Monthly Archives: February 2005

41 – Fresh water for Perth 3: myths and misconceptions

Policy makers attempting to address the “shortage” of water in Perth are in desperate need of some simple economics. Clear thinking about prices, costs, values and incentives would go a long way.

All over the world, responsible public water management is inhibited by public attitudes to water. Water is seen as:

  • too important
  • too fundamental
  • an intrinsic right
  • “free”
  • already committed

so reforms are extremely difficult. In 2000, the World Water Council said “There is a water crisis today. But the crisis is not about having too little water to satisfy our needs. It is a crisis of managing water so badly that billions of people – and the environment – suffer badly.” As a generalisation, and notwithstanding outrageous election promises (see PD#40), water is better managed in Australia than in many other countries, but there is still great scope for improvement.

Sound pricing is only one part of water management, but it is an important part. It is also politically challenging. “There are many ways to promote equity, efficiency and sustainability in the water sector and water pricing is probably the simplest conceptually, but it may be the most difficult to implement politically” (Rogers et al. 2002).

Part of the problem is the need to overcome a number of popular myths and misconceptions, as follows.

Water is not free

Yes, it falls from the sky, but getting it from where it lands to your tap can be an expensive business. Those expenses are relevant to the community’s decisions about water and how best to provide it.

Water is not infinitely valuable

Of course if we had no water, the value of getting some water would be very high indeed. However, that is not our starting position. In considering proposals to provide additional water, the relevant value is the value of that additional water, not the value to someone dying of thirst in the desert.

No particular use of water is intrinsically superior to other uses

The relevant value of water used for consumption is what consumers are willing to pay for it. When it comes to water values, irrigation does not hold any trump cards. If a domestic consumer is willing to pay more for a kilolitre of water than an irrigator is, it reflects that the value of that water is higher in the domestic use. There is no basis for considering water use for irrigation to be intrinsically superior.

Pricing water is not immoral

Certainly water is important, but that is no reason to exempt it from sensible pricing. Indeed, if it is so important, why would it not be seen as immoral to give it away at a subsidised price? That runs the risk that it will be wasted on low-value uses, or the risk that viable opportunities to conserve water will not be taken up because it is cheaper just to buy more.

If you set the prices cleverly, you can create a situation where water consumers behave in a way that they do not wish to use more water than is available, and they maximise the overall value from water usage. In other words, when they consider the benefits and costs to them of a use of water, they make a decision that maximises the overall net benefits to the community. You achieve this by the simple means of setting the price equal to the relevant measure of the cost of the water (or by using markets to do so if that is feasible).

In addition to overcoming those myths and misconceptions, there are some insights that water managers need to grasp to make good pricing decisions for water.

The relevant cost of water

If additional water infrastructure is not on the agenda, the relevant cost to use as the basis for pricing is the variable cost of delivering the water: the amount it costs the water utility to deliver the last kilolitre of water to your tap.

If attention is focused on developing additional water sources, sound pricing gets complicated by the need to consider costs of additional infrastructure. In considering whether additional infrastructure (e.g. a 3700 km canal) is worthwhile, we need to consider how consumers would respond if they were charged the full cost, including full costs involved in developing the infrastructure. We should do this because people’s responses to higher prices is the best indication we have of the value of the extra water.

If we think that there would still be sufficient demand for water at that higher price, the benefits of the infrastructure would exceed the costs. We need to be careful about this because typically new water sources come in large lumps. (The mooted channel from the Kimberly to Perth would, it is claimed, provide 200 GL/year). There may be a worthwhile demand for say the first 50 GL, but not for the remaining 150 GL.

If additional infrastructure is actually built, you should probably use fixed charges (or tax revenues) to recover construction costs, rather than building them into the volumetric prices. The latter would result in people using less water than desirable/justified on a benefit-cost basis, given that a big portion of the infrastructure costs are sunk costs and unaffected by the future level of water consumption. You would still use a realistic variable cost as the minimum basis for pricing.

If it turns out that the additional infrastructure is not worth building, you can use pricing as a mechanism to reduce demand. This has a lot of advantages over the sorts of approaches typically used (education, subsidising water-efficient dishwaters!). For example, pricing affects all water users, not just socially responsible ones, it most affects those who use the most water, and it achieves water savings in the least-costly way for the community.

