The NSW government has faced calls to mothball the plant at Kurnell, with the Warragamba Dam expected to spill this week.
NSW Premier Barry O'Farrell earlier on Wednesday said a "stupid contract" entered into by the former Labor government tied the state to a two-year proving period, which meant the plant could not be shut down.
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But Finance Minister Greg Pearce later announced the Sydney Desalination Plant, owned by the government and operated by private contractor Veolia, had decided to slash its output from 90 megalitres a day to 45 megalitres.
The amount of water is the lowest the plant can "practically produce", and follows a cut to supply in December from 250 megalitres a day.
"I welcome the reduction, given rising dam levels," Mr Pearce said in a statement.
"The deal negotiated by Labor locked us into an arrangement under which the operators of the plant had discretion to run it at full capacity for two years, leaving us having to pay the same amount regardless."
However, Mr Pearce said shutting down the plant was not a responsible outcome.
"Shutting it down entirely would potentially shift any liability for any defects under its construction to the state government, and ultimately taxpayers, for the duration of its concession period," he said.
