Water Journal October 1990 by australianwater

REGROWTH IN

Official Journal

water

ISSN 0310-0367

Volume 17, No. 5, October 1990

AUSTRALIAN WATER AND WASTEWATER ASSOCIATION

Factors Affecting Bacterial Numbers in Distribution System

CONTENTS

K. Power and L. A. Nagy

My Point of View Association News

President's Message It Seems to Me

4 4

IAWPRC ..

Industry News

The NSW Branch Regional Conference, Jamberoo; Report

Book Reviews

Conference Calendar

....... ... .....

42 43

Plant, Products and Equipment

Focus on Management

(Associate Editor John D. Molloy) Pricing and the Mix of Politics and Economics for Water Industry Services

D. R. Gallagher

OUR COVER 10

European Approaches to Water Quality and Environmental Economics N. Morris and N. Owen

Conflict Resolution for the Water Industry D. Day

The Melbourne Board of Works has equipped its water meter readers with hand held electronic terminals replacing the old meter docket books. The Board's main frame computer transfers and receives data via Transaction Protocol 'Processors. The T.P.P!s facilitate the transfer of data , between the host computer and the Communications Interface Device when a terminal is connected. CJ.D.'s are located in the meter readers homes and at the regional depots. Use of the terminals has enabled the number of daily readings to be increased by up to 33 %, the validation of input data (i.e. the terminal warns the reader when a reading is outside the high or low parameter for that meter) and the updating of records daily. The terminal has a capacity to hold up to 1100 readings.

Privatisation - Corporatisation for the Water Industry

G. Watson and S. Whelan

Executive Remuneration in the Nineties: Major Issues and Trends

G. L. O'Neill and R. R. Clark

28 The Ultraviolet Technology of Australia advertisement on the inside front cover of our last issue (August, 1990) had approximately half of the black text missing. This was due to a fault in the platemaking process tor which the printers and editorial staff apologise.

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e,o Box

460. Chatswood NSW 2057 Facsimile (02) 410 9652 Telephone (02) 413 1288 Office Manage r - Margaret Bates

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EXECUTIVE DIRECTOR Peter Hughes Telephone (02) 41 0 9654

FEDERAL SECRETARY Greg Cawston Telephone (042) 29 0236

FEDERAL TREASURER John Molloy Telephone (03) 6 15 5991

BRANCH SECRETARIES Canberra, ACT P. Cox , PO Box 306. Woden 2606 (062) 498 522

New South Wales Mr David Hope. PO Box 460, Chatswood 2057 (02) 269 5212

Victoria J. Park C /- Water Training Centre, PO Box 409 , Werribee 3030 (03) 7 41 5844

Queensland D. Mackay, PO Box 412, West End 4101 (07) 840 4844

South Australia A. Townsend, CI - State Water Laboratories, E&WS Private Mail Bag. Salisbury 5108 (08) 259 0244

EDITORIAL CORRESPONDENCE E.A. Swinton , 4 Pleasant View Crescent, Glen Waverley 3150 Office Phone and Autofax (03) 560 4752 Home (03) 560 9306

Western Austra lia A. Gale, PO Box 356, West Perth 6005 (09) 242 4677

Tasmania A.B. Denne, PO Box 78A, Hobart 7001 (002) 30 5562

Northern Territory D. Hardiment PO Box 37283, Winnellie 0821 (089) 41 0144

ADVERTISING Ann Sykes-Smith

Applta, 191 Royal Parade, Parkville 3052 (03) 347 2377 Fax (03) 348 1206

PRODUCTION EDITOR J . Grainger, Appita, 191 Royal Parade, Parkville 3052 (03) 347 2377 Fax (03) 348 1206

WATER October 1990

PRICING AND THE MIX OF POLITICS AND ECONOMICS FOR WATER INDUSTRY SERVICES by D. R. GALLAGHER BACKGROUND An obvious feature of the urban water industry at the present time is the significant change which is being sought. For instance the focus for resource use is no longer simply finding cost effective solutions. Instead solutions are being sought within a corporate structure to provide an adequate rate of return to the capital employed. Cost effective solutions provide the least cost approach to meeting a target. In water supply the target is a water use requirement which is determined independently of the cost effectiveness analysis. Accordingly cost effective resource use is a supply side solution as .the value in providing the supply capacity to meet the target use is unquestionable. Whereas a rate of return solution is concerned with integrating the value in providing supply capacity with the costs of doing so. The question of interest is what is the value to the community (benefits minus costs) from increasing the water supply capacity? The target water use is determined within the benefit cost analytical framework. While the water supply objectives have not changed the planning process to provide for these objectives is substantially different. This change of focus does not only add demand-side informational resource requirements to the water agency's operational budgets. But as well the information sought on the supply side is changed. Rate of return reporting requires assessments of capital resources not merely in terms of how well they perform their stipulated functions in a technical sense but in terms of their current value to the agency's operations. The supply requirement approach to capacity planning has provided long service to the w_ater supply industry. These planning guidelines must now be set aside and new guidelines put in their place. The fundamental featur_e _of t?e new guidelines must be a focus on the worth of resources utilised m each function performed. How well is this change being managed? If we take the effort to set aside the current planning guidelines that we have come to know so well in the past, are we going to be able to formulate and implement new planning and operational procedures gui~elines without too much disruption? The circumstances can be likened to getting out of a groove, which we cut to guide our direction in the past, onto a flat surface, the playing field, and seeking to establish another path which better suits the enhanced set of procedures. Hopefully the surface is not slippery such that when we do move we do have control over our movements. We hope the linkages between actions and outcomes are stable enough for us to readily establish the needed new set of guidelines, to move to an appropriate position and to cut a new groove to guide our operations and thus settle down in comfort once again. Âˇ What steps can we take to increase the possibility that we are able to manage the necessary change effectively?

PLANNING FOR CHANGE Planning for change effectively requires at the very least two basic elements. The first element involves development of a conceptual understanding of the forces which we perceive to contribute to change. The second element is concerned with the empirical aspect of change. The conceptual development element seeks to provide a framework for analysis of the process(es) which are identified in the changes being sought. An outcome of this activity is a statement, a theory of how the process of interest works. In this particular case the process of interest is pricing. Accordingly an initial ta~k of the present discussion is to build a conceptual model to a_ss1st in the formulation of an explanation of what consequences are likely from pricing actions. In the development of this conceptual model two questions need to be addressed. What are the main factors which determine the outcomes of pricing actions? How do these factors interact? 10

WATER October 1990

David Gallagher B.Ag.Ec (First Class Honours, New England), MAg.Ec. (New England), Ph.D. (University of NSW) has recently resigned as the Director of the Urban Water Policy Centre at the University of NSW where he was a member of. the Faculty of Commerce and Economics, for about 16 years. Research areas include: development and application of management system models to project assessment and pricing procedures in the resources sector, with particular emphasis on water and energy resources.

D. Gallagher

Together these questions provide the structure or source of the pricing process. Conceptual modelling not only provides an understanding of the surface we lift ourselves onto, but it also directs attention to information requirements which are necessary to assess the magnitude of likely changes. The information requirements are an important ingredient to the empirical model building process, the second element in the planning process. The empirical model provides the content or scale of the pricing process. It is frequently the case that empirical models are incomplete representations of conceptual models. A usual contribution to this hiatus between models is the lack of availability of observations of variables identified as important in conceptual models. Together conceptual and empirical models determine our movements across the surface of the playing field. Conceptual models provide direction for change whereas empirical models provide a basis for estimating 'the magnitude of the li~ely consequences arising from the actions we take. An all too obvious feature of the planning process is the uncertainty inherent in it. How to accommodate the uncertainty is a major task in managing change. Attention recently has focused on scenario analysis as a framework for development and evaluation of alternative plans for action for the future (Gallagher, 1989).

SCENARIO ANALYSIS Scenario analysis seeks to challenge the conventional wisdom. It aims to expand decision makers' horizons and visions thereby building up conceptual experiences and enhancing understanding of the processes. A target of scenario analysis is the development of strategies to deal with possible and surprise events. "To deal with" in this context means having the capacity and the opportunity to take decisions to improve resource use efficiency. The conceptual and empirical modelling activities are integral parts of the scenario framework . A main purpose of these models is assessment of alternative future events, of the states of the world, of what actions ought to be taken, and the associated consequences. Flexibility through understanding is a key feature of the scenario planning framework and the water industry could do a lot worse in accepting it as the focus for the future.

MANAGING CHANGE In the urban water sector significant changes in tariff policy occurred during the 1980s particularly the second half of the 80s. These changes are still occurring and have some time to ru_n before the new guidelines will be clearly established across the mdustry as a whole. The focus of this discussion is pricing of water industry services and the appropriate mix of political and economic factors. The water industry services are water supply, wastewater disposal and drainage. Little attention is given to drainage in this discussion. The water sector has an integrated structure which tends to lead to complexities associated with how the system functions. This paper

MARGINAL PRICE SCHEDULE (a) SYDNEY WATER BOARD 1989/90

cents per

62 1

0 250

k L per annum

500

(b) SYDNEY WATER BOARD 1990/91

cents per

60 55 45 30 27

15 0 219

300

kL per annum

is concerned with water supply pncmg and leaves aside the integrated complexities associated with water supply and wastewater tariffs. In the 80s changes occurred in the way water enterprises charge for their services, both water supply and wastewater collection and disposal. Looking at water supply a dominant feature of change has been the move to place more emphasis on the unit price element of the water supply tariff. The rate at which this change has progressed has varied across the country. Reasons why the rate of change has been unequal are varied though it does appear that the imminence of the need for system augmentation has been a major factor contributing to higher rates of change. The dominant water supply tariff in place in the early 1980s had as its central elements a water rate based on property value, an 'excess' water price, and a water allowance. The water allowance being derived from the water rate divided by the excess price. Consumption in excess of the water allowance is paid on a per unit basis at the excess price. In some cases a next step was to break the nexus between the water rates and the water allowance. For example the Sydney Water Board introduced in 1985/ 86 a uniform water allowance of 300 kL per annum per residential property independent of the property value. Subsequently the Sydney Water Board lowered the water allowance to 250 kL in 1989/90, and to zero in 1990/91. The unit price schedule became an increasing block schedule and quarterly billing introduced. For example, in 1989/90 the minimum water rate was $106, the water allowance 250 kL, the first price block between 250 and 500 kL incurred a charge of 45 cents per kL, and beyond 500 kL the price was 62 cents per kL. The Sydney Water Board in 1990/91 has made major changes to its water charging procedure. These changes provide an opportunity to demonstrate the conceptual and empirical modelling process outlined above. The following diagrams depict changes which have been implemented in the water tariff. In diagram (b) the price of the first block has been increased, but its size has been reduced, while the price of the second block has been reduced as has been its size, and the price of the third block has also been reduced. Leaving aside for the moment the likely impacts from quarterly billing, an interesting question is what incremental change in water consumption could be expected by residential unit between 1989/90 and 1990/91 in the Sydney Board's area? The 1990/ 91 water supply tariff requires an increase in expenditure by a residential unit if it wishes to maintain its 1989/90 level of consumption except for high levels of c-0nsumption. As the 12

WATER October 1990

unit price in the third block is lower in 1990/ 91, for consumption levels in excess of 1050 kL per annum (for those paying the minimum rate) the required level of expenditure is less. The increase in expenditure for a residential consumer consuming 350 kL per annum is about 16 per cent. The household faces a marginal price (i.e. the cost of using the next unit) of 55¢ per kL and an average price (i.e. average cost of all units) of 50¢ per kL, both of which are higher than the levels in 1989/ 90. Alternatively the household is able to purchase about 12 per cent less water if it does not alter its level of expenditure. The marginal price is 55¢ per kL and the average price is about 49¢ per kL . Again both are higher than the levels faced in 1989/ 90 (45¢ per kL and 43¢ per kL respectively). The actual outcome of the tariff change will lie somewhere between these limits determined by the level of responsiveness of the household to the higher marginal and average prices. The household faces a 22 per cent increase in marginal price but reported research indicates that overall household water use is relatively unresponsive to marginal price changes. It has been difficult because of the rates based water tariff to obtain Australian estimates of the marginal price responsiveness of household water use to marginal price changes. (See Martin and THomas (1986) for a discussion of policy relevance in urban residential water demand studies). A price elasticity (i.e. the responsiveness of quantity demanded to changes in price) of 0.24 for example, suggests that a 1 per cent increase in price encourages a 0.24 per cent decrease in water use in the household. In such circumstances the 1990/ 91 water tariff through its price effects for households consuming 350 kL per annum could have the impact of about 5 per cent reduction in water use. Obviously the more responsive water use is to price changes the larger will be the impact on the level of water use of any price change. The concept of price responsiveness (price elasticity of demand) is built on the notion of consumers being able to purchase the amount of water they wish to purchase at the marginal price. That is households are presumed to face a wate.r tariff which has one element, a unit price. Such is not the reality. Hence in addition to the price change, consideration should be given to the change relativities in the water tariff between unit prices and the size of blocks. The impact of this change can be seen by viewing the difference between what is actually paid and what would be paid if all units of consumption were charged at the marginal price. Under both tariff schedules households pay an average price which is less than the marginal price. For the 350 kL case this difference term is about 169 per cent larger under the new water tariff structure. Conceptual modelling suggests that the impact of this difference term should be equivalent in magnitude to an income change but with opposite sign. The income effect is such that as household income increases the level of household water consumption is expected to rise as well. But the empirical models report that while the sign of the difference term is usually such that it is opposite to that of income, the magnitude of the impact tends to be much lower. But water use tends to be more responsive to income changes than it is to price changes. Empirical results show income responsiveness of water use varies in accord with a variety of factors but significantly with household technology. The change in the water tariff overall between 1989/ 90 and 1990/ 91 for the Sydney Water Board suggests a water use reduction of between 2 and 4 per cent due to the difference term. Hence a likely impact of the change in the tariff structure is to reduce the reduction in water use to about 8 per cent overall, a decrease of about 28 kL per annum. Overall the Sydney Water Board is unlikely to experience a reduction in its revenue flow. A 12 per cent reduction (43 kL) is required for the new tariff schedule to generate no additional revenue. The impact of the new water tariff is not uniform across all residential users. Consumers who use in excess of 500 kL per annum experience about a 11 per cent fall in their marginal price. A likely consequence is about a 3 per cent increase in usage. The difference term will tend to add to this increase resulting in about an overall 4 per cent increase in usage. The revenue impact is in the order of a 19 per cent increase. At lower levels of usage reductions in water consumption may tend to be less as usage may be less responsive to tariff changes. The tendency will be towards lower consumption levels. The end result of the 1990/ 91 tariff in terms of usage rests with the distribution of consumption categories. Increased cash flow seems assured.

This discussion has focused on water supply pricing without concern for possible interactions between water supply and Âˇ wastewater tariffs. It is the usual case that water consumers are presented with a bill which includes both water use and wastewater charges. The size of the total bill is influenced by the structure and level of charges in both areas. The extent to which consumers can influence their total expenditure on water services is determined by the relative importance of unit price elements in water supply and wastewater tariffs. If wastewater charges are used to counterbalance water supply price increases and if consumers respond to the total water bill demand management through water supply pricing could result in increased water use. The comments to this point has focussed on what seems to be a typical public sector tariff structure, a tariff structure having a lump sum payment for service availability and block pricing of usage. Two questions emerge: What is the justification for this structure? and What is the appropriate basis on which to set the level of charges?

