The revelation that water users in Melbourne have been over-charged to the tune of $300 million highlights deficiencies in the mechanics of setting water prices in that state. Unfortunately, the flaws associated with regulated water prices are much more severe and deep-rooted than many would realise and also extend beyond Victoria.

Under the National Water Initiative, water prices should reflect the cost of water and the resources required to deliver it to users. This ambition can be traced to the competition reforms that were agreed by all states in the 1990s.

The model is firmly grounded in economic notions like cost recovery. In simple terms, economists would argue that a price should cover the costs of all resources used to deliver water. Anything more (or less) would unnecessarily distort other choices in the economy.

Most people are familiar with this type of argument. But they probably don’t realise how difficult it is to operationalise or how easy it is for politicians at different levels of government to manipulate the outcome.

Most of the cost associated with delivering water is tied up in the infrastructure used to harness, produce and deliver it, along with the infrastructure to deal with waste water.

This infrastructure tends to last a long time. So the prices faced by water users are primarily driven by how this infrastructure is valued in the first instance and the accounting techniques used to determine the rate at which pipes, drains and desalination plants are depreciated or replaced. Whether those assets are required to deliver a return to the owner (often the state government) is also an important driver of water prices.

There is plenty of wriggle-room in this domain. Choosing one technique over another can change the value of assets, and thus water prices, by millions.

Second, the rate at which new infrastructure is added to increase water supplies should follow some logic that ties demand and supply. This same logic should result in low-cost augmentation works being selected before high-cost alternatives.

Unfortunately, this logical approach has not been applied in many jurisdictions, especially Victoria. In that case the previous state government decided that three different approaches to augmentation should be simultaneously pursued. The one low-cost option, purchasing water from irrigation districts, was ignored. The current state government’s decision to effectively prohibit the use of the north-south pipeline that joins Melbourne to irrigation supplies only serves to exacerbate this problem.

In addition to governments intervening to opt for politically advantageous, high-cost water augmentation projects, it is also possible to distort water prices by “gifting” assets to particular water users. These gifts reduce the value of the infrastructure water prices are based on.

Without trawling through all the detail of how this works, the result for the Victorian government is that the state runs two sets of books for its water utilities. One set of accounts is called the regulatory accounts. The other is the statutory accounts. The former is used as the basis for setting water prices and excludes infrastructure that has been effectively donated by government. Perhaps not surprisingly, nearly all of these gifts are outside Melbourne, like the billion-dollar irrigation upgrades in the north of the state. The upshot is that water prices are artificially depressed in those districts.

Clearly, this stands in contrast to the approach used in Melbourne, where customers are paying for augmentation works that have not been delivered. Another important consequence of the divergence between accounts is that the value of “statutory” assets has gone up substantially as a result of paper revaluations. This has improved the credit rating of the state. Nonetheless, some water users are still subsidised by the way the “regulatory” asset base has been set outside Melbourne. You will see similar inconsistencies in other jurisdictions.

Usually when governments are confronted with these types of challenges they respond by arguing that water should be subsidised in special cases, particularly to the poor. Unfortunately, the presumption seems to be that the people in metropolitan locations can universally afford to pay more than others.

What is less clear is why a low-income resident of a city, who happens to have a large family or a vegetable garden, and thus uses more water, should subsidise rural water users, regardless of their income. In the case of Victoria, it is also not clear whether the state government intends to return the dividend it collected from the Melbourne water utilities so it can reimburse those who have been over-charged. Coincidentally, this amounted to more than $300 million between 2009-11.

Governments should legitimately be able to subsidise some activities over others. However, this should be done through the general revenue collected as taxation and not by taxing city water use and pretending it relates to cost. In a similar vein, transparency would be improved if the regulatory and statutory accounts of the state’s water utilities were harmonised.