The customary practice of meeting urban water deficit through supply augmentation by tapping distant and multiple-use water sources often disturbs prevailing sectoral allocation and causes inter-sectoral water conflicts. The common prescription for resolving such conflicts involves market-based approach to inter-sectoral water allocation. Under conditions of an uneconomic rate structure and pervasive use inefficiency and wastage in the urban water sector, inter-sectoral water transfers--whether market-based or otherwise--are likely to conceal inefficiency, damage incentive structure, and dampen the urge to explore supply augmentation options evident within current urban supply limits.

Utilizing both primary and secondary information pertaining to the water sector of Hyderabad city, India, this paper investigates the kind of policy changes and institutional conditions necessary to ensure the economic viability of market-based solution to inter-sectoral allocation problems in an urban context. This is done by (a) evaluating the economics of various supply augmentation options--both internal and external as well as structured and unstructured, (b) estimating the user-specific water demand and consumption response functions under alternative pricing (average and marginal) schemes, (c) calculating the net willingness to pay (NWTP)--considered to be an approximation of the value of raw water--of user groups from their respective price elasticities, (d) demonstrating how inadequate the NWTP is to justify most supply augmentation options including inter-sectoral water transfers, and (e) arguing that the economic conditions internal to the urban water sector can never support an externally imposed water transfer--whether market-based or otherwise--as long as the rate structure is low and uneconomical.

The main implication of this paper is that although local level supply augmentation options cannot, by themselves, solve urban water deficit altogether, their exhaustion is admittedly a necessary condition for market-based inter-sectoral water transfers to be free of the damage to the incentive environment facing urban water sector. Both to fully exhaust local level options and to economically justify macro level options, setting urban water sector right with proper pricing policy and legal and institutional changes is obviously the first reform task