Consumers respond to marginal price, not average price

Western Australian domestic water consumers face a reasonably high average cost for water but a low marginal cost because about half the cost consists of fixed charges (i.e., charges that do not vary with water consumption). In a situation where water demand is outstripping supply, this represents a severely bad approach to water pricing, as it provides only a weak incentive for conservation. What creates an incentive to conserve is the price of the last kilolitre, not fixed costs that are unaffected by consumption. It would make more sense to set the fixed charge to zero and increase prices per kilolitre accordingly.

[Side comment: If there is water trading among irrigators, the price they respond to isn’t necessarily the price they were charged for the water by the supplier. It could be the price they would get if they sold it (e.g. from one irrigator to another). The potential for water trading among irrigators reduces the problems from selling water very cheaply to irrigators, although the inability to trade between sectors (e.g. between irrigation and domestic) means that irrigators could still end up facing a market price that is significantly lower than the value of water in other uses.]

Recognising the different effects of marginal prices and fixed charges for water empowers the water supplier to do some innovative things. They could jack up marginal prices (to reduce demand) and compensate with reduced fixed charges (to reduce political resistance to the higher marginal prices) or they could even provide a fixed amount of free water, as they used to in WA . They would need to make sure that people did not expect compensation to be linked to current or future consumption, or that would defeat the purpose.

Overall, the potential to use pricing for better water management is great, but largely untapped (sorry).

David Pannell, The University of Western Australia

p.s. Reader Neil Barr was very interested in the proposed channel from the Kimberley 3700 km to Perth (see PD#40), and has been doing path-breaking research on the subject (involving an atlas and a ruler). He suggests that Adelaide is only a little further from the Kimberly than Perth is, and so an additional channel to Adelaide should be considered. Neil’s detailed and fully costed feasibility study has identified a number of advantages from this approach. It would free Adelaide from reliance on the fast disappearing water resources of the Murray-Darling Basin, and would provide Western Australia with a good case for joining the Murray-Darling Basin Ministerial Council, which would be terrific fun. Neil is clearly a man of vision. So too is Alistair Watson who suggests a shorter pipeline from the Ord to Katherine in the Northern Territory, where the water could be loaded onto the new train to Adelaide, thereby combining two visionary infrastructure projects.

Further Reading

Rogers, P., de Silva, R. and Bhatia, R. (2002). Water is an economic good: How to use prices to promote equity, efficiency and sustainability, Water Policy 4: 1-17.

40 – Fresh water for Perth 2: the State Opposition’s attempts

The State Opposition parties in Western Australia have staked their electoral prospects on their unconditional support for a water channel from the Kimberly to Perth. Their willingness to place politics above responsible economic management deserves the deepest condemnation.

In PD#39 I was highly critical of decisions about water supply and pricing in Western Australia made by the current Labor State Government. However the State Opposition (a Liberal/National coalition) has managed to trump the Government with an even worse approach to the issue during the current election campaign.

The biggest concern is their promise to build a covered channel to move water 3700km from the Kimberly to Perth. The State Government had cynically set up a feasibility study to examine the proposal. They knew full well that it wasn’t nearly a viable proposition, as almost revealed by the Premier Geoff Gallop in his passionate reaction to the Opposition’s announcement.

Knowing they were behind in the polls, Opposition Leader Colin Barnett decided they needed to take some risks, in the form of bold and “visionary” decisions. He announced a decision to go ahead with the channel without waiting for the feasibility study to be completed. When pushed, he asserted that the decision was absolutely unconditional; they would build the channel no matter what it cost.

There are all sorts of problems with this promise.