WATER TARIFF STRUCTURE A feature of water supply is the lumpiness of investment in supply capacity. For any given storage site there exists a storage size that best suits the site in engineering and cost-effectiveness terms. Accordingly capacity augmentation decisions are usually infrequent and add significantly to supply capability when they occur. In the time intervals immediately following system augmentation, the supply systems capacity is large relative to existing demands on the system and excess supply capacity exists. This lumpiness of supply capacity investment inherently creates a practical problem for pricing. System augmentation is demand worthwhile when the expected benefits over the life of the storage facility are at least equal to the costs of installing and operating the storage facility over its lifetime. The storage facility is an asset which has a long economic life and the benefits derived from asset utilisation tend to increase as the asset ages. On the other hand the pattern of costs is quite different as a large share of costs is incurred in the initial stages of the asset's lifetime. This asymmetrical nature of the benefit and cost streams associated with lumpiness of supply capacity projects creates cash flow problems for water supply enterprises. A usual element of the charter of water supply enterprises is that they shm.Âľd generate revenues to meet their expenditures annually. The traditional rates based water tariffs achieved this target very effectively. Any move to water tariffs which have unit prices as a core element has been seen as impractical as marginal cost based unit prices would fail to generate the annual revenue stream to meet expenditures. This argument focuses on time intervals during the storage facility's life when consumption is not limited by supply capacity and the marginal cost base for pricing is seen as the suppliers short run marginal supply costs. It is inappropriate to suggest that the supplier's short run marginal supply costs reflect the marginal opportunity cost over the life of the storage facility. The investment decision considers benefit and cost streams over the life of the project. If expectations of these benefit and cost streams are realised the community enjoys the expected net benefits from the project. At the same time pricing according to marginal opportunity cost will generate a revenue flow to meet the costs incurred over the life of the project. Such a pricing policy does not allow a constant price over the life of the project as the marginal opportunity cost of supply varies as the project matures. The marginal opportunity cost pricing model requires that, in the early stages of project life, price should reflect the supplier's short run marginal supply costs. With this price there will be no contribution to capital charges generated. Supply capacity is adequate to meet demands forthcoming at this price. Towards the latter stages of project life, prior to the next augmentation decision, price should exceed the supplier's short run marginal supply costs by reflecting the marginal opportunity of a unit of consumption foregone. At this price a contribution to capital charges is generated. If price was set equal to marginal operating cost the supply capacity would be inadequate to meet demands forthcoming. Price must now reflect the opportunity cost of water consumption foregone and be set at a level to restrict demand to supply capacity; this is demand augmentation. Note that the nature of water supply system augmentation is such that when supply capacity is inadequate to meet demand, with price at marginal operating cost, it does not

necessarily signal the need for further investment in system capacity. Effective planning require combining appropriate investment rules and pricing procedures based on marginal opportunity cost and therefore enables water supply authorities to meet revenue targets over the life of a project. Lumpy investments earn capital contributions in the latter stages of the project's life. This is quite different to situations faced by other supply authorities, for example, electricity generation. Electricity supply is based on an integrated supply grid with several generating facilities contributing to supply capacity. It is usually the case that the generating facilities are of different vintages and thus have different operating cost bases. The electricity supply authority seeking to provide a cost-effective supply will bring online the various generating units in operating cost priority order, the lowest operating cost units first. The electricity price at any stage is determined by the last (highest marginal supply cost) unit brought on-line. Hence all generating units (with the possible exception of the last brought on-line) used to meet demand at any time will earn a contribution towards capital charges as the price exceeds their marginal supply cost. The more efficient units will generate higher capital contributions. Accordingly in a supply system which contains an integrated set of supply facilities the capital contributions generated tend to be higher in the early stages of the facility's life. The supply authority is more able to meet the conventional revenue requirements and the price most likely will be more stable over time and seemingly more acceptable politically as in all intervals it is based on marginal supply cost of the highest cost unit used. In supply systems in which, due to lumpiness, single supply source is available, the marginal opportunity cost based price will increase over time reaching a peak just prior to system augmentation. If the new supply facility operates in parallel with the existing facility, price should reflect relative marginal operating cost. The two-part tariff structure has emerged in response to the unacceptable revenue flow generated by the single unit price structure. Unacceptability here should be read in relation to the revenue requirements to meet obligations which are prescribed in the political arena. The two part tariff provides the opportunity to generate a revenue flow to meet capital financial requirements. The first part of the tariff, the lump sum charge, which is independent of consumption, is deemed to be a capacity availability charge. The second part of the tariff is a unit price based on operating costs. Equity aspects are introduced if charges vary according to property values and the like.

LEVEL OF CHARGES What is the appropriate base on which to determine the level of charge for each element of the water tariff? The two part tariff structure has emerged as an appropriate water tariff because of its revenue generating capability in each time interval of a project's life. The two part tariff is a pricing policy with a budget constraint. Conceptually getting the level of charges 'right' is somewhat complex. Most take the view that the unit price should be set equal to marginal operating cost. But given the constraint that water agencies need to be financially autonomous, the setting of the unit price and the lump sum charge are not independent activities. The setting of price above marginal operating cost may have undesirable consequences when viewed in isolation (when supply capacity is adequate to meet demand at this price), but the action could lead to a reduction in the size of the lump sum charge, thereby allowing more consumers to enter the market. The size of the lump sum is a main determinant of whether a consumer enters the market at all. The notion that the lump sum charge be set to reflect capacity to pay has some intuitive appeal. Together the two elements of the tariff are the tools for meeting revenue requirements as well as providing incentives to users to conserve water resources. The minimum level of charge for the unit price is the marginal supply cost. Together the two elements should generate the appropriate revenue flow for the agency to meet its obligations. At the same time the unit price should reflect the impact of additional consumption on the supply system, the marginal opportunity cost. Beyond these principles the setting of the level of the tariff elements is an empirical issue. The level of charges reflects not only the operating efficiency of the supply agency, and the cost of system augmentation but also the level of water demand. WATER October 1990 13

Existing excess capacity from past augmentation decisions impose additional financial burdens. In summary attention should be directed towards two points -in relation to the structure and level of water tariffs. Firstly, the notion of marginal cost used in the discussion has a temporal base as it is derived from the investment planning or project appraisal cash flow analysis of projects within a supply system. Marginal operating cost reflects the time stream of costs over the planning period and not just costs in the current interval of the planning period. Secondly, within this integrated framework the traditional distinction between a "short run" versus a "long run" approach is void of content and consequently irrelevant. Pricing must be done in a dynamic framework and not in a static one.

COMMENT Urban water pricing provides opportunities for influences outside water agencies to have an influencing hand. The Jumpiness of investment, financial obligations and the marginal opportunity cost concept create an environment in which effective information systems are essential for consumers to be aware of the state of play. The information systems must not only have a cost of supply focus but importantly a demand assessment focus. Little such information Âˇ is readily available. How then can judgements be made of the level of performance of water agencies?

REFERENCES D.R. GALLAGHER, (1989) - Water Management Strategies: An Economic Perspective, paper presented to The State Of Our Rivers Conference, Canberra. W.E. MARTIN and J.F. THOMAS, (1986) - Policy Relevance in Studies of Urban Residential Water Demand, Water Resources R_esearch, 22(13), 1986, 1735-1741.

EDITORIAL MATTERS: The Journal Committee welcome the submission of papers relating to water resources, hydrology, treatment, supply, wastewater treatment and disposal, and related scientific and management matters. A length of 3000-5000 words is preferred. Material should be submitted to the Editor as hardcopy, typed or printed double space, with wide margins (for the convenience of the referees and the editor). Two copies are preferred. Once a paper has been accepted, perhaps after some amendments required by the referees, authors should, if possible, also submit a copy of the amended material on disk (IBM or Macintosh, preferably in ASCII 'text only', or in a standard word-processing format). Alternatively, pages from electric typewriters or laser printers (not dot matrix printers) can be computer-scanned by the typesetter. Diagrams must be suitable for photo-reduction to a width of 57mm or 90mm without loss of clarity. (This can be checked by using a photo-copier with a reduction facility). Photographs can be either B & W or colour prints, provided that the contrast is adequate. Each author is required to supply brief biodata relevant to the particular paper, and a personal photograph (B & W or colour). The Committee also welcomes brief progress reports or papers of about 1000-1500 words which can be published less formally as Technical Notes, rather than as full papers. Letters to the Editor, Industry News items and Personalia can also be submitted.

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WATER October 1990

European Approaches to Water Quality and Environmental Economics by N. Morris and N. Owen INTRODUCTION Over the last two decades, Europe has been struggling to find and set standards by which seemingly intractable environmental problems may be solved. Acid rain is destroying its forests, lakes and buildings. Drinking water contains high and rising levels of pollutants. Toxic waste dumps, inadequately policed in the immediate post-war years are now causing seepage into water sources. The early development of the nuclear industry, particularly in Britain, created problems which are only now being recognised and rectified. Many of the most popular beaches are now regarded as health risks. Eastern Europe, heavily polluted and a major exporter of SO 2 , is a central focus of concern. Heightened international awareness of environmental problems, coupled with pollution levels which are obviously too high, have created a political will to do something positive. In the vanguard of this movement is the European Commission, which has taken the lead in setting numerous directives for environmental standards of all kinds. More stringent controls are being discussed. Political rhetoric becomes ever more 'green'. Yet in Europe, as in Australia, the practice is lagging some way behind the rhetoric and ideals. Very few of the Commission's Directives are implemented, and numerous countries are in default. The United Kingdom, for example, faces European Court action to force it to do more than its present rather feeble attempts to react. All over Europe, political reality is delivering far less than the European Commission and the speeches of politicians seem to want. The problem in Europe, as elsewhere, is that there are costs as well as benefits to environmental policies. Cleaning up power stations requires massive capital expenditures and increases running costs; reducing the level of nitrates in water has disastrous effects on farming efficiency. Operating a 'clean' economy inevitably means that its citizens will be poorer, its industries less competitive and employment lower. If competitor nations are less assiduous, much comparative advantage will be lost. Yet a route has to be found which makes a sensible compromise between the costs and the benefits of environmental policies. This requires, crucially, that environmental standards are set sensibly, and enforced in the cost-minimising way. Europe is beginning, rather belatedly, to realise this, and to examine the mechanisms whereby this may be achieved. Our research at London Economics has pioneered methods of comparing alternative policies and choosing the most cost-effective implementation of the chosen one. The questions are legion. How should water quality standards be determined? Should environmental standards relate to discharges themselves, or to the quality of water in rivers, aquifers and estuaries? How can the cost-effectiveness of water quality proposals be assessed? And what instruments can be deployed in order to secure environmental objectives reliably, and at affordable cost? . Are command-and control systems preferable to those based on charges or permits? How do tariff structures affect behaviour? In what follows, we explore how European experience can provide useful insights into these issues.

THE ROLE OF THE EUROPEAN COMMUNITY (EC) IN WATER QUALITY The European approach to water quality will be of particular interest to Australian audiences since in some ways Europe is evolving a federal structure in its approach to environmental, and other, issues. To do so, it is having to reconcile disparate national approaches to environmental policy. Water pollution, unlike air pollution, is not a global problem, but it is a transnational problem. European rain drains into seven seas and each of its catchment areas span several countries. There is therefore a natural impetus towards co-operative solutions. An added impetus has been provided by The Single European Act (SEA), came into force in 1987 in order to unblock progress towards achieving a single, unified EC market, by means of qualified majority voting. The target is end-1992 (and for this reason this process is referred to simply as "1992"). 16

WATER

October 1990

Nick Morris is Managing Director of London Economics. Previously Deputy Director of the Institute for Fiscal Studies, he has played a central role in UK policy debate throughout the last decade. His research work spans energy, water, agriculture, tax and social security systems, financial services and market strategy.

N. Morris

Nicholas Owen is Director of London Economics Environmental Consultancy. He was previously Deputy Head of the Prime Minister's policy unit, and played a major role in the run-up to European integration through the analysis of the benefits of a unified market.

It has important environmental dimensions (for a fuller account, from which some of this summary is drawn, (Haigh, 1989). The 1957 Treaty of Rome (which established the EC) has been amended by the SEA to empower the European Commission to propose environmental legislation not specifically related to trade (eg in relation to wildlife habitats). In addition, certain principles of EC environmental policy - such as the principles of prevention and the polluter pays - now have legal force. It is also recognised that the use of national environmental initiatives by Member States, there is clearly advantage to be gained, in the 1992 context, from a common EC approach. But what has all this to do with water, which is not, and is not likely to be, traded within Europe? Compliance with water standards imposes costs on industry; variations in standards between countries could therefore 'distort', in some sense of the term, competition between Member States. On the other hand, it can be argued that there is room for diversity here. For example, oil refineries in Germany discharge benzene into rivers used for drinking water whereas they do not in Britain; the relevant emissions standard therefore needs to be more stringent in Germany.

ALTERNATIVE APPROACHES TO WATER QUALITY Two approaches have been used in pollution control - emission standards and environmental quality standards. There has been a long-running dispute between the protagonists of these two approaches, which has featured in the dealings of the UK with the EC. Much of EC environmental policy features uniform emission standards. Thus, for example, the Nitrates Directive requires that nowhere, and at no time, should nitrates in groundwater and surface water supplies exceed 50 mg / litre, irrespective of whether Âˇ environmental damage is being caused. However, if one takes the view that pollutants are of concern only in so far as they actually reach a sensitive target (such as a natural habitat, humans, or buildings) in quantities likely to inflict damage, then the second approach - that based on environmental quality standards - is to be preferred. According to this view, if no damage is done, there is no pollution; and therefore to eliminate pollution, it is not necessary to wholly restrict emissions. This point has underlain the UK opposition to some draft Directives which have emanated from Brussels. In the water context it was questioned why a country with the UK's natural environmental advantages - estuaries which are sluiced twice daily by powerful tides and short, fast-running rivers - should comply

with emission standards which were required by neighbouring countries without these advantages. Why, in short, should the UK not be allowed to exploit a comparative advantage in water-polluting . industries? This debate also bears on precisely where in the pollution pathway one chooses to monitor standards. For those who believe that the purpose of pollution control is to prevent vulnerable targets from being put at risk, the most appropriate point of control is close to the target eg at the household tap. However, there may be practical reasons for monitoring further 'upstream'. European debate - though not yet practice - is moving away from uniform controls and towards those flexible enough to reflect changing ecological tolerance levels. The concept of 'critical loads' (the level of pollution which the environment can stand and still recover) is becoming central to the European debate. And it is becoming clear that more sophisticated systems than traditional command-and-control methods - such as charges, traded permits, or ambient permits - are going to be needed if sub-critical loads are to be achieved at costs which the political and economic system will accept.

THE ECONOMIC ANALYSIS OF WATER QUALITY LEGISLATION: NITRATES IN THE WATER SUPPLY This awareness of the need for better systems for policy choice has been heightened by mistakes which have been made in the past. Since 1970, the European Commission has been imposing controls based on little analysis of effects or comparative effectiveness. The measures which the European Community has introduced to curb nitrates in water sources are an example of how, for want of quantified cost-benefit analysis, environmental concerns can propel forward a policy enormously expensive in terms of resources, in return for minuscule benefits. Despite this, nitrates in water have become the flagship of the European Commission's strategy. High nitrate concentrations are alleged to have some connection with a condition in babies known as the Blue Baby Syndrome, and with stomach cancer. Yet the Blue Baby Syndrome was last reported in the UK in 1972 and the last fatality attributed to it was in 1950. The incidence of stomach cancer appears to be negatively related to nitrate concentrations; it has declined as nitrate concentrations have risen, and is lowest in those areas of the UK where nitrate concentrations are highest. In over one-third of the land area of England and Wales, nitrate concentrations exceed the limit proposed by the European Directive. Research by London Economics (1990, April) has provided a way of measuring the cost of complying with the Directive, and has also suggested how these costs could be minimised. By modelling the water supply, the underlying geology, and the farming industry in an integrated and localised way, it is possible to calculate: • how rapidly different policies to reduce nitrogen applications would be expected to reduce nitrate concentrations in water supplies; and • the economic effect of such policies on farming. It turns out that the areas where the rates at which farmers apply nitrogen are highest happen also to be on chalk. Water percolates very slowly through chalk so the aquifers in these regions have accumulated nitrogen over decades. It will therefore require a correspondingly long time to reduce nitrate levels on the ground water supply in some areas, even if nitrogen fertilisers were outlawed altogether. The answer for such areas must lie in water treatment, rather than in drastic changes in farming practice. Curative solutions include water storage (to facilitate denitrification), blending, and treatment. Of the treatment methods, the ion exchange technology appears to be the most effective. We have compared the costs of complying with the Directive by two different means: • Water treatment, and • Changes in land use and farm practice We calculated that the water treatment solution would cost at most £100 million a year in the UK. If a farming solution were to be sought, involving switching from arable crops to woodland or to rough grazing, we calculated that the annual profits of the farming industry in England and Wales would be reduced by £340 million. Half that fall would occur just in East Anglia (the most productive arable farming region in the country). The conclusion is that it would cost over three times more, in resource terms, to

deal with the problem at source than it woul,J cost to deal with the problem by water treatment. Two lessons emerge from this analysis: • an optimal solution would involve a mix of policies - changes in land use, changes in farm practice, and water treatment depending on local geology and farming practice • constructing environmental policies on the basis of old mottos such as 'prevention is better than cure' is not good economics. One might also add the thought that it is not good environmental politics either. A number of European Member States are finding it difficult, or unappealing, to comply with this Directive. It could be that the Europeans are discovering for themselves the painful lesson learned by the US: that it is unwise to rely on the maxim that the tougher the law, the more it achieves.

