Dynamically Efficient Urban Water Policy

Many urban communities are considering infrastructure investments to augment their water supply in response to actual or expected shortages due to weather variability and, in some cases, due to climate change. To address short-term imbalances between supply and demand, water utilities frequently use mandatory water restrictions to curb demand. By contrast, adjustments to the volumetric price of water are rarely used as a demand-management tool in response to variability in catchment inflows. To evaluate the welfare losses from the typical water restrictions approach to demand management and supply augmentation, we compare ‘business as usual’ to the use of dynamically efficient water pricing to determine: (1) the volumetric price and (2) the optimal time to invest in additional supply given variability in water availability. To calculate welfare losses a practical method is used that simultaneously calculates the optimal dynamic volumetric price, the optimal time to invest in new supplies, and the optimal use of water restrictions while accounting for climate variability, the costs of supply augmentation, and the demand for water by households. Using actual data from a large metropolitan center, model results show that the present value of the expected costs from using supply-inflexible volumetric water pricing generates large welfare losses in excess of the annual average household water bill. These losses are attributable to: (1) on-going water restrictions and (2) premature supply augmentation, but 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. The results are both important and of general interest because global expenditures on water infrastructure are estimated to be some $75 billion/year and there is no jurisdiction, as far as we are aware, that employs dynamically efficient water pricing.