  1. It is an affront to responsible decision making. Committing to such a huge project without anywhere near all the facts is absolutely reckless. All sorts of uncertainties and concerns have been raised in the ensuing debate, including economic, technical, social and environmental issues.
  2. The information that the Opposition had to make the decision seems seems to have been highly inaccurate. The claimed construction costs ($2 billion) are clearly much too low. According to the Government, the Water Corporation of WA has costed it at $4.6 billion, not including the costs of acquiring land, providing power, building roads and treating the water.
  3. Barnett claimed that water would be delivered to Perth for $1/kilolitre(KL). John Quiggin, writing in the Australian Financial Review of 10 Feb 2005 pointed out that the claimed construction costs alone would be enough to account for $1/KL. Once one accounts for more realistic construction costs and includes things like pumping, maintenance, treatment and reticulation, the realistic delivery cost would be much higher. State Treasury’s rough estimate was $6.50/KL. According to one correspondent to Crikey.com, “an independent consultant came up with a cost of $9.5-12.4 billion and $6.10 per kilolitre for a pipeline back in 2002” (although I haven’t seen that report). Current water prices for most domestic and industrial water users and all irrigators are under $0.75. The Opposition refuses to concede that their costs are wrong, so there has been no announcement by them of how the difference would be funded. But it would be funded by the community one way or another. We can’t know what the costs would really be without a lot more analysis (that’s part of the point!) but the opposition’s numbers are obviously fanciful.
  4. Beyond those financial costs, there are uncosted environmental and social impacts, which have raised the ire of many.
  5. There is an assumption that around 40% of the water will be used for irrigation. If that happens, I don’t imagine that irrigators will be charged anything like the real cost of the water they use (currently in the south-west they are charged about $0.03/KL). If irrigators were again given favourable pricing, either the Government would have to subsidise that directly, or it would require an even greater price to domestic and industrial users. Quiggin suggests that “the costs for residential users could be as high as $10/KL. At that price, fanciful options such as transporting icebergs from the Antarctic start to look attractive.”
  6. Even more importantly, at that price, if it were to be charged to water consumers, there would be a massive contraction of demand. It seems certain that demand for water would fall so much that the water from the channel would not be needed. It would be too embarrassing if the channel was built but then nobody wanted the water. For that reason it is highly likely that the government would provide massive subsidies on water prices to all users, not just irrigators, to make the water attractive enough to use. The community of WA would still pay far more than the water is worth, but in a way that was hidden and unrelated to their water consumption. The Government would have to take public money away from hospitals, education, the environment, and so on to pay for water that costs more to provide than it is worth to us.

This raises the obvious question, why not use pricing to reduce demand as the first option? If there is still excess demand for water after prices have been increased 10 fold, (or 200 fold in the case of irrigators), then it might be reasonable to reconsider the channel. If there is not excess demand at those prices, it shows that the community’s valuation of the water is less than the cost of providing it. The implication is obvious.

Perhaps the most depressing thing about the whole appalling saga was the community response. At least initially, polls found 70% support for the plan. (I’m not sure what has happened to public opinion since. There has been so much criticism of the idea that people may have gone cool on it. I certainly hope so.) Are people really so susceptible to such simplistic, politically cynical, economically irresponsible promises? Apparently they are.

David Pannell, The University of Western Australia

39 – Fresh water for Perth 1: the State Government’s attempts

The State Opposition parties in Western Australia made the news this month with their ideas for providing fresh water to Perth. As lamentable as those ideas are, the current State Government has its own history of appalling mismanagement of the issue.

Western Australia has long had the most irrational pricing scheme for domestic water users. All Australian states break their water charges into a fixed charge just for being connected, and a volumetric charge that varies with how much water you use. Obviously, the smaller the volumetric charge, the less incentive users have to conserve water. In Sydney, the volumetric charges account for 80% for what domestic users pay, while in Perth it is the lowest of any state, at only 50%.

The good news about that is that it provides an opportunity to make significant savings in water simply by re-adjusting the water tariff. If you reduce the fixed charge and increase the volumetric charges by just the right amount, you could achieve water savings without any change in costs to consumers (important politically) or revenue to suppliers (important to them). With all the concerns about Perth’s water crisis over the last few years, it would have been an ideal time to make this change. Perth’s water users would surely have accepted it as sensible and desirable. In fact I suggest that they would have accepted overall price increases in the circumstances.

In 2003, the relevant agencies put three options to the State Government, involving different systems for adjusting domestic water tariffs. The most dramatic change was judged to save 15GL, while the least dramatic only affected extremely high water users, and would save only 1GL. All three options were designed to be revenue neutral. In all their courage, the Government chose the 1GL option, presumably out of fear of political costs from a more extreme change. Given that all three were revenue neutral, this reveals an extraordinary degree of political cowardice.

We are left with a situation in Perth where 60% of domestic water users and 70% of business users pay a marginal price for water that is below the marginal cost of supply, which was estimated at about $0.75/kilolitre(KL) in 2003. That cost is based on water from existing developed sources. If we consider the need to bring on new sources, the marginal cost is of course much higher.

