Making economic efficiency easier for the water sector to understand

Frontier Economics' Tim McNamara, Mike Woolston and Dinesh Kumareswaran were commissioned by the Water Services Association of Australia (WSAA) to produce the report Understanding Efficiency to explain in "plain English" the concepts of economic efficiency and how they apply to the water sector. The report also illustrates what efficiency looks like under different scenarios using examples from the water sector and detailed case studies. Below is the Executive Summary of the report.

About this report

The aim of this report is to explain in ‘plain English’ the concepts of efficiency and how these are utilised within businesses, by economic regulators and others to assess service and expenditure proposals in pricing submissions and business cases.

Efficiency in the urban water sector

It is important for businesses to be able to understand and demonstrate efficiency, not just to get approval of pricing submissions from regulators – but also to demonstrate they are providing value for money to customers, owners, and other stakeholders.

Common or dictionary definitions of ‘efficiency’ tend to focus on the relationship between inputs and outputs of producing a good or service, but this narrow interpretation may lead to misconceptions. Minimising costs may not necessarily be consistent with providing customers’ desired service levels, maintenance and investment in asset capability and supply resilience, or delivering broader outcomes which are desired by customers or society.

Rather, economic efficiency can be seen as synonymous with value for money - providing the services customers want at the lowest long-term cost. The regulatory frameworks applied by most economic regulators do provide for broader ’value for money’ outcomes in assessing efficiency.

Some common misconceptions about efficiency

There are a number of common misconceptions about demonstrating efficiency in the urban water sector. These related misconceptions include:

1. Efficiency means prices need to be flat or declining
2. Efficiency is about cutting costs to the minimum
3. Efficiency is incurring lowest possible costs over the upcoming determination period
4. Efficiency means providing services at the lowest possible standards consistent with regulatory and other obligations
5. Efficiency is about deferring new investment as long as possible and running assets to fail
6. Efficiency means minimising costs even if this leads to higher risks
7. Efficiency means neutralising the impact of other drivers of expenditure (e.g. growth) so prices remain constant overall without having to disaggregate the drivers
8. Efficiency means demonstrating on a once-off basis that a business is efficient relative to the industry standard.

A common thread underlying these misconceptions is that ‘efficiency’ is synonymous with cost minimisation. Not only is cost minimisation in itself not an appropriate objective - but it is not an appropriate interpretation of what it means to be ‘efficient’.

Minimising costs may not necessarily be consistent with:

• providing services at the level customers want
• maintaining and investing in asset capability and supply resilience
• delivering broader outcomes which are desired by customers or society.

How is efficiency measured and demonstrated?

While how best to demonstrate efficiency may depend on the audience, fundamentally it is about demonstrating that a proposal is in the long-term interests of customers.

The overarching approach of economic regulators in determining efficient levels of expenditure for regulated urban water businesses, which they then allow to be recovered in regulated prices, typically involves:

• Establishing the services to be provided to meet regulatory and other obligations and customers' preferences
• Establishing the minimum expenditure needed to efficiently deliver these services
• Setting prices which are forecast to enable the business to recover the total expenditure which the regulator has deemed to be 'prudent and efficient'.

Typically regulators adopt a ‘prudency and efficiency test’ to provide assurance that the businesses are (1) doing the right things; and (2) doing those things as efficiently as possible.

Regulators typically assess the prudency and efficiency of operating and capital expenditure individually, as well as the trade-off between these two types of expenditures:

• While both detailed ‘bottom up’ assessments of various operating expenditure items and broader ‘top down’ approaches which focus on broad categories of expenditure have been applied by regulators, the latter (particularly the base-step-trend approach) is becoming increasingly widespread.
• Approaches to assessing the efficiency of capital expenditure typically examine the business' capital governance frameworks, policies and procedures, and review a sample of the business's proposed capital expenditure projects. This generally requires reference to an identified need or cost driver, evidence that the business has considered alternate solutions including non-network solutions, and that the cost of the defined scope and standard of works is consistent with conditions prevailing in the relevant markets.

What lessons does recent regulatory experience provide?

We examined a number of recent regulatory reviews and decisions by state economic regulators. This provided a number of key insights and lessons that can be drawn upon for future periods.

• The Base Step Trend methodology is being adopted by a number of water regulators
• Capital projects exposed to uncertainty have the potential to be deferred to future periods
• Willingness to pay studies are helpful but should not be used in isolation to justify expenditure
• Consultation and analysis is required to demonstrate the prudency of projects
• The introduction of new services needs to predominately benefit customers
• Capital expenditure proposals should be supported by robust business cases
• Regulators often require alternative options to providing the service to be considered.

Guidance for demonstrating efficiency 

We have identified some overarching guiding principles that should be adopted to demonstrate the efficiency of expenditure proposals regardless of the context in which efficiency is being measured or demonstrated: 

• Adopt a business case (or cost-benefit analysis) approach to all expenditure proposals 
• Focus on the long-term interests of customers, considering factors including operating and capital expenditure trade-offs and the impact on service standards over time and supported by Net Present Value NPV (analysis)  
• Consider both prudency and efficiency of expenditure, including how cost proposals incorporate efficiency targets and continuing efficiencies (as would occur in a competitive market)
• Explain trends in operating and capital expenditure and key drivers of these trends  
• Develop a narrative that explains the link between expenditure and outcomes for customers 
• Conduct analysis that is proportionate to the size and impact of the potential expenditure. 

However, there is no single methodology or technique that is appropriate to use in all circumstances to measure and demonstrate efficiency. The appropriate approach may vary depending on factors such as the nature of the: 

• expenditure (i.e. operating vs capital expenditure or large ‘step’ in operating expenditure) 
• activity (discretionary vs non-discretionary expenditure). 

Table 1. Approach to demonstrating efficiency - a guide