Australian urban water utilities face a significant challenge in designing appropriate demand management and supply augmentation policies in the presence of increasing water scarcity and uncertainty over future dam inflows. This paper considers the design of optimal demand management and supply augmentation policies for urban water. In particular, scarcity pricing is considered as a potential alternative to the predominant demand management policy of water restrictions. A stochastic dynamic programming model of an urban water market is developed based on data from the Australian Capital Territory. The model involves an explicit consideration of uncertainty via a probability distribution over dam inflows. Given a specification of the demand and supply for urban water, state dependent optimal price and investment policies are estimated. The results illustrate how the optimal urban water price varies inversely with the prevailing storage level and how the optimal timing of investment differs significantly between rain dependent and rain independent augmentation options.


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