THE USE OF ECONOMIC INSTRUMENTS FOR SECURING WATER STANDARDS The unnecessarily high cost of some environmental initiatives is turning attention to the use of economic instruments, as a means of implementing environmental policies. Financial incentives can be used to encourage polluters to modify their behaviour, and to look for least-cost ways of reducing emissions. The advantage of using the market is that it harnesses the initiative, knowledge and judgement of individual polluters. Rather than force all polluters to behave alike, irrespective of the damage they do, or the pollution control costs which they face, the marketbased approach would allow each polluter to balance control cost against the damage he causes. Four West European countries are reported by the OECD (1989) as levying effluent charges - France, Germany, Italy and Netherlands. For the most part, these charges are too low to have an incentive effect. They are designed only to raise limited amounts of revenue for financing water treatment investment. The German effluent charges, for example, are designed to reinforce water standard regulations; if the discharger meets the minimum standard, 500Jo of the charge is waived. The weak impact of the charges is reflected in the fact that, according to the OECD survey, only lOOJo of dischargers complied with the minimum standards in 1981 (and this after a 5-year introduction period). This result was not perhaps surprising, in view of the fact that the charge burden was only onequarter of the average cost of water treatment. Recent research by London Economics (1990, June), for the UK Department of the Environment, on the effectiveness of economic instruments to control acid rain, indicates that if charges are to be effective, the level of charges needs to set in relation to the cost of avoiding pollution, rather than in some half-hearted fashion dictated by political acceptability. Our work also suggests that economic incentives can be a more efficient means of securing environmental objectives that administrative solutions involving investment in specified types of pollution control equipment. But as important as the level is the structure of the effluent charges. As the great US authority on environmental economics, Tom Tietenberg (1988), explains uniform effluent charges cannot be cost-effective, because they take no account of the damage which each polluter causes to critical points in the river system. To illustrate the point, consider the effect of the oxygen demands imposed on a river by the discharge of biodegradable wastes on the level of dissolved oxygen (DO) - one measure of water quality. Some sections of the river could assimilate the discharges; at others the DO level may be critically low. An economically efficient charge structure would charge polluters in relation to their contributions to causing these critical loads. Charges of this kind - so-called ambient charges - would depend on polluters' upstream distance from these lows, and on the temperature and stream flow of the river. In short, location matters, in water and in air pollution, and environmental modelling is needed if an efficient charging structure is to be devised. Our own research on acid rain has indicated that if the environmental authority is able to identify those ·locations where pollution exceeds critical levels, and model the 'transfer relationships' (which describe how pollutants are transported from its sources to these locations), it is then possible to devise a charging structure which could reduce pollution at these locations to the desired level at significantly less cost to industry than would be the case if a uniform charge were imposed.

continued on page 30 WATER October 1990

CONFLICT RESOLUTION FOR THE WATER INDUSTRY by D. DAY ABSTRACT Water is a basic need for all of us. Disputes over water resources are lively, important and will always be part of society. Who gets water, how much, where, when and of what quality are questions and problems falling directly on urban water utilities and state water management agencies as well as the community. Conflicts, frictions, and the need for conflict resolution and mediation talents is universal, whether for a public utility, a private company, or within the home. These examples site the water industry primarily in NSW but many of the strategies and tactics for resolving differences apply universally.

Dr Diana Day is a water resource planner and environmental policy analyst, currently with the NSW Department of Water Resources. She has published widely in water and land planning and catchment management, is Chair of the Australian Water Resources Council Planning Committee and editorial committee member of the Australian Journal of Soil and Water Conservation. The views expressed in this paper are solely those of the author.

INTRODUCTION The importance of dispute resolution expertise in the water industry was seen to be so important that in late 1989 the Australian Water Resources Council Planning Committee with the NSW Department of Water Resources and the Western Australia Water Authority organised two national workshops for water managers conducted in Sydney and Perth. Dr Jerome Delli Priscoli of the US Corps of Engineers was invited to Australia to give the two day workshops . Dr Priscoli was in charge of developing the largest alternative dispute resolution program for the US Federal Government. The workshops were a success, a first major step by the water industry in Australia to raise the strategic importance of conflict resolution for agencies and their staff, particularly in the area of public involvement programs. (Delli-Priscoli, 1989) Water management in Australia must cope with unpredictable rainfall, very thirsty clients, catchment control aggressions, water price and pollution crises, multiple and escalating water use demands, efficiency purges by central government, riverine resource degradation, drainage and flooding nightmares, the recent sewerage and environment mega-issue along the coastline, and last but by no means least, pouty and difficult people. There are now more government and private sector players on the stage of environmental management. The stage is bigger and there are more bumps in the night. Environmental concerns now often present major crises for government. While the recognition of the self interest of all parties involved in a conflict is of vital importance to solving problems, many agencies and individuals shy away from the prospect preferring to concentrate on their own needs. This doesn't work . Public involvement, a key aspect of conflict resolution strategies, is vital to water resource use decisions and a happier life for all. However, lessons on what public involvement programs were successful and what were not do not seem to be learnt or shared, nor analyses undertaken. This paper stresses that informal approaches to individuals to solve a dispute is a vital mechanism to alleviating or resolving conflicts. Informality tends to be used at the beginning or at the end of a dispute. It can be risky but dividends can be high (Day, 1990).

GETTING INTO SCRAPES AND GETTING OUT If you want a conflict on your hands here is what you must do. (This applies especially to a government agency or a manager therein). You must play with misinformation, never talk to other parties, allow multiple unconsulted but relevant parties to co-exist, allow internal dissension and personality conflicts to flourish, deliver overnight policy strikes, neglect the environmental implications of your actions, play with the media, be indecisive, sit on major sensitive reports and do not alter your legislation as the years roll by whilst just about everything else changes. On the other hand if you want to get out of a conflict or avoid one, reverse the above. Significant solutions in almost any sector include: - the bluff, the informal yarn with beer, ministerial review or intervention, formation of a peak forum, multiplayer workshops, localising the conflict, devolving power and information to community groups, putting out early discussion papers to the public so they know what is going on, organising intensive public consultation and input before an 'event', recognising t~e self interest

of other parties in negotiation and developing expertise in conflict resolution into the fabric of corporate life. However, 'wild horse' conflicts and non-solvable problems still occur. Valuable social planning exercises do occur which would be killed if public participation was promoted. Too much public consultation might also be a disinvestment. 'Data' may be either very important or very irrelevant to an outcome in managing the environment or any management decision! The examination of the water industry in NSW (Day, 1990) led to the above causes and solutions to conflict being teased out but many of the lessons are obviously significant for government agencies of all types. Much is also relevant to the individual. Expertise in resolving conflicts and in negotiation is important in any market place, or any place without a market!

HOW DISAGREEMENTS START Many disputes arise when the use or development of natural or other water systems or natural environments is seen not to give fair, stable or equitable outcomes. Conflicts arise between ministers, agencies, and between government1 and client groups such as irrigators, mining industry or local public interest groups. These disagreements can have many origins such as poor communication, personal slight, major value differences or data discrepancies. In NSW there is a constellation of resource development issues impacting on water resources. Water allocation must be more precise as demands escalate. Some people are going to miss out. Better rules and more efficiency mean that water users must change their behaviour. This causes anxiety and conflict. Agencies must therefore deal more frequently with public interest groups. However they do this with different levels of success! Water agencies in Australia must now commercialise and yet they must be environmentally conscious. They have immediate challenges in 'managing' water resources around coastal resort developments, in irrigation areas, in major housing expansion and for sand and gravel mining for concrete for these developments and sewerage treatment from them. Once catchments provided water only for people within them or nearby. No more. Urban water managers are looking further and further away for water supply. Where is your weekend retreat? Outside the water sector we have the sporadic but escalating invasions of often environmentally 'negatively value-added' industries such as woodchips, pulp mills and feedlots. These are most significant for water allocation changes and the potential deterioration of water quality through effluent disposal, dimunition of river flows due to abstraction of water or through major land clearance and land use change. All natural resource management agencies must be on 'alert' when considering these new industries. Effects of such major industrial development ripple through the environment, not only at the site of use but whenever land use change supports natural resource consumption. The media can be a central initiator or presenter of conflict. Issues become instant public affairs in the media which is critical to the formation of public opinion. The media was not helpful to the WATER October 1990

Sydney Water Board on sewage. However, it gave significant positive coverage to a major coastal water resource management issue over most of 1989, a coverage unprecedented for a water resources issue - but later challenged by the lengthy forest resources debate. Âˇ

PROBLEMS Flooding:

Many water agencies have interests in Western Sydney and so the setting up of the Upper Parramatta River Catchment Trust was not straightforward. Political commitment to a recently frequently flooded electorate made this Trust happen, the public were all for it though some government groups were worried about power losses. The outcome is that positive flood mitigation measures are now being more effectively dealt with and the community also pays a levy - a double bonus for government. Levee construction has been a major activity around towns and also along rivers and floodplains to mitigate against flooding, more frequently in the rural context. While levees tend to keep water out of high value cash crops, levee plans can also promote crises of confidence. Farmers must be sold the benefits by government. Levees may and have been built in the wrong places, especially by farmers seeking flood protection for crops. Flood waters may be redirected by these levees causing further flooding problems Âˇelsewhere. Conflicts may have led to the odd levee being blown up. Drainage:

Draining cities is a big task with big problems and big costs. This has led to some stalemate between many agencies who believe they all have a role but don't really want all of it. Delimiting the extent of agency role is problematic. An ageing drainage system requires co-operative help from Councils and agencies - one aim is to get the community to look after and manage the asset. Often Councils are not enthused by more responsibility due to the cost of additional flood mitigation work. In some cities there is ongoing conflict between council and the water utility about sharing responsibility for management of urban drainage and flood mitigation works. Mining:

Mining rivers for sand and gravel is getting more and more precarious for rivers as well as the industry as resources are running out. There is frequently conflict between industry, property owners, local councils and state governments about the location and nature of mining and the stability or instability of the river system in question. Over-mining is evident on the North coast of NSW in particular. Many rivers have just about been mined to death (ie, high geomorphic and ecologic instability and degradation). New resources must be found out of the river banks and bed. Certainly deposits on fossil or old elevated terraces are more attractive to river managers. Hard rock quarries are another answer. Sewerage:

Sewerage disposal has been a key environmental concern at Sydney particularly over the past few years. Conflicts have emerged at a nu'mber of levels in what has become a major national issue and international embarrassment. Elements of the conflicts include the public perception of 'trust worthiness' of major water utilities; pressure by public action groups to rectify ocean pollution; problems of storm water pollution by urban runoff being foisted on the Sydney Water Board by local Councils; a report on bioa.c cumulation of toxic organochlorines and heavy metals in fish near the Board's outfalls; considerable media exposure of the environmental concerns aided by retired Water Board employees and a public who increasingly did not know who to believe. The issue was of a wild horse type - it went on and on with multiple players, voices and outcomes. Public dissatisfaction continues but government is addressing a difficult and expensive problem. The result outside Sydney was a scare and high awareness amongst all major city water utilities and communities along the Australian coastline. Overnight, public attitude to ocean outfalls for sewerage disposal was changed. The Sydney crisis had multiple spinoffs including national assessment by the Australian Water Resources Council (AWRC) of effluent standards and sewerage treatment.

GETTING PEOPLE OFFSIDE - BEING ONE-EYED Underlying causes of disputes are many and they can relate to the type of issue, institutional behaviour, cultural differences and changes to economic activity. Generally speaking, regardless of the type of issue there are a number of path choices which will allow conflict to develop. 20

WATER October 1990

A radically new policy being introduced overnight to the public can really get everyone off side, especially'"if it is a new and likely greater price for water and if you, the ratepayer, haven't been consulted at all. This happened in Newcastle in 1982. In this case the public besieged helpless innocent Water Board employees who weren't aware of much either. In this situation the causes of public controversy were no public consultation, and a new general manager who was placing a major cultural change imprint on the Hunter Water Board with Ministerial backing in the right political climate. Neglecting the environmental impacts of a policy can create nightmares. This has been experienced in the earlier flood mitigation plans of state water agencies where the environment was almost last on the list. Even today the processes of collaboration and consultation on many water matters may be a little perfunctory and as always, and for most issues, the element of personality differences can be at the crux of the failure of a process of consultation or non consultation. Newcastle for example is examining new water source options which include using what is available in the region first, but then by necessity building a storage at one of a number of possible locations. The recent review of source options for Newcastle and the seeking of deferment of Tillegra Dam was largely in response to public concern about the location of future storages. This concern has rightfully goaded government into addressing future programs much more closely and in so doing, addressing the full range of community and social interests as well as environmental and economic ones. Stalling, vacillation and ambiguity can get you or your organisation into quick trouble. Sometimes the problem goes away. More likely it re-emerges like the Tillegra Dam controversy in the Hunter Valley. Here the community finally demanded an answer to where the next dam was to be - they certainly didn't want the dam at Tillegra on the Williams River. National media assisted the push for government action. State indecision certainly had a backlash. Indecision about water licence applications can also make trouble in many states. Ambiguity of rules and regulations regarding release of a water bird breeding allocation from Burrendong Dam on the Macquarie River created a controversy between water managers and local water users. The cause was a difference between agreed rules for water allocation as documented in a public document and, differently, in a departmental operating document.

FIXING DISPUTES IN NSW The theoreticians see that there are four pathways to resolving conflicts, by political action in legislation, by bureaucratic solutions, by the law and by market processes where prices can be allowed to balance supply and demand and hence resolve conflict. While all the above mechanisms apply in NSW there is a dominance of the political and bureaucratic channels. A sprinkling of court activity and quasi judicial approaches also features. , Interviews across and outside the NSW water industry have revealed a number of 'solutions' to conflict. Violence is one. Blowing up of a levee or threatening government employees with guns or a cement necklace are some evidences of trying to solve a conflict by frustrated government clients. It doesn't work. A better system is the provision of good data and establishment of credibility on the part of an agency. For example, disputes between agriculturists and water industry staff, or river miners and government, often have as a pre-requisite to settlement that there be provision of good convincing data to all parties. Farmers may wish to see and have independent checks on calculations for floodway plans. Extractive industry not believing they were accelerating river bed lowering near Tamworth finally accepted scientific evidence from the Department of Water Resources that they were, and then moved to a more suitable site. Government officers need to establish good credentials with the public and government must be able to justify and/or join in decision making with irrigators, urban water consumers or major rural industry. However agencies often do not have uniform credibility or jurisdiction in different parts of the state. Bluff has been occasionally used as a last resort by agencies without legislative power to enforce a policy. Compromise solutions to rural or urban engineering may not be optimal technically, but an outcome is usually achieved which is acceptable to all. Informal approaches to examine tension between parties may be very successful. Face to face contact with the public is often critical

in resolving disputes, particularly in many rural irrigation situations, across Australia. Informality is now being used more between agencies - to tentatively explore joint interests in water and land management. Players must be on good speaking terms, show respect for other parties, should state how they feel about the issue and actively listen to the other side of the conflict. People often only want to be heard. Facilitative workshops can be very popular and successful in resolving a conflict or setting guidelines for avoiding conflict at a later stage. One was undertaken to get parties together to talk about allocating water to the Macquarie marshes wetland - for water bird breeding. At the workshop later on (the water was never allocated) - government, conservation groups, landholders and technical experts all participated in exploring values and issues. A clearer, more common picture emerged from the meeting. A later request for water was agreed to, the original dispute centring around government agencies citing different ground rules documents for water allocation requests and decisions. An independent review of an issue can defuse it or bring interests together either to change or re-affirm government policy. Reviews have been undertaken for the sewerage outfall project at Sydney and for the deferral of Tillegra Dam construction for Newcastle in the Hunter Valley. This latter Ministerial review re-evaluated all water supply options for Newcastle, leading to an anticipated deferral of a new dam to about 30 years beyond 2002 and an increased use of existing water supply sources and infrastructure. (But, who knows what future economic growth might bring?) Ministerial intervention can directly sort out a conflict especially when things get a little out of hand or where it is politically expedient. Intervention is commonplace - often a minister might be requested to intervene by affected parties. Intervention was demonstrated in a conflict over mineral sand mining and urban water supply from the Tomago Sandbeds at Newcastle and also in the formation of the Upper Parramatta River Catchment Trust in Western Sydney.

