Cheap water comes at high cost

Fluctuations in supply are a fact of nature. When that fluctuation is in water, it poses a particularly acute problem for some - as in the current drought.

As water is essential, and from nature, it is often regarded as a (free) public service. While there is no doubt that some water needs just have to be met, it rarely justifies tying the pricing hand behind your back. Using price to match demand to the supply available would avoid the need for water restrictions such as those being introduced in Melbourne this week. Higher prices would also stimulate investment in water supply and distribution. By contrast, under-pricing water guarantees that shortages are exacerbated and funds for investment limited.

In most markets, an excess of demand over supply leads to a price rise – conserving use and financing substitutes and new technologies. A bad grape season in France means that Beaujolais prices will be higher, encouraging more production next year. Any pub that served beer at less than cost would quickly find itself simultaneously running dry and going broke.

Even so, periodic variability in supply should not create crises if the rationing mechanisms used instead of price are perceived as fair and predictable. Urban users accept the need for restrictions if they are not frequent. Commercial users such as farmers could take out insurance, or more likely self-insure, against the possibility of a bad year. A profitable farming activity would require that the good years compensate for the bad, with last year’s good crop compensating for this year’s poor one - which will see a winter crop harvest of less than half last year’s bumper crop.

In fact it is not the variable supply per se that is the real problem. It is the possibility that as currently priced there is just not enough water; that for a number of regions demand is consistently outstripping supply.

This situation of shortage is not because supply has been stagnating. In the last 50 years the storage capacity of large Australian dams has increased fourfold. Rather, demand has grown even faster, placing consistent and increasing pressure on water resources. The cheapest sources of supply are utilised first, so that in many regions the options for significant increases in supply are limited or costly or both.

Part of the problem is that water is priced permanently below the cost of supply, particularly for much irrigation water. This is being addressed under the National Competition Policy reforms, whereby the States are making progress towards full-cost pricing of water. Progress is slow, however, because of the very real social costs involved in changing land use away from low-value crops (per volume of water input).

An increase in the price of irrigation water would help to redress the balance between demand and supply. The price increases would be significant in areas currently facing "chronic" water shortages, and would signal that current land uses may not be economic in such regions. The allocation of water property rights, and institution of water trading, would also help, since those endowed with tradable water rights would have an asset from which they would seek to earn the best income. Allocation of these rights would create new wealth, which if captured by government could assist with problems concerning the environment and salinity.

This raises a further issue, which lies at the heart of Australia’s long-term water problem. It is the fact that water use by one user often imposes external costs on others. Some of these "externalities" have already been dealt with - for example, untreated waster water used to be dumped in rivers and seas. Now users have to pay for the cost of treating their waste before it is released back into the environment.

In Australia the big externalities are rising salinity and river degradation. Salinity is an "external cost" because excessive water use on one property causes rising salinity and land degradation in another. Similarly, those chopping down trees do not currently bear the consequences for rising dryland salinity. While the NCP water reforms are making some progress in ensuring users face the direct costs of water supply, the external costs remain unaddressed.

Again, pricing is likely to be an important part of any solution. By increasing water prices to reflect the costs imposed on the environment and other users Australia can ensure that water usage decisions are in the nation’s best interests. Until then, a valuable resource will continue to be squandered.