Mixing economics with water

Water price regulation: in the best interest of consumers

Have you ever thought about who regulates the price of water that comes out of your tap? Victoria’s independent economic regulator for water prices is tackling a difficult area with a new pricing framework that focuses on customers.

As a regulatory analyst and former graduate at the Essential Services Commission, my work focuses on regulating the state government owned water sector, which has its own specific regulatory challenges. The primary challenge is that we regulate 19 water corporations with a range of customers in both urban and rural areas, and we need to get the best outcome for all customers. Each water corporation also has a monopoly, since they are the only supplier of water and sewerage services in a particular area. (It would not make sense, after all, to have more than one set of pipes and other infrastructure supplying water to each area, because it would cost too much.) In the Victorian water sector, price regulation is less about providing better value through competitive markets and more about finding other ways to motivate utilities to improve and innovate.

PREMO framework: putting customers at the centre of water price reviews

This wouldn’t be an economic article without a discussion of incentives, and the commission’s new PREMO framework for water prices is all about rating price submissions and providing incentives for water corporations to provide better customer value.

First, a bit of background on how a water price review works: each water corporation proposes its prices and services it will provide for the next five years in a price submission. Next the commission responds to this price submission by accepting or rejecting the different parts of the proposal.

The PREMO framework links reputation and financial incentives to the level of ambition in a water corporation’s price proposal. A water corporation may propose to improve services while reducing costs. It also holds water corporations accountable for the actions and decisions they make and for delivering the service outcomes they proposed. This results in better outcomes for the customer because it encourages water corporations to address issues raised by their customers.

The PREMO framework focuses on five elements: performance, risk, engagement, management and outcomes. The last four elements happen at the start of each (generally five-year) water pricing period, while the first element happens right at the end.

  • Performance: We assess performance at the end of each five-year pricing period, when it becomes clear to what extent each water corporation has achieved its commitments.
  • Risk: We consider whether water corporations demonstrated a robust process for identifying risk, and appropriately managed who (corporation or customer) bears the risk.
  • Engagement: At this stage, we assess how well a water corporation has engaged with customers to ensure their price submission meets the needs of its customers.
  • Management: For management, we consider the prudency and efficiency of forecast expenditure, the level of productivity improvements committed to and the supporting information provided to justify proposed costs.
  • Outcomes: A water corporation must also propose a set of outcomes that its customers will receive during the next regulatory period. An example outcome could be ‘safe and clean drinking water’ or ‘reliable water and sewerage services.’

Each water corporation does a self assessment on each of these elements (it seems that assessments don’t end after university), and then proposes an overall rating for the whole of their price submission. The water corporation rates the last four PREMO elements and their overall price submission as either ‘basic’, ‘standard’, ‘advanced’ or ‘leading’.

Reviewing water prices using game theory

Time to get your game on now – or at least your game theory! Next, the commission rates the water corporations’ submissions. The combination of the commission’s rating and a water corporation’s rating of the price submission can be shown on a game theory matrix, where a water corporation is assigned a ‘return on equity’ based on where it falls in the matrix. A return on equity is a rate of return earned by a water corporation to cover borrowing costs used to fund capital investment.

The PREMO matrix – a one-shot game – is designed so that a water corporation will get the best outcome (a higher return on equity) if it puts forward its best offer and provides an honest self assessment of its price submission. The water corporation’s self assessment is the best possible rating that it thinks the commission will make. If a water corporation has rated itself higher than it is rated by the commission, then the return on equity will be lower than it would be had the water corporation given itself an accurate rating.

Figure 1: Indicative regulated return on equity

Performance reporting: making things competitive

What if I told you monopolies could compete against each other? Well they can… sort of. By comparing the performance of urban water corporations with each other it is possible to see the performance of standouts and those falling a bit behind in a particular area. In the past, we have measured performance on common measures for all the urban water corporations such as the number of pipe bursts and leaks, typical household bills, and the number of residential customers on instalment plans.

From now on, we will also assess each water corporation against their own outcomes, which were informed by their engagement with customers. This should be more meaningful, because the outcomes of each water corporation are tailored to the needs of their customers rather than being ‘one size fits all.’

Why mix water with economics?

I like mixing economics with water for a few different reasons. I like economics, I like water, I like variety and I like analysis. Seriously, I’m the kind of person who prefers water over coffee, soft drink and any other cold or hot beverage. And the variety of the work is great – sometimes I am helping out at stakeholder forums, writing reports or working with spreadsheets. Not to mention all the training I did as part of my graduate year. I also enjoy thinking about and applying the interesting concepts that come up in my work.

But the biggest reason I like this work is that it makes a tangible difference to Victorian lives. By helping to regulate the Victorian water sector, I ensure that water prices don’t go any higher than they need to be, and that customers continue to receive high-quality, reliable services from their water corporation every time they turn on a tap.