CREATING SOLUTIONS FOR THE FUTURE The NSW Water Resources Council was formed in 1989 to promote co-ordinated water resources management across the State. Conservation and improvement of water quality for all uses is one aim of the water industry and the new Council assists in this process. Also a new review system is being considered for applications for water allocations. The 'people' are now being given more choice in disputes. This will happen when a specialist water tribunal is set up, for irrigation water disputes in particular. The tribunal will also require a prior reconciliation process to be undertaken where all parties are called together to talk the issue through. This process would be conducted through the state water management agency. If this informal approach fails the tribunal would be called upon although unresolved points of law could go to the Land and Environment Court. Localising community conflicts with government and also getting to the community early with issues has been significant in NSW. Following from little early consultation with the public over the Sydney sewerage problems - a changed approach has allowed government to consult early and quickly when new policies are being developed. For Gerringong-Gerroa sewerage planning, south of Kiama, government is now engaged in intensive consultation with the community to develop a sewerage scheme that the community prefers. Good Ministerial liaison between agencies and their Minister's offices assists in the policy process especially when the tyranny of distance intervenes. Recognising the self interest of all parties in a dispute is most important - all groups must be acknowledged and catered for in some way. Environmental protection initiatives are the touchstone for this emerging multiple involvement.

ODDITIES AND UNEXPECTED Certainly some anomalies occur in how policies work out and techniques for implementation can vary markedly. There is a good degree of unpredicability in the conflicts area in water management. Where and when will be the next acute water shortage? Who knows where the next toxic spill will be? Or its contents? Who's dam will fail? How will communities and governments react? Sometimes opposite results are achieved . For example, the introduction of pay-for-use water in Newcastle was an overnight

policy 'event'. No consultation occurred. But the results were excellent, a 30 per cent reduction in trend for domestic water consumption. Yet if there had been an allowance for public input at the time - the scheme would have had no chance. Ministerial support for a risky venture paid off with a change agent manager prepared to take on the city. However, for the next Hunter Water Board project, a major new ocean outfall, the public relations campaign was intensive. There was lots of public consultation this time, but public interest was surprisingly small, the public saw its interests as being served. Split ministries can cause problems too. In NSW there are in effect two ministers for water: one for NSW water resources and another for the Newcastle and Sydney Water Boards and the NSW environment. A third minister for public works oversees water and sewerage in rural towns.

CONCLUSIONS: MAKING EVERYONE HAPPIER The informal approach to resolving conflicts is obviously a vital component of management. Informal, positive and listening discussions between agencies and the community are vital prerequisites to success. Just about gone are the days of overnight policy strikes and no consultation. It doesn't work with the public and it gets agencies into hot water. Indeed the water sector is very exposed to the public as a provider of an essential product and the manager of the environment from which it comes and to which it returns. Therefore numerous solutions to conflict have been tried - some have failed. It is often timing but more likely the approach used. .Positive outcomes are likely to follow through - formalising the informal, setting up conciliation meetings, workshops and through the formation of co-ordinative groups across the water sector such as the NSW Water Resources Council where issues are aired. Sharing information can be very important, it reduces tension and increases the number of approachable parties. Management must be more vigilant in terms of its legal and moral responsibility to the community. If this is let slip, the agency might be undone. Legislation will be tested over and over again when powers are questioned. This is seen by mineral sands mining issues at Tomago in the Hunter Valley and by alh,ivial sand and gravel mining along the Murrumbidgee River. The 'matey' meeting and casual chat is vital to the process as it involves the simple ability to see and hear another point of view. It is a simple process and it brings pei>ple around very quickly. The development of inter-personal communication skills is most useful for managers, government officers dealing with the public and public interest groups themselves. Such skills are not wasted in the office or at home either. Agencies must be mindful of implementing policy and of the negative as well as positive results. Credability of data will be an element. Checks must be made on this as there is a more sophisticated public about nowadays. That public also has first hand knowledge of many regional water resource matters - all this needs to be brought into management from afar. Public involvement has moved right forward in importance but natural resource management agencies and other sectors are still operating in a continuum from fostering little involvement to fostering a lot, sometimes. Enhanced training opportunities in dispute mediation and conflict resolution is a prime need for government and for regional catchment management groupings. The public involvement process needs training and developing. Public involvement is NOT public relations. Appropriate social impact assessment is indeed the major requirement for agencies who participate in land and water planning. Above all too, we need conflict - it is a healthy sign in planning, it means we don't all have a miserable value or approach. Planning thus caters for more people, more values and hopefully for a more stable ecosystem.

REFERENCES DAY, D.G. (1990) - ' Resolving Conflict in the NSW Water Sector (Informality, Anomaly and Innovation)' in Handmer J, Smith D. and Dorcey, T (eds) Resoluuon of Conflict in Australian Water Management. Centre for Resource and Environmental studies. The Australian National University (in press) DELLI-PRISCOLI, J. (1989) - Resolving Conflict by Involving the Public in Water Planning Decisions' a Manual (Australian Water Resources Council Planning Committee, NSW Department of Water Resou rces. (copies in NSW Dept. Water Resources library and Western Australia Water Authority Library).

WATER October 1990

Privatisation-Corporatisation for the Water Industry A picture of current developments in theory and practice by G. WATSON and S. WHELAN ABSTRACT Privatisation, Corporatisation and Commercialisation are terms used interchangeably as possible solutions to the problem of increasing the efficiency of Government Business Enterprises. More recently, research on the theoretical impact of these processes and empirical observations of outcomes where they have been implemented has enabled them to be distinguished. The first half of the paper deals with what has happened in practice with regard to the water industry in New South Wales in particular, reasons for these developments and why, in practice, privatisation and corporatisation are not likely prospects in the near future for the water industry as a whole. The second half of the paper discusses the theory of efficient water industry management from the economic point of view of the principal-agent problem.

INTRODUCTION Privatisation, Corporatisation, Commercialisation refer to processes which can be quite distinct in their implementation and in the outcomes they produce. However, over recent years the terms have been used interchangeably at times. Furthermore, often the threat of implementation has been enough to instigate the desired · changes within the public sector. More recently, observation of events within the water industries of England, the United States of America and New Zealand, and legislation in New Zealand and New South Wales relating to the establishment of State Owned Corporations (SOCs), have established the ground work for distinction between these three processes. How is each process distinct? The processes involve varying legal rights and responsibilities which impact on costs through the levels of accountability and decision-making autonomy implied . Each defines a different claim by governments on revenue flows, approach to costs, and influence over operations as a privilege of ownership. Implied in these claims, approaches and privileges are varying degrees of exposure to, or protection from, the disciplinary forces of a contestable market, that is varying degrees and levels of competition. Privatisation necessitates a transfer of ownership and with it the loss of a direct claim by government on revenue flows. Also lost is the right to direct individual outcomes. The process requires a discounted valuation of future stock values and cash flows. Generally the right to maintain operating capacity from consolidated revenue is lost. On the positive side investment decisions are no longer hampered by Global Borrowing Limits for example. The prospect of .competition is greater. The problem of possible market failure must be addressed separately. How to simulate the market is only noted in passing in a later section of this paper. Corporatisation maintains claims on revenue flows. Direct influence over outcomes is generally forfeited by the definition of a corporation's sole objective as maximizing the net present value of the business to its share holders. (The problems of measuring value or policing compliance are not addressed here). The intention is to establish an operating environment for appropriate public sector enterprises which replicates the internal and external conditions faced by successful private enterprises. The option of using the corporation as an economic, social or political tool is still open though once removed. Commercialisation is the more variable of the three processes in its internal workings, and the final state of the evolving enterprise. This is because it defines a change in the management (sociology and culture) of an enterprise without defining a new legal entity. Commercialisation is more concerned with accounting for costs. It differs from corporatisation in that environmental and social obligations may be involved in the objectives. Control over the structure and level of revenue flows is maintained as is the decision to influence outcomes from operations. It is also likely that costs 22

WATER October 1990

Genevieve Watson: BCom (Merit) 1978 University of NSW; DipEd 1980 University of NSW; Graduate Studies in Econometrics 1988 Sydney University. Currently enrolled in a PhD program at University of NSW under the topic of Marginal Cost Pricing with a Case Study intended in Trade Waste Treatment. Has been with the Urban Water Policy Centre since its inception and consulted for the NSW Inquiry into "Local Government Rating Other Revenue Powers and Resources''.

G. Watson

Stephan Whelan: Stephen is a fourth year honours student at the University of NSW studying for a B.Com(Hons.) in Economics. Stephen has worked for the Urban Water Policy Centre in the Summer Vacations 1988/ 89 and 1989/ 90, holding an AWRAC Summer Scholarship for the latter period.

S. Whelan

will be greater under a process of commercialisation than corporatisation, as the former is likely to predominate in areas where there is little competition amongst suppliers or few producers of the same good. Although aimed at facilitating increased' economic efficiency, each process requires a varying degree of trade-off between control and economic efficiency. This trade-off is brought about through the associated changes in equity and the control endemic in the forces of a contestable market. The supply and disposal of water for domestic, industrial and agricultural use has passed to and fro from private to public ownership in its short history. Over this time the location, reliability and charges of supply have been convenient policy tools for economic and social development (Paterson, 1984 is one of many historical summaries). In our opinion this unique history of the water industry in Australia indicates the preclusion of privatisation and corporatisation as processes in favour of increased efficiency of operations. This leaves the option of commercialisation to be examined for options and prerequisites in its contribution to a more efficient management of resources by the public sector. The two most important aspects of commercialisation are: • delineation of clear, consistent, stable objectives and • the creation of a quasi-contestable market framework. Governments have begun to address the problem of the definition of objectives. The second necessary condition is not so easily implemented. One of the reasons is that in a monopoly situation the market needs to be simulated by a complicated set of indicators, sanctions and rewards. Even when the above is achieved, and that is no mean feat, the principal-agent problem (to be more fully developed in the latter half of the paper) and second best constraints resulting from past inefficiencies impose costs which are difficult to quantify and control.

THE PUBLIC ENTERPRISE Public enterprise managers were once assumed to have a normative character and as such were to be altruistic and so conform to optimality rules once they were discovered. Whether this ·statement was true or not of the past has not been tested empirically. Now the objectives have changed, especially in the water industry in Australia, and the old practices have been found wanting in fulfilling the new directions. It is hard to ignore the fact that public

enterprise managers form their own goals. No one is prepared to risk the outcome of old assumptions proving false; therefore, they . must be replaced by positive analysis. Central to the policy debate is: 'What would happen if control was decentralised and public enterprises allowed to determine, for example, their own prices?'. To answer such questions we need a theory of the objectives of public enterprises as autonomous organisations. Just what is a public enterprise? For the purpose of this analysis it is defined as one which has: â&#x20AC;˘ Direct political control, â&#x20AC;˘ Tradeable goods, â&#x20AC;˘ Welfare objectives. Historically, public enterprises have developed for a number of reasons, both economic and social. This paper concentrates on one particular form of public enterprise, the Government Business Enterprises (GBEs) which are" . . . organisational units within the public sector, which produce goods and services which are, or could be, sold or tendered in the market place without compromising the government's economic or social objectives" (Steering Committee, 1988, p2). GBEs are engaged in a wide variety of activities including water, and the N.S.W. government's corporatisation framework is intended to apply to 'self sufficient monopolistic bodies such as the Sydney Water Board' among other entities (p2- 4) . The term SOCs (State Owned Corporations) will be used to refer to 'corporatised GBEs'. Firstly there may be market failure such as the exercise of market power by a natural monopoly. The supply and reticulation of water is a good example. Imagine the impact on costs of two reticulation systems in a suburb. Other market failures are economies of scope (the same work gang could work on both roads and mains etc.), economies of scale (overhead costs are spread over a higher level of output thus reducing their impact) and sunk capital (the return on capital may be a long way off, say 20 to 30 years, and with the private discount rate being above the social optimum, a myopic private capital market which is risk-adverse would be unwilling to invest in capital resources) . There may be externalities such as pollution or positive health outcomes which are not costed or valued in present accounting practices. Secondly, it is possible to structure pay-offs from management of the resource by capturing rents and reallocating them. This redistribution can be achieved by applying a deferential pricing policy to groups of customers. It is more commonly known in the industry as cross-subsidisation. Thirdly, there may be a need for central planning through infrastructure provision. This is mainly necessary where market failure is apparent but could also be based on equity and security considerations. The fourth reason why public enterprises have developed historically is one of ideology (see Rees, 1984, pp2-8).

THE MAIN CONCERN For some years now there has been a general uneasiness that society as a whole is not obtaining the maximum return from public sector management of resources. The quick answer was seen to be emulation of the private sector. Here, the operations of market forces are able to liquidate businesses which do not supply the desired output or service, takeover those not efficient in achieving adequate rates of return, or replace boards not working in the interest of shareholders. The main area of concern is the greater costs of public ownership (Piggott in Abelson, 1987). However, where there is competition these differences are insignificant (Cranston in Abelson, 1987). Cost inefficiencies in public enterprises are due to a Jack of succinct definition of objectives and ownership. Objectives in the past have been poorly defined, complex and unstable. A division between equity and regulation has resulted in failures in monitoring and control allowing the interests of managers and/or ministers to take precedence. A contestable market has not and cannot operate of its own accord for all the reasons of market failure given earlier. But neither was the institutional form one which allowed the flexibility to respond to these forces even if they were merely simulated. A better institutional form is one which maximizes benefits over costs. How to define and measure many of these benefits and costs is still a difficult problem. What is required is a concise definition of performance. Whereas in the past achievement would have been

measured in terms of meeting a require~ent for water, it is now likely to be explicitly stated in terms of economic efficiency in the management of the water supply in meeting demand. In the past water was perceived as a need to be met by building more dams. It was financed by charges more akin to a tax than a price. Increasing environmental and economic pressures have precipitated a change fo the cognition of water. It is now a commodity with time, place and quality characteristics in both supply and disposal. Economic theory suggests the best way to manage this commodity is to charge a price for it related to its cost (the theory assumes cost minimisation and the use of different price structures to address social questions). In implementing operational, financial and pricing policies akin to the private sector there are three avenues of institutional organisation available. These are privatisation, corporatisation and commercialisation. In choosing between them consideration must be given to the outputs produced and the outcomes desired from the process of change, and the likelihood of the resultant institutional framework yielding the desired consequences in a sustainable fashion. The institutional framework implies attention to both the internal and external environment under which the enterprise operates.

PROCESSES TO A SOLUTION We will consider privatisation first, as it is, in our opinion, the least likely option to be followed by State governments in Australia in respect to the water industry. Historically the water industry began in Australia in private hands. To the liberal minded bureaucrats of the day the necessary prerequisite of market failure indicated a need for nationalization. From these tender and tumultuous beginnings water policy in Australia proceeded as a tool of social development. Now a school of thought suggests that the size of the national cake could be increased if economic development is given sovereignty over social development in the management of water resources. Private ownership was not successful 100 years ago. Would it work now? In the United States private ownership of water supply authorities is common. However, it has not been seen as successful in containing costs, protecting the environment or producing a value-for-money service. These are prerequisites on water managers' agenda in Australia. In England windfall gains were made by the founding shareholders when assets were revalued to current assessment on acquisitiqn. In both England and N~w Zealand foreign ownership of strategic resources is growing. The security implications of this in terms of financial and defence considerations are disquieting. For these reasons there are only small sections of the water industry likely to face privatisation if current developments in practice persist. The sections most likely to benefit from free competition from the private sector may include, for example, meter supply, maintenance and reading, or wastewater treatment. Corporatisation is a second alternative. In New South Wales a State Owned Corporations Act 1989, has been enacted to this end. These new companies have one basic objective, which is to maximize the net present value of the enterprise to the shareholders. It is perhaps fair to say that the new State Owned Corporations (SOCs) are to be managed on a profitability basis to generate income for other social obligations on the government's agenda. They are to be established within industries where the market has achieved a minimum critical size such that the inefficiencies caused by unregulated monopolies and cartels are less likely to become entrenched. This then leaves the option of commercialisation as a last alternative to produce an institutional framework to encourage economic efficiency within the water sector of public enterprises. It was mentioned earlier that the failure of public service operations to maintain costs and effectively supply goods and services was due to poor definition of equity and objectives. Privatisation defines both of these but with increased risks to a wide range of securities. Corporatisation reduces those risks at the expense of increased costs through accountability requirements. A corporation may still be used as a policy tool so long as the responsible Portfolio Minister tables the request in Cabinet and is able to meet the tendered cost of the social obligation. However, the shareholders (voting ministers) and the objectives are well defined. Why then not corporatise all public enterprises? The reasons are two-fold. Firstly, there are many changes needed within each enterprise before it is ready to convert from break-even to discounted present value. As noted from the English experience, WATER October 1990

identification and valuation of assets is not the least of these. The second reason lies in the history of the development of the water industry in Australia. Water resource management and pricing have been an intrinsic part of social development with income distribution and macro and micro economic policy effects.