Meanwhile, there is another opportunity to save water that is going un-exploited. The biggest set of water users is the irrigation farmers. South West Irrigators pays less than one cent per KL for bulk water, and on-sells it to farmers for around 3 cents. Now irrigation can clearly be a very valuable use of the water, but if you price it that low, irrigators have little incentive to conserve it. Actually, that overstates the case. In some cases water can be sold in a water market, in which case, the “opportunity cost” to farmers from using the water is its market price. Even so, the loss of water from irrigation channels in the south-west is conservatively estimated at 25-30%. And notwithstanding the existence of water markets, the 3 cents per KL price amounts to a massive hidden subsidy to our irrigators. Fixing this is apparently too hard politically.

To rub salt in the wounds, the quality of water provided to irrigators is often higher than that coming out of the taps in Perth. There is actually plenty of good water for Perth for decades to come if we could only fix up this mad set of situations. A responsible solution has to include substantial reform of pricing schedules for all users before we commit to major new infrastructure.

However, the State Government’s next step was to announce a large desalination plant. I’m not sure what the marginal costs of supply will be out of this plant, but based on a review of desalination economics in 2000, I expect it will be well over $1/KL, and could be over $2/KL. The result of this will be a huge widening of the gap between the cost of supply, and the benefit of the lowest value use (in low-value parts of the irrigation sector). Also, it makes the effective subsidy to irrigators correspondingly bigger.

The essentials of the pricing system and the allocations to irrigation are untouched. The imperative for the state to save water just got much greater, but the incentive for water users to do so is absolutely unchanged. The levy that will apparently be charged to cover the construction of the desalination plant will not change incentives to conserve water because it is unrelated to the level of water consumption.

There was one more politically cynical act to come. Recently the Government announced a committee to examine the feasibility of building a channel to bring water 3700km down to Perth from the State’s north-west. The talk in state agencies was that the Government knew full well that the plan is not even remotely economically viable, but they used the committee as a stalling tactic. They can appear like they are doing something about the continuing water crisis, while delaying the actual decision until after the election (which is in just over a week’s time, as I write).

Overall, the State Government’s approach to the issue has been cynical, cowardly, and economically irresponsible. There was an opportunity for the State Opposition to step in and be the good guys. But instead they stepped in with a plan that is so monumentally ill-conceived that it almost makes the Government’s plans look wise and responsible. More on that in PD#40.

David Pannell, The University of Western Australia

38 – Personality and the adoption of innovations

This is an edited extract from Pannell et al. (2006). Thanks to my co-authors, Neil Barr, Roger Wilkinson, Frank Vanclay, Allan Curtis, and Graham Marshall, who wrote more of these words than I did.

Personality may potentially play a major part in the style of decision making used by farmers and other landholders, although because of measurement complexity, it has rarely been studied. One important personality trait is ‘locus of control’. Individuals with a strong belief in their own ability to influence the circumstances of their lives are described as having an ‘internal locus of control’. Persons with this personality trait are likely to experience less stress in decision making. The individual portrayed in John O’Brien’s famous Australian poem “Said Hanrahan” (see below) no doubt had an external locus of control. (“If we don’t get three inches, man, or four to break this drought, We’ll all be rooned,” said Hanrahan, “Before the year is out.”) and may have been more troubled by stress during decision making. The limited research into farmer stress in Australia has shown that financial difficulty alone does not predict stress. Stress is instead a combination of circumstances and the interpretation placed upon those circumstances by the individual.

Economists study ‘risk aversion’ which is perhaps a personality trait. Risk aversion describes an individual’s tendency to take or avoid risks in their decision making. Empirical evidence is that landholders vary widely in their personal degree of risk aversion. More risk-averse farmers may tend to rapidly adopt an innovation that is perceived to reduce risk or to not adopt an innovation that is perceived to increase risk.

Another important personality trait is introversion-extroversion. Shrapnel and Davie (2001) and Shrapnel (2002) examined the personality profile of a sample of Queensland graziers. Of 14 general personality styles expected in the wider community, graziers were found to generally fall into a limited suite of five styles. ‘Our findings indicate that they are indeed a special breed, with characteristic[s] that set them apart from members of an urban community’ (Shrapnel and Davie 2001, p. 177). These characteristics include a tendency to introversion and discomfort within group situations. This work provides an indication of why one-on-one relationships are likely to be preferred by many farmers over group settings. This personality trait will influence the extent and nature of a farmer’s personal networks. Personal networks are an important influence on adoption behaviour and are increasingly important as a medium for the implementation of government and industry programs.

