The determination of appropriate pricing for water is critical to improve efficiency of the pipe-borne water supply system in many developing countries. A major problem faced by the water sector is that prices are almost universally below the level required for full-cost pricing. Under-pricing of pipe-borne water results in over-consumption, reduces new investments, diminishes the quality and quantity of water delivered, slows spatial coverage especially for poor settlements, and jeopardizes financial viability of water supplying entities.
This thesis evaluates current and alternative pricing strategies for pipe-borne water in Sri Lanka against the criteria of efficiency, equity and the financial viability of the water utility. Existing literature on residential water demand has primarily focused on the developed countries. This thesis evaluates a demand model for residential water for Sri Lanka using the Cobb-Douglas and Stone-Geary functional forms on aggregate panel data. Price elasticity ranges from -0.06 to -0.58 and the income elasticity varies from 0.03 to 0.14. The Stone-Geary specification provides an estimate of the portion of water use insensitive to price changes as 2.7 to 4.5 cubic metres per month per household. The number of household members, temperature and rainfall are also important determinants of household water consumption.
The analysis also includes an estimation of demand functions for the industrial and commercial water consumers. The sensitivity of water use in relation to price is observed in both user groups and the findings are consistent with the analyses conducted elsewhere: industrial water demand is highly responsive to price changes compared to commercial users. The price elasticity for commercial and industrial water demand is -0.16 and -0.76 respectively. The number of connections and weather variables are important determinants of commercial and industrial water demand.
Production decisions of the water utility are modelled using a trans-log cost function. The average marginal cost in the short run (SRMC) is estimated at Sri Lankan Rupees (SLRS) 16.50 and in the long run (LRMC) as SLRS 47.25 per cubic metre. The LRMC estimates differ from the SRMC estimates by a substantial margin. Further, all estimates of marginal and average costs are substantially higher than the existing average volumetric charges. The results for both short-run and long-run indicate scale economies in the technology of water supply.
Finally, this thesis evaluates the welfare effects of current and alternative pricing rules using the estimated residential, industrial and commercial demand coefficients and short-run and long-run cost coefficients. The simulation results show that a movement from the current tariff structure to a two-part tariff (volumetric charge equals to SRMC) leads to the highest welfare gains. In the absence of SRMC pricing, the deadweight loss per cubic metre for residential, commercial and industrial consumption is SLRS 0.30, 3 and 19 respectively. In terms of consumer surplus calculations, SRMC pricing provides the maximum aggregate consumer surplus gain even though residential users lose the gains to industrial and commercial users outweigh these losses. Equivalent variation calculation for income deciles (residential consumers) showed that all income deciles lose from the alternative pricing rules (commercial and industrial users gain). However, with SRMC pricing, equivalent variation for the poorest and the richest groups are comparable.
The findings of this thesis are useful for the policy makers and water utility managers in assessing the likely effects and prospects for demand management using the pricing mechanism. The continuous supply of water at the current subsidized rates may lead to a collapse of the water supply systems, while the inelastic nature of water consumption provides opportunities for revenue increases for the water utility by increasing water charges. The estimations of short-run and long-run marginal costs are significant to regulators in the design of water rate structures. Inefficient water pricing has been fiercely criticised for failing to provide potable water to all citizens. Further, policy makers can employ a mix of connection subsidies, education and communication campaigns to stimulate connections to the pipe water network. In order to improve equity, the water companies can reduce the installation fees, giving low-income households access to water connections or reinvest profits in network expansion to un-serviced areas