DRAWBACKS STILL TO BE RESOLVED The Principal-Agent Problem

The operation of a public enterprise as an agent for the government, whom we consider to be the principal, having been democratically elected by the shareholder, has intrinsic costs. There is an opportunity cost when preferences presented by the agent are not the best with reference to the preference ordering of the principal. The more decentralised control is, the higher the risk is that the agent will bias information in favour of his own preferences. The implications for economic efficiency of this conflict of interests is examined in detail later. Efficiency-Objectives

Leaving the equity question for a moment we are left with questions of objectives and market forces. In the process of commercialisation the objectives of public sector enterprises are being defined. They include, in general, directives to be commercial in operations and to have regard for management of the water resources through their cyclical process. Internal Operations

In respect of commercial operations the public sector enterprises are establishing internal cost centres and opening up to private competition in the supply of services. This change will tend to have the long run effect of removing high cost support services from the public arena, thus, increasing overall managerial efficiency. Costing Externalities

At first the environmental consideration in public sector objectives may reduce the comparative economic performance of the public sector enterprises. With the passage of time an economic cost should be placed on the assimilative properties of the environment. If all industries are required to meet the full costs of their use of environmental resources, the relative economic efficiency of public sector enterprises as measured in dollar terms through the accounts should be restored. Water authorities provide an important commodity. How then can their efficient operation be assured and the benefits of a contestable market captured? To achieve this end, Ministerial control needs to be removed, Boards made accountable to shareholders, and technical and allocative efficiency assured. Simulating a Contestable Market

An attempt to mimic the operation of a share market has been established with the requirement of a Real Rate of Return. This is a ratio between revenue flows and asset stocks. As such it is sensitive to monopoly pricing practices and inflationary pressures on the current value of capital. To regulate the situation further, mechanisms in the form of performance indicators must be put in place. An economically efficient enterprise practises technical efficiency if it faces loss of business, loss of profit, or take over. These forces tend not to operate as effectively on a water authority because of the special nature of its output and the scale of capital required toÂˇ establish it. Again an accountability mechanism needs to be established to ensure that the public enterprise remains innovative and cost efficient while providing the range of services required by its customers (most of whom through tax payments will also be shareholders). Such an enterprise will also be efficient in its impact on the allocation of resources between competing outputs if it practises marginal cost pricing. This is often referred to as allocative efficiency. At present the majority of water authorities in Australia conventionally base prices on longrun average costs. This tariff can be demonstrated to be inefficient (Howitt, 1990). However, procedures are not sufficiently developed at the moment to allow the implementation of charges for service based on operational costs and including a component of capital costs, i.e. appropriately defined marginal cost. Prices which include the full cost of services indicate to the consumer the full cost of operating, maintaining and administering the system as well as signalling the likely costs of increased capital investment necessitated by growing demand for supply or disposal. In view of the assimilative constraints of the environment the full cost of environmentally neutral disposal techniques should be imposed. 24

WATER October 1990

These regulatory practices increase t~ accountability of an enterprise but also impose costs in terms of monitoring and reporting. The principal-agent structure provides a framework for analysis of searches for improvements in industries such as the water industry.

THE PRINCIPAlrAGENT We conclude in the first half of this paper that in addressing the problems of CBE's in the water industry history precludes wholesale privatisation. It appears in practice commercialisation is currently favoured over corporatisation as a solution. Would corporatisation in fact provide a better solution? Lack of a concise equity definition, clear objectives and competition has been put forward as reasons for inefficiencies in the way GBEs utilise resources. One possible explanation can be envisaged in terms of the principal-agent problem associated with the separation of the ownership and control characteristic of GBEs. In fact, the principal-agent problem may be used to understand why GBEs could be inefficient in their present form, to provide a rationale of corporatisation as an attempt to improve the performance of GBEs, and, to explain why corporatisation is unlikely to provide a total solution to the 'problem' of GBE performance. While literature on the nature of the principal-agent problem can be somewhat technical, the concept of a 'principal-agent relationship' is significantly simpler, and on closer inspection can be found in a wide variety of social interactions. Ross (1973) has defined an agency relationship as " ... arising between two (or more) parties when one, designated the agent, acts for, on behalf of, or as representative for the other, designated the principal, in a particular domain of decision problems" (p. 134). In essence, a principal-agent relationship occurs when one party makes decisions, or takes actions on behalf of another party, supposedly in the latter's interest, eg employer/ employee. The reasons for the existence of a principal-agent relationship are numerous. The agent may be more able than the principal to undertake some task by virtue of better or less costly access to information. Alternatively, the principal may simply be unable to undertake the task himself (see Rees, 1985). Marginal Efficiency

Principal-agent relationships are characterised by a number of features of concern in the present discussion, the most important being the information asymmetry which gives rise to the so called 'principal-agent problem'. It is usually the case that there is imperfect information concerning the action the agent has or should have undertaken. In many situations, the action of the agent will not be directly observable. For instance, it is often impossible for the employer to directly observe the actions of the employee, or the insurer to determine exactly the actions of the insured. Alternatively, it may be the case that the principal desires the agent to take action on the basis of information available to the agent only. Such a situation may form the very basis of the principal-agent relationship. Given the existence of the information asymmetry, the principal cannot determine whether the agent has taken actions they themselves consider 'best' in that situation. Therefore, even if the principal is able to observe the outcome of the agent's actions he may not know whether the action was in his best interests. For example, the voter may be able to identify correctly the action of the government, but not be in a position to determine if the action was appropriate (Stiglitz, 1987). Alternatively, the range of feasible outcomes may not be known to the principal. The asymmetry of information which characterises principalagent relationships poses problems when the interests of the principal and agent do not strictly coincide, as is usually the case. For instance, the level of effort an employee finds best may not necessarily coincide with the-level of effort an employer would find optimal. That the employee finds work 'distasteful' in some sense is sufficient for an incentive to exist for the employee to 'relax' on the job or 'shirk'. Ultimately then, the principal-agent problem is one of economic incentives, an issue which is at the centre of the public sector performance debate. The need is for the principal to provide appropriate incentives for the agent, thereby ensuring that their interests coincide as closely as possible. When their interests don't, it is likely that the agent will take decisions which conflict with the interests of the principal. Regulation

The second characteristic of principal-agent relationships of particular interest is closely related to the problem of the

information asymmetry, viz the question of monitoring. Although actions of the agent are not usually perfectly observable, it will often be the case that there is a 'signal' associated with the effort or actions of the agent. For instance, the output of the employee will often give a good, though not necessarily perfect indi~atio~ of_the ~ffor~ applied. If it was in fact the case that there was a moru~or~ng signal perfectly correlated with the effort of the agent, the pnnc1pal-agent problem could be overcome. The agent's effort could be inferred from the eventual outcome, and the principal could simply specify some outcome in return for a fixed reward to the agent. Subject to acquisition costs, information from a monitoring sign~! additional to the outcome which eventuates will be valuable m constructing incentive schemes for the agent, ie it is in the interests of the principal to use that information to induce behaviour from the agent in the former's interest (Singh, 1985, p600). The fact that monitoring signals are not usually perfectly correlated with efforts of agents has already been noted. A reason is the final aspect of the principal-agent relationship which is of significance here, viz uncertainty. It is the case that u?cert~inty of some form is intrinsic to the principal-agent relat1onsh1p. The implication is that the eventual outcome is a function of both the agent's effort and some other 'influence' or 'state of the world'. For instance, in the employer/employee relationship, the resultant output ·is likely to be a function of the reliability of the equipment used as well as the employees' own effort. It is now possible to visualise in simple terms the structure of a generalised principal-agent pro~lem. One indi_vidual, the agent, must choose some action from a given set of choices. The outcome which eventuates depends on the choice of action by the agent and extraneous influences (or "the state of the world which prevails"). The outcome confers benefits on a second individual, the principal, who in turn makes a payment to the agent. The rewards derived by the agent depend on the payment made by the principal (benefits) and the action chosen initially (costs). This discussion raises three questions for the water industry in relation to its operations and the nature of the playing field on which . actions take place. • How well do water agencies' actions conform to the demed government outcomes? • How effectively can these actions be maintained? • How reliable are the linkages between an agency's actions and ensuing outcome?

THE FIRM AS A PRINCIPAL-AGENT The principal-agent relationship is found in a wide variety of circumstances, but our particular interest is in firms characterised by the separation of ownership and control. The owner, usually shareholders, are the principals who delegate day to day control and running of the firm to management, the agents. Whereas the 'outcome' can broadly be considered as profit, management will not necessarily always pursue profit maximising behaviour; decisions will not always be taken in the O\\'.ner's interest. Management may participate in behaviour which serves its own interests rather than those of the owners. In addition, while profit is to a large extent conditional on the decisions of management, it also depends to a· significant extent on factors ~xtraneous _to managerial control, eg the state of the economy will necessarily impact on the level of profits irrespective of the decisions of management. Adam Smith writing in 1776 foresaw such significant problems in firms characterised by the separation of ownership and control that he doubted that they could feasibly exist for an extended period of time and on a large scale. The 'anxious vigilance' with which people watch over their own money is unlikely to be as anxious when other people's money is involved (Jensen & Meckling, 1976, p305). Since then, numerous other writers have expressed similar misgivings as to the efficiency with which managers of firms characterised by the separation of ownership and control utilise the owners' funds (see Strong and Waterson, 1987; Berle and Means, 1967, p113; Coase, 1937). The hypothesis that firms are not strictly run according to the interests of their owners is significant in that it recognises that management of firms is to a certain extent able to exercise discretion in the use of the owners' funds. The inevitable result of this is that a decision-set in conflict with the strict interests of owners is likely to be adopted by management. In reality, the matrix of management's alternative utilities pursued may be as large as human experience.

GBE AS A PRINCIPAicAGENT The principal-agent framework has been used to analyse relationships between government and 'public firms' or GBEs (see Guesnerie and Laffont, 1984; Rees, 1988). It should be noted however, that the concept of government as the principal and management as the agent involves several simplifying assumptions. It ignores the existence of hierarchies or coalitions of interest, and treats management and government as single individuals. In reality, there are more likely to be numerous principal-agent relationships amongst voters, government and the groups which constitute the GBE organisation. Nevertheless, such an approach can be justified as a 'fruitful simplification' for analytical purposes (Rees, 1988). Despite the existence and the seriousness of the principal-agent problem in firms characterised by the separation of ownership and control, the last two hundred years or so have been characterised by the exceptional growth of private corporations of this form. The growth of such corporations is, in part, indicative of their ability to organise production more efficiently than the best available alternatives. Whereas various hypotheses have been forwarded seeking to explain such a phenomenon, it is clear that a number of legal, social and institutional mechanisms have evolved which facilitate this growth. In attempting to mimic the operating environment and performance of equivalent private sector firms, the corporatisation process gives explicit recognition to the ability of those mechanisms to induce efficient performance. Nevertheless, the inability to reproduce those mechanisms within the confines of a public sector environment suggest significant limitations in the success of the corporatisation process in achieving this goal.

PRINCIPAL-AGENT PROBLEM AND THE CONTESTABLE MARKET The nature of those mechanisms and why they cannot be reproduced to the same extent in the public sector environment, particularly that occupied by the water industry, can now be set out. The Sharemarket The nature of the ownership rights in open corporations, ie freely tradeable residual claims in the form of shares, gives rise to sharemarkets which subsequently act as ' a low-cost efficient mechanism for aggregating and conveying information on the performance of corporations and management. In turn, the existence of the sharemarket encourages the development of professional analysts who provide .,c ost effective information to potential market participants. Ultimately, this type of analysis provides significant incentives for management to perform in the interests of the shareholders, as a result of which their performance will be reflected in the share price (Jennings and Begg, 1988, pp20-21). Irrespective of the steps taken in any corporatisation process, it is unlikely that the monitoring power of the sharemarket can be adequately reproduced for SOCs. By retaining public sector ownership, the powerful mechanisms which operate via the sharemarket do not become available, as the incentive to monitor the performance of SOCs by individuals is tempered significantly when ownership rights are not freely tradeable. In effect, individuals are in a free rider position, with few of the potential gains from more stringent monitoring being accrued by individuals. In essence, the absence of a sharemarket creates a void which is unlikely to be filled. One interesting possibility which remains is the use of non voting tradeable equity which is available in New Zealand (see State Owned Enterprise Act 1986, s.11). In a sense, a pseudo sharemarket is thereby created. Nevertheless, non voting transferable equity is likely to be an imperfect substitute for shares, and any monitoring mechanisms subsequently constructed around their existence are likely to reflect this.

The Market for Takeovers The existence of sharemarkets creates a market for 'takeovers' or for corporate control. When a firm is performing inefficiently perhaps due to managerial slackness, its share prices will not reflect accurately its earning potential. As a consequence it is likely to become a target for a takeover by a rival firm or managerial team which feels it can reap a higher return. Therefore," .. . the threat of takeover acts as a powerful constraint and incentive for management teams to act in the interests of the shareholders" (Jennings and Begg, 1988, p.24) . Retention in the public sector of corporatised entities ensures that the threat of takeover no longer acts as a restraining mechanism on managerial behaviour. WATER October 1990

The Market for Management A mechanism stressed by some writers, especially Fama (1983), is that of the managerial labour market. The market's assessment of the 'worth' of management is related in the main to the· performance of the firms controlled. Consequently, management will have a 'vested' interest in performing well, thereby enhancing its own reputation and future potential earnings. Given that the corporatisation process emphasises the adoption of management incentive schemes like those utilised in the private sector, with remuneration based on performance, the importance of such mechanisms is particularly relevant. Nevertheless, the strength of the incentive provided by the market for managerial labour in SOCs should not be overstated. The 'payoff in terms of higher future potential earnings may not necessarily outweigh the benefit of non pecuniary rewards currently enjoyed, in which case the impact of the managerial labour market will be reduced significantly. Quite possibly this could occur to the point where it exerts little or no influence. Other factors also suggest that the impact of the managerial labour market is likely to be easily over-emphasized. Despite a commitment to 'letting the managers manage', the actual degree of independence given to management will have a major bearing on the influence of the managerial labour market's role in inducing e·fficient behaviour. If management is stifled by political interference, the effectiveness of the managerial labour market is likely to be curtailed significantly. Further, given the degree of difficulty inherent in assessing accurately the performance of management of SOCs, eg lack of the sharemarket, the worth of the managerial labour market is likely to be significantly diminished. Monitoring by Debt Holders Like holders of equity, debt holders have a vested interest in ensuring efficient managerial performance. Lenders recognise that conflict of interest may arise between themselves and shareholders in the use of debt after it is issued. Consequently, lenders generate additional information on the performance of management teams and impose costs on under-performing teams by raising the cost of debt finance available. In short, the interests of debt holders provide a significant incentive for management to perform in the interests of shareholders. While the interest of lenders is no less significant for funds lent to SOCs, the existence of an explicit or implicit government guarantee reduces substantially the risk associated with those funds. There is as a consequence, significantly less incentive to monitor the performance of SOCs by lenders. Whereas the State Owned Corporations Act, 1988 sets out specifically that the 'obligations' of a SOC are not guaranteed by the NSW government (s.16) , it is somewhat inconceivable that the government would allow a SOC, particularly one supplying essential services such as water, to go 'broke' as such. Seemingly, the only way such a policy is believable would be if the government in fact allowed a SOC to go 'bankrupt'. Either way, the monitoring of SOCs by lenders is unlikely to be anywhere near as rigourous as that for similar private sector firms. The Threat of Bankruptcy Perhaps the ultimate sanction on managerial ineptitude and inefficiency, bankruptcy sets an upper limit on the amount of value which can be lost through unsatisfactory management performance. The effect of bankruptcy on managerial worth is likely to be disastrous. As was noted above however, the possibility of bankruptcy is either non existent or extremely unlikely in the case of SOCs. As long as the government continues to fund SOC losses, managerial agency problems are likely to be accentuated. Competitive Neutrality Competitive neutrality, incorporating a 'level playing field' in both input and output markets, is advanced as a major reason for reducing managerial agency problems. The suggestion that competition in product markets is significant in controlling managerial agency problems is particularly significant given the monopolistic environment in which many GBEs, such as those in the water industry, currently operate. The reasoning behind such a contention is intuitively simple. In a competitive environment, the firm that produces at least cost given the required return, is more likely to survive. Inability to produce at costs similar if not lower than competitors costs because of managerial slack will almost always lead to lower market share, reduced earnings and ultimately, the possibility of bankruptcy. Clearly, this suggests that competition in product markets is a significant constraint on managerial agency problems. 26

WATER October 1990

While the above view seems to be intuitively appealing and is accepted as such (see Jennings and Begg, 1'988, p31), it can overemphasize the significance of competitive markets. In reality, managerial discretion may persist given costly enforcement and monitoring, notwithstanding the existence of competition in the product markets. Rather, it has to be shown that monopoly power makes the imperfections in other management controls less efficient (see Strong and Waterson, 1987, p33). The discussion of the principal-agent problem above should make clear that the inefficiencies associated with GBEs are not new, and similarly, corporatisation is unlikely to completely solve the 'problem' of GBE performance.