A widely discussed and long-standing concept is categorisation of landholders across a spectrum from innovators to laggards, presented with little change from Rogers (1962, pp. 168-171) to Rogers (2003, pp. 282-285). Landholders do indeed have personal characteristics that influence their adoption decisions fairly consistently. However, the concept of adopter categories implies that innovativeness is a personal characteristic that people apply equally to every adoption decision that they make. This is not so. People who adopt one innovation early are not necessarily early adopters of all innovations. It may be that the innovation in question is particularly attractive in their individual circumstances, whereas the same decision-maker when considering a different innovation that is less attractive to them than to others may behave as a slow adopter or non-adopter.

David Pannell, The University of Western Australia

Said Hanrahan

“We’ll all be rooned,” said Hanrahan,

In accents most forlorn,

Outside the church, ere Mass began,

One frosty Sunday morn.

The congregation stood about,

Coat-collars to the ears,

And talked of stock, and crops, and drought,

As it had done for years.

“It’s looking crook,” said Daniel Croke;

“Bedad, it’s cruke, me lad,

For never since the banks went broke

Has seasons been so bad.”

“It’s dry, all right,” said young O’Neil,

With which astute remark

He squatted down upon his heel

And chewed a piece of bark.

And so around the chorus ran

“It’s keepin’ dry, no doubt.”

“We’ll all be rooned,” said Hanrahan,

“Before the year is out.”

“The crops are done; ye’ll have your work

To save one bag of grain;

From here way out to Back-o’-Bourke

They’re singin’ out for rain.

“They’re singin’ out for rain,” he said,

“And all the tanks are dry.”

The congregation scratched its head,

And gazed around the sky.

“There won’t be grass, in any case,

Enough to feed an ass;

There’s not a blade on Casey’s place

As I came down to Mass.”

“If rain don’t come this month,” said Dan,

And cleared his throat to speak —

“We’ll all be rooned,” said Hanrahan,

“If rain don’t come this week.”

A heavy silence seemed to steal

On all at this remark;

And each man squatted on his heel,

And chewed a piece of bark.

“We want an inch of rain, we do,”

O’Neil observed at last;

But Croke “maintained” we wanted two

To put the danger past.

“If we don’t get three inches, man,

Or four to break this drought,

We’ll all be rooned,” said Hanrahan,

“Before the year is out.”

In God’s good time down came the rain;

And all the afternoon

On iron roof and window-pane

It drummed a homely tune.

And through the night it pattered still,

And lightsome, gladsome elves

On dripping spout and window-sill

Kept talking to themselves.

It pelted, pelted all day long,

A-singing at its work,

Till every heart took up the song

Way out to Back-o’-Bourke.

And every creek a banker ran,

And dams filled overtop;

“We’ll all be rooned,” said Hanrahan,

“If this rain doesn’t stop.”

And stop it did, in God’s good time;

And spring came in to fold

A mantle o’er the hills sublime

Of green and pink and gold.

And days went by on dancing feet,

With harvest-hopes immense,

And laughing eyes beheld the wheat

Nid-nodding o’er the fence.

And, oh, the smiles on every face,

As happy lad and lass

Through grass knee-deep on Casey’s place

Went riding down to Mass.

While round the church in clothes genteel

Discoursed the men of mark,

And each man squatted on his heel,

And chewed his piece of bark.

“There’ll be bush-fires for sure, me man,

There will, without a doubt;

We’ll all be rooned,” said Hanrahan,

“Before the year is out.”

John O’Brien

Further reading

Pannell, D.J., Marshall, G.R., Barr, N., Curtis, A., Vanclay, F. and Wilkinson, R. (2006). Understanding and promoting adoption of conservation practices by rural landholders. Australian Journal of Experimental Agriculture 46(11): 1407-1424. Access paper at Journal web site here. Pre-publication version available here (161K).

Shrapnel M, Davie J (2001) The influence of personality in determining farmer responsiveness to risk. Journal of Agricultural Education and Extension 7, 167-178.

Shrapnel M (2002) ‘Bushies and cockies – beyond the myths: The personalities of our outback land managers.’ MSc thesis, University of Queensland, Brisbane.

Rogers EM (1962) ‘Diffusion of Innovations.’ (Free Press: New York)

Rogers EM (2003) ‘Diffusion of innovations.’ 5th ed. (Free Press: New York)