Economic Framework for Estimating Long-Run Marginal Costs
Advisory Services
The Situation
The Smart Water Fund, an initiative based in Victoria, Australia that invests in water industry-led research and innovation in urban water management, commissioned a NERA team led by Director Greg Houston to assist Victorian water businesses with estimating the long-run marginal cost (LRMC) associated with their services, and informing the application of LRMC principles in pricing decisions.
NERA's Role
NERA developed a framework which showed that, in the case of a generic, vertically integrated water business, water volumes along with trade waste volumes and/or pollution load are likely to be the only service dimensions for which it is appropriate to estimate LRMC for application in tariff structure decisions.
NERA recommended that, for the functional levels of service dimensions characterized by a relatively 'lumpy' profile of capital expenditure, LRMC should be estimated according to the perturbation approach (also known as the 'Turvey' approach); and for the functional levels of service dimensions characterized by a relatively 'smooth' profile of capital expenditure, LRMC should be estimated according to the average incremental cost approach (AIC).
The Result
The framework developed by NERA also included a set of common assumptions/procedures to assist businesses in the application of each of these approaches. Overall, since any estimate of LRMC is based on a forward looking set of assumptions, NERA strongly recommended to the Smart Water Fund that sensitivity and/or scenario testing be conducted to ascertain the extent to which changes in these assumptions affect the estimated LRMC. This allows for the effect of the various uncertainties in LRMC assumptions to be examined, and so to convey the range of uncertainty attributed to any particular estimate.