CONCLUSION The nature of GBEs/SOCs is such that they pose a 'problem' which is impossible to solve unambiguously. All solutions must accommodate the principal-agent problem, and are likely to be severely limited by past inefficiencies. Of course, such a statement presupposes that a 'problem' exists. In reality, the variety of functions undertaken by GBEs and the inherent difficulty of measuring the adequacy of their performance ensures that the 'problem' of GBEs, and solutions to it are difficult if not impossible to define. The experience of New Zealand suggests that corporatisation can have significant effects on the operation of GBEs (see Steering Committee, 1989, p7-8). Nevertheless, even given a commitment to pursue corporatisation vigorously, gains in Australia are limited by the nature of State/Commonwealth relations and the sustainability of any gains achieved.

REFERENCES Abelson, P. (ed) , (1987), Privatisation An Australian Perspective, Australian Professional Publications, Sydney. AWRC Planning Committee Specialist Working Group, Financial and Cost Recovery Policies/ Water Industry, April 1987 (confidential), Intragency Performance Comparisons, March 1988 (confidential) Newcastle, Australia. Ball, Dr. Ian (1988), Definition of the Reporting Entry, mono 8 AARF Melbourne. Berle, A. and Means, C. (1967), The Modern Corporation and Private Property, Harcourt, Brace and World Inc., New York. Boland, J. (1988), Some Experiences with Rate of Return•as a Performance Indicator in the United States, U.W.P.C. Sydney September. Coase, R. (1937), "The Nature of the Firm", in Stigler, G. and K. Bowlding, (eds), Readings in Price Theory, George Allen and Unwin Ltd ., London at p. 331. Department of Accounting and Financial Management, University of New England (1988) Australian Water Authorities, Fi1fancial Guidelines and Performance Measures, Report 2 Vol. 2, April, Armidale. Department of Environment (1974), The Water Services: Economic and Financial Policies, 2nd Report to the Secretary of State for the Environment, Her Majesty London. Fama, E. (1980), "Agency Problems and the Theory of the Firm", Journal of Political Economy, vol. 88, no. 21, p. 388-407. Gallagher, Dr. D. and Watson, Ms G. (Sept. 1988) Overview; Basic Concepts, Capital Valuation, Performance and Assessment in Asset Management for the Water Industry Procedures and Practices, Kingsford. Guesnerie, R. and Laffont, J-J. (1984), "The Government Control of Public Firms and the Economics of Incomplete Information: An Introduction", in Pestieau , P. and M. Marchand (eds), The Performance of Public Enterprises, NorthHolland , Amsterdam at p. 159. Howitt, R. and Vaux, H.J. (1990), "Water Trading and Efficiency Criteria in California" presented at Water Allocation and Transfer Systems in a Maturing Water Economy, Armidale N.S.W. July. Jennings, S. and Begg, S. (1988) , State Owned Enterprise Policy: Issues in Ownership and Regulation, New Zealand Business Roundtable. Jensen, M. and Meckling, W. (1976), "Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure", Journal of Financial Economics, vol. 3, pp. 305-60. Kerr, Jean H.G. (1989), The Concept of Equity in Financial Accounting, mono 9 AARF Melbourne. Key Strategies and Techniques to Maximise Public Sector Performance Seminar (1990) - Menzies Hotel, Sydney 13- 14 June. Miller, M. M. and Islam, M. (1988), The Definition and Recognition of Assets, mono 7 AARF Melbourne. Muskin, S. J. (ed) (1972), Public Prices for Public Products, The Valia Institute, Washington . OECD (1989), Economic Instruments for Environmental Protection. Officer, R.R. (1989), Financial Targeting for Public Enterprise: The Criterion of a Rate of Return to Capital. Graduate School of Management, Melbourne University, May. Paterson, Dr. J. (1984), Chairman Water Management Audit Task-force (unpublished) Aust. Porter, M .G. (1982), Private Resource Development and Public Utilities - Some Hazards of Sleeping with Elephants, Discussion Paper No. 24, November, Monash University, Victoria. Rees, R . (1985), "The Theory of Principal and Agent: Part 1", Bulletin of Economic Research, vol. 37, no. 1, p.3-26.

continued on page 30

EXECUTIVE REMUNERATION IN THE NINETIES: MAJOR ISSUES AND TRENDS by G. L. O'NEILL and R. R. CLARK ABSTRACT This paper discusses the factors which will determine the levels and types of remuneration built into the packages offered to senior executives in Australia in the coming years. These factors include the effects of present and possible future forms of taxation, capital accumulation for superannuation, social and political scrutiny and links with performance. Executive remuneration strategies must address the aims and objectives of the organisations and be designed so that an individual's compensation, andÂˇ incentive, is dependent on achievement of those objectives. The next decade will see many changes.

Graham O'Neill is Director Remuneration and Human Resource Consulting Services for The Wyatt Company, specialising in executive remuneration planning and design and consulting on strategic human resource issues. He is a Member of the Australian Psychological Society, the American Compensation Association, the Australian Institute of Company Directors and, in 1988, was elected a Fellow of the Institute of Personnel Management. Graham is a frequent commentator on remuneration and human resource issues and a regular contributor to professional journals on these and related topics.

INTRODUCTION The primary objective of this article is to identify those issues most likely to have a direct impact on determining executive remuneration trends in this decade. The focus is with remuneration paid to senior executives. It is this level of management which directs and controls the resources of each individual enterprise; consequently, the decisions made by these men and women have a direct and far-reaching impact on the success or otherwise of their respective organisations. As a consequence of their role and its impact, executives are paid differently from other managers and salaried and wages employees. These differences are not just in the relative amounts paid but also in the way that they are paid. Bonuses, incentive payments, share schemes and a range of other cash and non-cash benefits are commonly available to people at this level. Another significant aspect of executive remuneration is its socioeconomic impact on the broader community. Australia, as the most recently settled of the developed nations, has only a very limited history of accumulated personal and family wealth compared with Europe, the United States and the United Kingdom. In general, wealth - as it exists for the managerial and professional groups in Australia - is derived from salary, cash and non-cash benefits and ultimately superannuation. Salary and benefits (eg motor vehicles, housing loans, investment loans) are used to provide the cash flow which enables executives to maintain their respective life styles. Superannuation is the prime means for accumulating deferred wealth which is used to create sufficient cash flow to enable the executives life style to be sustained into retirement: this has become increasingly important as the retiring age moves back from age 65 to the mid fifties and also as younger executives opt out of corporate life and choose alternative careers. As a result, there is a growing awareness within organisations that part of the overall remuneration strategy needs to provide wealth creation opportunities for executives - not only as a reward mechanism but as a means of removing the burden of individual finance planning from the executive who also faces onerous job demands. In predicting executive remuneration trends for the 1990s, it is impossible to escape the constant reminder of the profound changes taking place across Europe, the United States and Asia. With the impending trade unification of Europe in 1992, recognition of the need for regional co-operation in the vastly populated Asia-Pacific area and Japanese and American influences on world trade and business, we are in the midst of increasing globalisation of the world economy which will have an impact upon demand for senior executives and thus executive remuneration.

MAJOR INFLUENCES ON EXECUTIVE REMUNERATION Four issues have been identified as significant influences on executive remuneration for 1990s. These are - Taxation, Executive Wealth Creation, Social and Political Scrutiny and the Link with Performance. Footnote: This article is a synopsis of a chapter to appear in a soon-to-be published book: O'Neill, G (Ed) Corporate Remuneration in the Nineties: Strategies for Decision Makers: Longmans Professional Publishing, 1990

WATER October 1990

Ron Clark is the principal of Consulting Laboratory Pty Ltd and the Human Resource Consortium. Ron is a psychologist by profession and began his career in education and clinical psychology before moving to industry in both line and personnel management roles. His management consultancy experience began in 1970 and since then he has consulted to private and public sector organisations on human resource management matters with an emphasis on human resource strategy, organisational analysis and review, remuneration management and job evaluation.

Taxation The Fringe Benefit Taxation Legislation (FBT) introduced into Australia in late 1986 provided ~ watershed for salaried remuneration in general. In the decade or so before the legislation there was a growing movement towards a 'cafeteria' approach to remuneration. This allowed executives to construct total remuneration packages to suit their individual lifestyles and represented significant monetary advantage. Whilst all components of remuneration were taxable, in practice, the administration of existing tax laws largely failed to collect levies on items such as motor vehicles and other cash allowances. Thus, in many instances executives were able to order their remuneration affairs to maximise available cash and minimise Pay-as-you-earn (PAYE) taxation liability. Although the immediate impact of FBT was to halt many of these practices, it soon became evident that so long as the FBT rate was lower than the PAYE rates, significant benefits could still be made by taking remuneration in the form of fringe benefits rather than as taxable salary. An added advantage was that, under the new legislation, taking significant amounts of remuneration in fringe benefits became legitimate. Prior to FBT the relationship of many tax-claimed activities to work-related or income-generating functions were dubious at best. As a result there has been a growing move within both the private and public sectors to introduce a 'total cost to company' approach to executive remuneration . This allows a greater degree of flexibility in the design of an executive's remuneration package to more directly suit individual needs. Two important points to note here are that firstly, the advantage operates in favour of the taxpayer only as long as there are appropriate differences in the respective PAYE, corporate and FBT tax rates; secondly, the existing system operates only in favour of higher income earners, that is those whose total package - were it all taken in salary - puts them significantly above the top PAYE rate. Many western economies have some form of executive packaging in place, but none appear to provide such direct and legitimate taxation benefits to high income earners as those which currently exist in Australia. It is highly likely that within the next few years

the Federal Government, irrespective of the party in power, will move to close the current arbitrage between the company and PAYE tax rates. There remains a strong perception that the current PAYE tax structure is too high and is subject to an inevitable 'bracket creep'. Some countries have introduced limited tax rates supported by a consumption or value-added tax. For example, New Zealand operates with two PAYE tax scales (280Jo and 330Jo) and has a Goods and Service Tax of 12.5%. Broadly similar systems work in the United Kingdom and the United States. The issue of a consumption tax in Australia is still being debated. There remain sufficient indications, however, that our overall tax structure may be reviewed, particularly after the next federal election, with a consumption tax being more favourably regarded. Executive Wealth Creation Mention has been made previously of the impact on executive remuneration of wealth creation within Australia. Notwithstanding the previous comments regarding the packaging of executive remuneration, there has always been a practical need to maintain a sufficient cash component (ie PAYE salary) to effectively service the superannuation requirements of executives. However, recent Âˇ (and continuing) changes to the legislation governing superannuation, together with the imposition of Reasonable Benefit Limitations (RBLs), has not only complicated the design of executive remuneration packages but also put a clear limit on the extent to which superannuation can effectively be used as a wealth creation mechanism . In spite of the limitations of superannuation, organisations are faced with the continuing need to provide some means of capital accumulation for executives if they are to attract and retain competent people. We are already seeing significant movement by companies to create wealth outside the traditional avenue of the superannuation package - executive share schemes being a prime example. Despite those who point gloomily to the October 1987 stock market crash, share plans are generally perceived by executives as desirable and contributing to longer term capital accumulation. Apart from wealth considerations, share schemes also carry with them a certain status value which by itself, may well have a positive impact on executive morale. It is clear that this is one approach to remuneration which will increase in prevalence in the coming decade. Irrespective of what happens in the taxation arena, it is predicted that more and more organisations will move to introducing wealth creation opportunities for executives in this decade. The major design considerations for organisations are to ensure that such plans are within the concept of total remuneration cost to company (which allows packaging flexibility within a defined total cost), and that they provide for an ease of administration and are clearly within current taxation legislation. Social and Political Scrutiny There has always been a degree of public commentary about executive remuneration. Media reports regarding the amounts paid and the so called 'perks' often attract attention and result in media stories ranging from quite inaccurate to balanced assessments. Given then executives are most usually paid between six and ten times average weekly earnings, such scrutiny is to be expected. The first formal step in monitoring the amounts paid and annual movements in remuneration for executives came with the 1986 amendment to the Companies Code. This required salaries at specified levels paid to executives and Directors of listed companies to be reported in the Annual Report to shareholders. More recently, the Federal Government has on several occasions warned that it may act to control management salaries if they continue to increase at significantly higher rates than award governed wages. Although there is some pressure to control executive remuneration, there is consistent data available to demonstrate that Australian managers, especially senior executives, are paid considerably less than their overseas counterparts. Figure l is based on the 1989 Worldwide Total Remuneration Survey produced by the consulting company Towers Perrin Forster & Crosby and compares the salary paid to Australian Chief Executives with the salary paid to Chief Executives of similar sized companies in other countries. Overall, Australian Chief Executives rank ahead of only Korea and Singapore and are less than half of the average US$543 000 per

Argentina

238

Australia

208 240

Belgium

306

Brazil

360

Canada

284 287

France Germany

359

Hong Kong

232

Italy

352

Japan Korea Mexico Netherlands Singapore Spain Sweden

130 208 220 184 252 223 307

Switzerland United Kingdom

228 543

United States Venezuela

240

Source : 1989 Executive Pay Update, TPF & C

Fig. 1 -

Comparison of CEO Remuneration (in US $000)

annum paid to Chief Executives in the United States. Even a comparison with countries which have similar sized economies (eg Netherlands, Sweden and Belgium) shows Australian executives to be disadvantaged. We believe that comparisons of the remuneration of Australian executives with their overseas counterparts, no matter how unfavourable for local executives, will not be effective in influencing any general upswing in senior remuneration levels. Apart from the uniquely Australian "tall-poppy syndrome", recent corporate performances, the general economic environment, our isolation from the northern hemisphere and overall market size are all factors which militate against executive remuneration in Australia increasing to the American and European levels. The Link With Performance In March 1990 some 300 leading representatives from the corporate sector met under the auspices of the Business Council of Australia to discuss the level of Australia's foreign debt. The National Business Summit on the Foreign Debt, as this meeting became known, pinpointed the critical issues affecting economic performance as a result of Australia's level of debt as being the continuing high inflation rate - nearly twice that of our trading partners - and the fact that nearly 200Jo of export income is required to service this debt. Apart from broad-based economic strategies designed to lift international competitiveness, the National Business Summit focused on the 'incentive to work'. In summary, it was argued that inflation reduces the incentive to work and increases the incentive to evade and avoid taxation. The heavy reliance on income tax especially where the top marginal rate cuts in at less than twice average weekly earnings - and an ad hoc approach to indirect tax, can only be overcome by a tax system of greater integrity specifically a tax structure which encourages savings and investment rather than tax avoidance and evasion.

