supply