DEVEWPING AN EFFECTIVE REMUNERATION STRATEGY The Economic Environment In the lead-up to Australia's current economic situation executive remuneration has been buffeted by the same economic and market forces which have affected overall corporate performance. These include a sustained period of high inflation during turbulent and difficult economic times, together with constantly changing WATER October 1990

taxation, superannuation and financial planning rules. Overall, they have all combined to create a very complex and elusive planning environment for executive remuneration. Income Differentiation The four major issues identified as influencing executive remuneration planning for the corning decade - taxation, executive wealth creation, social and policy scrutiny and the link with performance have been earlier outlined. In addition an increasing differentiation between wages and salaried employees and a rapidly growing acceptance of pay comparisons based upon industry sector and job function are increasingly evident. It is against this background that decisions about executive remuneration are being made. What is missing is a strategic approach to determining executive remuneration which requires remuneration policy to be consistent with the objectives of the organisation - both private and public - to take account of general domestic and international trends for executive remuneration. By definition, this will require a demonstrably flexible method of remuneration planning, and one which will not be unnecessarily constrained by salary administration principles accepted as truisms in the past but which may well be the shibboleths of the nineteen nineties. · Clearly, there are as many permutations and combinations of executive remuneration packages as there are companies and executives. The answer is not to be found in a search for 'the one best way' of delivering remuneration; the answer will be found in developing an approach which permits each organisation to create its own remuneration future, rather than being continually responsive to the internal and external demands made upon it. There is nothing new in saying that the answer is to develop a clearly articulated remuneration strategy. What is new is the direction and focus of strategies needed for the nineties. To meet the challenge of this decade, a strategy has to be directed towards the outside world, not the internal 'comfort zone' of the organisation. The executive remuneration strategy must address the aims and objectives of the organisation and be designed such that an individual executives' compensation is clearly dependent upon the achievement of co~porate objectives. Whilst this is not a new idea, it does require innovative approaches. Future Challenges and Issues There is a need to focus more on the future issues and challenges to be met in designing a strategically based and defensible remuneration policy. The solutions will vary, and rarely, if at all, will be the same for any two organisations. The issues that they need to address will have elements in common. These issues will include: • market positioning and how total rewards relate to the different environments and markets in which the organisation operates; • how reward and incentives are linked to the organisation's performance; • what will be the mix between short and long term incentives; and, . • how the balance between individual and team performance is achieved. In essence, these are the challenges for this decade.

G. WATSON and S. WHELAN continued from page 26 Rees, R. (1988), "Inefficiency, Public Enterprise and Privatisation", European Economic Review, vol. 32, pp. 422-31. Rees, R. (1984), Public Sector Economics, 2nd edition, Weidenfeld and Nicolson, London . Ross, S. (1973), "The Economic Theory of Agency: The Principal's Problem", American Economic Review, vol. 63, no. 2, pp.134-39. Singh, N. (1985), "Monitoring and Hierarchies; The Marginal Value of Information in a Principal-Agent Model", Journal of Political Economy, vol. 93 , pp.599-609. State Owned Co-operations Act 1988 (N.S.W.) State Owned Enterprise Act 1986 (N.Z.) Suttcliff, P. (1985), Financial Reporting in the Public Sector: A Framework for Analysis and Identification of Issues, AARF, Melbourne. Steering Committee on Government Trading Enterprises, (1988), A Policy Framework for Improving the Performance of Government Trading Enterprises, Government Printer, NSW, Sydney.

WATER October 1990

N. MORRIS and N. OWEN continued from page 17 The UK has focused on water standards more than most other countries in Europe. This is partly because the recent privatisation of the industry has led to a fundamental re-evaluation of tariff structures and of capital expenditure programs. The agreed 'asset management plans' of the newly privatised companies contain large capital expenditures on water treatment plants, and the UK has made a formal commitment to cleaning up its drinking water by 1995. A particular lesson for the Australian water industry is the effects of non-cost-reflective charges on behaviour as environmental standards are imposed. Effluent charges are determined by a complex formula which only approximates to cost; in many cases the choice made by companies whether to carry out pre-treatment is distorted by this, leading to a socially less than optimal outcome. The UK is learning, the hard way, the price of setting tariffs on the basis of inadequate analysis.

CONCWSIONS In this article we have tried to distil some of the issues we in London Economics have faced over the last four years in attempting to apply economic principles to environmental problems in the European context. These conclusions from this work are partly economic, partly political. It is worth summarising them: • Environmental policies impose large costs, usually much larger than is {ealised when they are proposed. There is a real trade-off between them and economic performance. The role of economic analysis is to choose the right compromise; • Economic modelling is vital to assessing the efficiency of pollution control policies . This must be done against a background of a proper cost-benefit methodology, otherwise very expensive policies yielding minuscule benefits may emerge; • It is easy to get side-tracked into controlling pollutants which do little damage. This then detracts from efforts to tackle real problems; • Unless there is broad acceptance of policies they will not be implemented, whatever a federal authority rules. Further, policies need to be adopted by all states to avoid unfair competitive advantage emerging; , • Command-and-control systems implemented by bureaucratic authorities are often ineffective and clumsy. Well-designed market-oriented policies can deliver the same environmental outcome at lower cost; or they can deliver a superior outcome at the same cost; • Local conditions are very important in determining both the targets and the methods of implementation. In some cases for example where water flow through aquifers can take decades - they can rule out groups of policies; • Water, sewage and effluent tariffs are very important in determining behaviour. Failure to set these tariffs at cost-reflective levels can lead to socially less than optimal outcomes.

REFERENCES Haigh, N. (1989) "EEC Environmental Policy & Britain", (1989) 2nd Revised Edition, Nigel Haigh, Longmans, London. London Economics (1990, April) "Policy Responses to the Nitrate Problem". London Economics (1990, June) "Acid Rain and Market Mechanisms", June 1990. ~dDra~ · OECD (1989) "Economic Instruments for Environmental Protection" Tietenberg, T. (1988) "Environmental and Natural Resource Economics", 1988. 2nd Edition. Scott, Foresman & Co., London.

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FACTORS AFFECTING BACTERIAL NUMBERS IN DISTRIBUTION SYSTEM by K. POWER and L. A. NAGY

ABSTRACT This literature review outlines the main factors which influence bacterial numbers within distribution systems. A reduction in bacterial numbers may be caused by the level of treatment of the raw water disinfection practices or other system management procedures. An increase in bacterial numbers may be caused_ by the organic and microbial load of the water, the presence of sediments and biofilms, system characteristics (service reservoirs, pipe age and length), or other physical-chemical parameters.

Kaye Power, B.Sc. (Hons) was the project officer on the Urban Water Research Association bacterial regrowth in water distribution systems study. She is currently engaged in a Ph.D. studies at the University of N.S. W. on the same topic.

INTRODUCTION . The microbiological biota of potable water consist of microorganisms originally introduced from the raw water source, theri subsequently modified in density and diversity by treatment processes, and selective pressures within the dis_tributio~ system (Geldreich, 1987). The modification of bacterial density most frequently encountered is an increase, this increase has been ter~ed regrowth. Such regrowth can result from the recovery of orgam~m from injury, (such that they are later capable of growth on routme sampling media), germination of spores formed by shock exposure to disinfecting agents such as chlorine, recontamination ~ia reservoirs, resuspension of sediments which accumulate bacteria, and the detachment of microorganisms from biofilms, sediments . and larger microbial aggregates. Regrowth of bacteria within any water distribution system is of concern to both water and health authorities. The presence of environmental coliforms either surviving or growing within the distribution system undermines the validity of the data from routine sampling programs which were originally inte!lded t? indicate contamination by faecal matter and the possible existence of pathogens. The presence of environmental coliforms within a distribution system not directly derived from a contamination event can make compliance with water quality guidelines extremely difficult for water authorities, often causing annual results to fall into the non-compliance category. High heterotrophic plate count (HPC) numbers can P?Se a secondary problem by inhibiting or masking faecal coliform detection. Inhibition can result in reduced colony sheen of Escherichia coli bacteria on Endo medium (Burlingame et al, 1984), production of bacteriocin-like substances by HPC bacteria (Means and Olson, 1981) or the growth of high numbers of coliforI? antagonists (LeChevallier and McFeters, 1985a & b). Due to this potential interference it is generally considered that the lev~l of H~C bacteria should be kept below 500 colony formmg umts (CFU)/lO0mL (Geldreich et al., 1972; Geldreich, 1986a). A further important reason for reducing HPC bacteria, environmental coliforms, and regrowths is the ability of many organisms found in distribution systems to behave as opportunistic pathogens. Burke et al., (1984a & b) established a link between the increase in Aeromonas sp. in drinking water and Aeromonasassociated gastroenteritis in individuals using that water, in Perth, Western Australia. Much work has also been done on the growth of Legionella pneumophila in water environments including water distribution systems (Dutka et al., 1984; Hsu et al., 1984: Stout et al., 1985). If it is possible for Aeromonas ~nd_ Leg_ionella to survive and in some cases to multiply in water distnbution systems, then it may be possible for other pathogenic or potentially pathogenic bacteria to behave in a similar manner: Generally, factors which influence bacterial numbers ~ithin distribution systems can be divided into those which result m an overall decrease and those which result in an overall increase in bacterial levels. These factors, together with some methods of control are discussed below.

FACTORS DECREASING BACTERIAL NUMBERS A reduction in bacterial numbers within a distribution system is caused by factors such as the level of treatment of the raw water 32 WATER October 1990

Laslo A. Nagy, B.Sc. (Hons) and Ph.D., is a director of Aquatech Pty. Ltd. He has published several papers in the fields of Microbiology, and water management. For the past ten years he has worked on various aspects of drinking water quality and microbial regrowth in drinking water distribution systems.

disinfection practices and system management procedures (eg air â&#x20AC;˘ scouring, swabbing and maintenance).

Treatment The treatment of raw water is designed to remove or at least reduce the numbers of microorganisms, o'rganic matter and turbidity entering a distribution system. The processes used by various water authorities aim to produce biologically stable water which will not support the growth of microorganisms to any significant e~tent. In this respect water authorities have control over the quality of water they introduce into their system by the extent of treatment they carry out. The most important step in treatment is the disinfection process (Hutchinson and Ridgway, 1977); Waters which have been subjected to full clarification are more easily disinfected and possess higher overall quality than waters which have not. Disinfection Since the early 1900s the most widely used disinfectant has been chlorine, due to its rapid inactivation of most pathogenic organisms (Wolfe et al., 1984). Free chlorine produces lethal lesions in the cell membrane (Hass and Engelbrecht, 1980) and causes irreparable damage to essential metabolic functions. Maintenance of a chlorine residual along the length of a distribution pipe controls bacterial numbers by deactivating any remaining or reintroduced cells, (such as cells which periodically 'slough off from pipe biofilms), while the loss of a chlorine residual allows recovery of bacteria which have been partially injured (LeChevallier and McFeters, 1985a). The formation of trihalomethanes (THMs)(which are suspected carcinogens), by the reaction between chlorine and organics in water has resulted in the increased use of alternative methods of disinfection such as chloramination. Both disinfection methods cause cellular destruction, but chloramination results in lower levels of THMs. Chloramines generally require longer contact times and higher concentrations to achieve the same biocidal effects as chlorine, but they are maintained for longer periods of time within the distribution system (Wolfe et al., 1984). Several field experiences have indicated the effectiveness of chloramination under certain conditions such as long distribution systems (D. Cunliffe, personal communication, 1989) but it can be ineffective under other conditions, such as open reservoirs (Means et al., 1986; Fyffe and McNeill, 1989).

Other means of disinfection for drinking water include the use of ozone, iodine, potassium permanganate, silver, UV radiation and chlorine dioxide. Under certain conditions, they have an advantage over chlorination or chloramination (Hutchinson and Ridgway, 1977). System Management Procedures Adequate air scouring, swabbing and maintenance programs within a distribution system will also decrease the level of bacteria present. Regular system maintenance should remove areas of sediment and biofilm build-up as well as associated bacteria. The removal of biofilm and sediment _will reduce the bacterial inoculum which is constantly seeding back into the water. For example, a mains swabbing program carried out by the Water Board (NSW), along with increased chlorine residuals helped to control high coliform levels during an increase in Klebsiel/a numbers (Ireland et al., 1983).

FACTORS INCREASING BACTERIAL NUMBERS An increase in bacterial numbers within a distribution system may be caused by factors such as the organic and microbial load of the raw water, the presence of sediments and biofilms, system . characteristics (service reservoirs, pipe age and length), and physicalchemical parameters such as temperature. Organic load of water The organic load of water has often been implicated as a possible factor in the regrowth of bacteria. More than 90-100 years ago, bacteriologists realised that regrowth depends on the presence of organic and inorganic compounds which serve as an energy source for bacteria (Baylis, 1938; Van der Kooij and Hijnen, 1985). Within the aqueous phase only a small percentage of organic matter is available for utilisation by bacteria, the remaining large macromolecules partition at interfaces. These absorbed molecules provide a conditioning film and a concentrated nutrient source for subsequent biofilm development. Bacteria capable of growth on extremely low concentrations of nutrients have been isolated from drinking water systems. A Pseudomonas aeruginosa strain was able to grow slowly in water containing low levels of amino acids, carbohydrates, carboxylic acids and aeromatic acids (Van der Kooij et al., 1982b) while a fluorescent Pseudomonas has been used to assess the level of assimilable organic carbon (AOC) in drinking water (Van der Kooij et al., 1982a). A Flavobacterium species was shown to utilise low levels of starch while other bacteria appeared to be highly specialised in the utilisation of glycerol and a number of oligo and polysaccharides (Van der Kooij and Hijnen, 1981 & 1983). Aeromonas hydrophila, in contrast, required the addition of low concentrations of glucose to stimulate growth (Van der Kooij et al., 1980). E. coil and other enteric bacteria appear to be capable of growth in fresh water if sufficient nutrients are provided (Hendricks, 1972; Mackay and Ridley, 1983). A bloom of E. coli in Lake Burragorang (Sydney, Australia) was related to an earlier algal bloom which on decay released nutrients into the water (Mackay and Ridley, 1983). A strain of Klebsiel/a pneumoniae was also shown to grow at low concentrations of carbohydrates and amino acids (Van der Kooij, 1988). The apparent ability of E. coli and other coliforms as indicators of recent faecal contamination. Nitrate levels in a drinking water system have been shown to correlate with HPC bacteria, suggesting that nitrate may also play a nutritional role in influencing bacterial regrowth (LeChevallier et al., 1980). Additionally nitrate will act as an energy source for nitrifying bacteria which do not contribute to the standard HPC population, but their biomass may serve as a food source for other heterotrophic bacteria (Van der Kooij, 1988). This problem which is frequently encountered by water authorities using chloramination as their method of disinfection, involves low chlorine residuals and high HPC numbers (Wolfe et al., 1988). The level of organic substances in drinking water will also affect disinfection as a high chlorine demand is created which increases the formation of potentially harmful THMS (Wilcox et al., 1983; Servais et al., 1987). The presence of organic compounds also interferes with the efficiency of chloramines in deactivating bacterial cells (Wolfe et al., 1985b). If excessive chlorine demand is experienced or the bactericidal activity is reduced then it may be difficult to achieve adequate contact times for deactivation of cells and to maintain chlorine residuals throughout the entire distribution system.

Microorganisms will grow in water when sufficient nutrients are present (Van der Kooij et al., 1982a & b) and higher concentrations of available nutrients will result in greater bacterial regrowth, moderated only by the type and diversity of carbon sources available. From work by Van der Kooij et al., (1980 & 1982b) and Van der Kooij and Hijnen (1981) it is obvious that some substances are more easily assimilated than others. large macro-molecules, while unusable in the aqueous phase, become concentrated at surfaces and undergo changes in configuration which allow degradation by bacteria. Consequently organic molecules in drinking water should be reduced as much as possible in order to minimise subsequent biofilm development and bacterial growth. Microbial load of water The microbial diversity and load in raw water may also increase bacterial numbers within a distribution system. The higher the numbers of bacteria present in the raw water at the time of disinfection, the higher the chlorine demand and the numbers of surviving bacteria. Furthermore, bacteria are extremely diverse in their ability to withstand environmental changes and stresses. Different bacterial characteristics afford varying degrees of sensitivity or resistance to disinfectants allowing some to survive treatment more easily than others. Higher levels of chlorine were found to be necessary to injure Yersinia enterocolitica, Salmonella typhimurium and Shigella sp., than E. coli or coliforms (LeChevallier et al., 1985). Bacteria have also demonstrated varying levels of resistance to substances such as quaternary ammonium compounds (Adair et al., 1969), antibiotics (Armstrong et al., 1981 & 1982; Phair et al., 1969) and low concentrations of metals (Singh et al., 1985; Singh and McFeters, 1986). Selective survival of certain organisms during treatment and passage through distribution systems is further highlighted by comparing the microbial biota of raw and treated waters. Ridgway and Olson (1982) compared the chlorine sensitivity of bacteria isolated from two different distribution systems. Bacteria isolated from the chlorinated water in the Irvine, California, system were found to have higher tolerance, to both combined and free forms of chlorine, than those from the unchlorinated Garden Grove system, with some organisms managing to survive a 2 minute exposure to 10mg/L of free chlorine. In a comparison of HPC bacteria in raw water with those in chlorinated water, LeChevallier et al., (1980) found that chlorine appears to select for gram-positive bacteria. After chlorination, their t1umbers in relation to the total (depleted) count were increased by a factor of three. It is presumed that the thicker peptidoglycan layer in the cell wall of gram positive bacteria enables them to survive at higher levels of chlorine. The numbers of pigmented bacteria in the distribution system frequently increases from that found in raw water especially when the water is chlorinated (Maki et al., 1986). Pigmented bacteria can also be found in elevated numbers in circulating and static water supplies (Herman, 1978) Wolfe et al., (1985a), found that a redpigmented species of Flavobacterium, which could survive 60 minutes of exposure to 1.0 mg/L of chloramine, was isolated from a finished water reservoir in Southern California. It may be possible that pigmentation offers increased protection from disinfection. Bacteria coated in exopolysaccharide slime may be more able to survive chlorination, by reducing diffusion of the disinfectant into the cell (Leyva! et al., 1984) Klebsiella spp., which are encapsulated in a slime coat, are frequently responsible for high coliform counts observed in chlorinated systems (Camper et al., 1986; Geldreich and Rice, 1987; Goshko et al., 1983a; Ireland et al., 1983; LeChevallier et al., 1980; Olson and Hanami, 1980; Ptak et al., 1973; Ridgway and Olson, 1982; Seidler et al., 1977). Greater slime production has resulted in certain strains of Ps.aeruginosa becoming more resistant to chlorine (Van der Kooij, 1982b) whereas the inhibition of slime production was shown to increase the susceptibility of cells to chlorine (Seyfield and Fraser, 1980). LeChevallier et al., (1988) also found that a strain of Kl.pneumoniae grown in a low nutrient medium was three times more resistant to chlorine than that grown in a rich medium. Turbidity and sediments Turbidity entering a reticulation system is made up of suspended matter such as clay, silt, finely divided inorganic and organic matter, plankton and other microscopic organisms (APHA, 1975). This turbidity will add to sediments in areas of the distribution system where there are slow flows and dead-ends. Elevated turbidity levels have been associated with increased numbers of microorganisms WATER October 1990

(Hass et al., 1983), and a decrease in chlorination efficiency (LeChevallier et al., 1981). Coliform bacteria have been observed to survive in turbid water chlorinated to provide 0.1 - 0.5 mg/ L free chlorine, for not less than a 30 minute contact period (Geldreich et al., 1972). Electron microscopy work on particles from drinking water indicated that bacteria may be protected from chlorination by their adsorption to suspended matter. Cells surviving chlorination have been seen either embedded within the particles or coated with amorphous material (LeChevallier et al., 1981; Ridgway and Olson, 1981 & 1982). Bacteria attached to granular activated carbon particles have also been found to be highly resistant to disinfection (Camper et al., 1986) and attachment of bacteria to surfaces has been shown to increase the survival of bacteria exposed to disinfectants. Under laboratory conditions, E. coli cells attached to glass beads were shown to be more resistant to chlorination than those in the aqueous phase (Hicks and Row bury, 1986). Entry of bacteria into a distribution system may occur via particulate matter which also enhances protection from chlorination. Ridgway and Olson (1981) calculated that approximately 150 particles/ mL in a particular sample of drinking water had attached bacteria, with 10-100 bacteria per particle or .1500-15000 particle bound bacteria/ mL of drinking water. Detachment of some of these bacteria from the surface of particles may result in apparent increases in bacterial numbers within the distribution system. Bacteria adsorbed to sediment particles can be removed by a reasonable sheer force or by a reduction in electrolyte concentration at which point the organisms are repelled from the surface (Marshall et al., 1971). Areas of sediment accumulation will provide protection and nutrient concentration for bacteria surviving treatment. Subsequent resuspension of such sediment will therefore result in an increase in bacterial numbers within the aqueous phase.

Biofilms The importance of biofilms in distribution systems and their contribution to increases in bacterial numbers is often underestimated. Biofilms consist of microorganisms and extracellular products associated with a substratum (Marshall, 1984). It is the constant removal of this biofilm from the pipe surface back into the aqueous phase which contributes to the deterioration of drinking water quality. A study conducted by LeChevallier et al., (1987) showed that in a New Jersey distribution system the growth of coliform bacteria on pipe surfaces could have been responsible for occurrences of indicator organisms in potable water supplies. Biofilm development consists of 4 main stages. The initial step involves the transport and adsorption of organic molecules to a clean surface. The adsorption of the molecular or conditioning film is believed to occur within the first few minutes of exposure to water (Dexter, 1979), and is essentially instantaneous when compared to other rate processes (Characklis and Cooksey, 1983; Characklis, 1984). The second step involves the movement of bacteria from the passing water towards the surface and subsequent attachment. Ti:ansport or attachment can occur via eddy diffusion (Characklis, 1981), chemotaxis, Brownian motion and electrostatic hydrophobicity, while water movement and gravitation may also act as a transport mechanism. Cells which have been transported to a surface undergo a two stage adhesion process of reversible adhesion followed by irreversible adhesion (Marshall et al., 1971; Marshall, 1985). Once cells have become firmly adhered to a surface and nutrient concentrations are sufficient, growth and further colonisation will occur. The third stage involves continued adhesion of cells from the aqueous phase as well as the growth of cells already attached. primary colonisers of surfaces will rapidly utilise the nutrients present and create conditions favouring the adhesion and growth of other organisms. The final stage of development includes continued growth and accumulation along with the detachment of biofilm. Detachment can be either by shearing, which is the continuous removal of small portions of biofilm, or by sloughing, which refers to a random and massive removal of biofilm (Characklis, 1984). Within the water distribution system the process of biofilm development and detachment continually seeds the water with bacteria, giving generally constant and occasionally high bacterial Âˇcounts.

Total prevention of biofilm development is not feasible, and the minimisation of biofilm accumulation exists as the best available option. The most common and popular means of biofilm control is by chemical biocides such as chlorine and chloramines. Chlorine will react with a biofilm in a three step process. Initially chlorine species enter the pipe segment and react with the chlorine demand components (viable cells and chemical compounds) in the bulk water. The chlorine species are then transported through the bulk water to the water-biofilm interface, where chlorine species diffuse and react within the biofilm releasing soluble and particulate matter into the bulk water (Safe Drinking Water Committee, 1982). Chlorine acts to destroy cells and exopolysaccharides as well as to remove biofilms from the surface. It reacts with various organic and reduced organic components within the biofilm, disrupts cellular material and to some extent deactivates cells within the biofilm. The greatest apparent effect is the reaction with extracellular polymers, which are responsible for the physical integrity of the biofilm (Characklis and Dydek, 1976). Those biofilms rich in polysaccharide material will exhibit a more rapid and ultimately greater chlorine demand. Low levels of chlorination are not sufficient to prevent the attachment of surviving viable cells and subsequent biofilm development. There is a need for continuous chlorination at high levels, which is not practical in water distribution systems. Consequently, other methods of biofilm and sediment build up control, such as air scouring and mechanical scraping of water pipes should be used in conjunction with chlorination. System characteristics Reservoirs which are uncovered or poorly designed and maintained contribute to the Microbialogical deterioration of water quality and provide a point of entry for nutrients and foreign matter, such as bird excrement and dust (Geldreich et al., 1972). Monitoring programs conducted on open reservoirs by the Metropolitan Water District of Southern California, the Seattle Water Department (Washington) and the Hackensack Water Company (New Jersey) indicated that uncovered distribution reservoirs exists as a weak link in the protection of potable water supplies (Committee Report, 1983). Open reservoirs can contribute substantial amounts of algae and other suspended matter to finished water reservoirs. Continued exposure to sunlight within these reservoirs stimulates algal growth and subsequent chlorination results in the release of nutrients for bacterial use (Hutchinson and Ridgway, 1977; Geldreich et al, 1980). The building of storage tanks with redwood lining in the United States resulted in a large proportion of them producing coliform counts in the water well above federal guidelines. This was believed to be due to soluble nutrients leaching out of the wood, stimulating biofilm development, and Klebsiella colonising the wood surface deep within the pores (Seidler et al., 1977). However the original source of Klebsiel/a was subsequently found to be the redwood which had been infected at an early stage of the tree's development, (Geldreich, 1986b). Other reservoir coatings and materials used in plumbing have also been shown to support bacterial growth (Burman and Colbourne, 1977; Ellgas and Lee, 1980; Reasoner, 1983).

Organisms introduced into service reservoirs with treated water utilise accumulated nutrients found in sediments and wall growths. Significantly higher numbers of bacteria have been recorded in the outlet water from reservoirs than in the inlet water (Silverman et al., 1983). The problem of nutrient accumulation and subsequent growth can be accentuated by inadequate reservoir cleaning and maintenance. In theory, a properly designed and maintained reservoir should improve the quality of water stored in it, by allowing further settling out of particulate matter, continued breakdown of organic matter and increased chlorine contact times. To achieve this, reconstruction or replacement of some service reservoirs may be necessary, while future reservoirs should be designed to improve water quality. Existing reservoirs should undergo appropriate cleaning and monitoring programs. Areas exist within distributions systems which aid bacterial survival and are open to colonisation and biofilm development. Dead-end mains are areas of low flow rates, high sediment accumulation and low chlorine residuals. Sediment in these areas supplies nutrients for bacterial growth and provides protection from chlorine residuals (Geldreichet al., 1972; Hutchinson and Ridgway, 1977; O'Connor et al., 1975; Reasoner, 1983). Organisms introduced into service reservoirs with treated water utilised accumulated nutrients found in sediments and wall growths. WATER October 1990

Significantly higher numbers of bacteria have been recorded in the outlet water from reservoirs that in the inlet water (Silverman et al., 1983). The problem of nutrient ac~umulation and subseque1w growth can be accentuated by inadequate reservoir cleaning and maintenance. In theory, a properly designed and maintained reservoir should improve the quality of water stored in it, by allowing further settling out of particulate matter, continued breakdown or organic matter and increased chlorine contact times. To achieve this, reconstruction or replacement of some service resevoirs may be necessary, while future reservoirs should be designed to improve water quality. Existing reservoirs should undergo appropriate cleaning and monitoring programs. Areas exist within distributions systems which aid bacterial survival and are open colonisation and biolifm development. Deadend mains are areas of low flow rates, high sediment accumulation and low chlorine residuals. Sediment in these areas supplies nutrients for bacteria growth and provides protection from chlorine residuals (Geldreich et al., 1972; Hutchinson and Ridgway, 1977; O'Connor et al., 1975; Reasoner, 1983). Older, longer pipes are more likely to contain areas of biofilm development than shorter, new pipes, McCoy and Olson (1986) reported that bacterial numbers increased with the distance travelled .along a pipe, while Bourbigot et al., (1984) found significantly more regrowth in older pipes than in new pipes. Levels of corrosion and tubercules increase with pipe age, (Geldreich, 1986b) and previous work has shown sheathed iron bacteria and nitrate-reducing heterotrophs in tubercules (Kelly and Olson, 1982; Ridgway et al., 1981; Tuovinen and Hsu, 1982) . The edges of water-main encrustations provide an area of high nutrient concentrations (Allen et al., 1979 & 1980). Longer pipes usually contain a higher number of dead-end mains, and areas of slow flow. Furthermore, longer pipes require higher initial chlorine dosages to produce adequate chlorine residuals throughout the system. This practice often prompts chlorine related taste and odour complaints from consumers closer to the initial point of treatment. Fluctuations in flow rates will affect bacterial numbers. Changes in water demand and subsequent flow rates occur daily (with less water used in the late evening), and seasonally (with higher demands in the summer). Any sampling system set up to measure bacterial numbers will be affected by these fluctuations in flow rates (Nagy, 1984). Sudden high water use (such as during a major city fire), will unsettle sediment, release organisms, shear off wall growth and result in unusually high bacterial counts. High flow rates decrease sedimentation, reduce chlorine contact time and result in the shearing of biofilm from pipe walls (Geldreich, 1986b). Organisms re-entering the aqueous phase at the ends of long pipelines are less likely to be exposed to sufficiently high chlorine residuals. Physical-chemical parameters

The temperature of water within a distribution system undergoes variation, both daily and seasonally. A study by Hass et al., (1983) on microbial alterations in water distribution systems and their relationship to physical chemical characteristics, concluded that a positive correlation exists between temperature and microbial numbers. Over a year period water temperatures within Sydney's distribution system ranged from 13 • C to 23 • C. During summer the numbers of coliforms are usually elevated, but these decease when water temperatures drop below 17°C (Ireland et al., 1983). In systems undergoing relatively small fluctuations in temperature, no major change in bacterial numbers was observed (Goshko et al., 1983b). The destruction of microorganisms by disinfectants is a chemical reaction and accordingly the rate is affected by temperature (Hutchinson and Ridgway, 1977). For example, chlorine residuals are less effective on bacterial cells during winter months (Nagy, 1984). Furthermore in winter, when temperatures are low, heterotrophic bacterial activity is minimal and, as such, nutrients will accumulate in most drinking water systems (Geldreich, 1980 & 1986b). There is a tendency during periods of bacterial inactivity to reduce chlorine dosages but at the onset of the higher temperatures this allows rapid growth producing the high HPC and coliform numbers experienced during summer. This rapid growth also encourages cellular detachment from surfaces, and adds to the numbers of bacteria already present in the water. Consequently, high chlorine residuals need to be maintained during the colder months in order to reduce biofilm development and nutrient accumulation as well as to continue the inactivation of any bacteria capable of future growth. 36

WATER October 1990

CONCLUSION Microorganisms within drinking water distribution systems can originate from organisms in the raw water and organisms introduced during distribution (eg via service reservoirs). Microorganisms from both categories may survive and contribute to regrowth. Continuing from the introduction of these organisms, regrowth may result from the recovery of organisms from injury, germination of spores formed by shock chlorination, recontamination, via service reservoirs, resuspension of sediments, detachment of microorganisms from biofilms, sediments and larger microbial aggregates. The most effective methods of control of bacteria regrowth include: • adequate treatment of raw water, to reduce the level of turbidity and organic matter entering the system and hence sediment accumulation along with biofilm development. • full treatment to reduce the microbial load of the water and enhance the efficiency of the disinfection process. • maintenance of a disinfectant residual throughout the system to help destroy any cells reintroduced or released back into the aqueous phase as well as to hinder bacterial recovery. • adequate flushing programs to reduce sediment and biofilm build up. • continuing maintenance and cleaning, including covering, of reticulation reservoirs, to reduce the reintroduction of bacteria and remove accumulated sediments. The aim of any water authority is to provide treatment and remedial procedures to water which will lead to an ultimate decrease in bacterial numbers as the water moves through the system.

ACKNOWLEDGMENTS This review was part of a study on bacterial regrowth within water distribution systems conducted at the Water Board's (Sydney) Scientific Services Laboratory and funded by the Urban Water Research Association of Australia.

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