Nine Recommendations for Urban Water Conservation Rates

Water conservation in cities is more important with each passing year, perhaps even with each passing month. Many communities are dealing with some effects of drought or low flows, depleting aquifers or polluted sources. Climate change may be having an impact, as well. Yet urban water demand varies widely, even in similar communities. Some communities use 10 times more water than other, similar communities! The differences in water rates, and relative affordability, for residential customers offer an excellent explanation for these differences in water demand.

Consider the differences between two desert communities: Community A uses an estimated 1,000 gallons per capita per day (gpcd), while Community B uses about 100 gpcd. Community A has flat rates of $2.25 per hundred cubic feet (Ccf or 748 gallons), served by a private utility; Community B has steeply inclined block rates with prices starting at $2 per Ccf, and rising to nearly $12 per Ccf, served by a city enterprise fund utility. Community A median income is $139,524; Community B median income is $36,939. The cost of water in Community A is less than 2% of median income; the cost of Community A’s water, if served in Community B, would be more than 10% of Community B median income (although its own average water use, along with co-billed wastewater and solid waste fees, is about 2.5% of median income).

Looking at these numbers, it is not surprising to see these differences: economic studies of water demand have found price elasticity of demand, and many of those studies also found income elasticity of demand as well. (Elasticity refers to the tendency to demand more or less of a product as the product price–or personal income–changes.)

The pattern is clear: expensive water is conserved, and cheap water is not! (And, as described, “expensive” and “cheap” are relative terms, dependent on income).

This pattern is well known among economists, but widely ignored in the water industry. That needs to change. Community B’s approach must find traction in Community A, and most other communities as well. Well-designed and executed water conservation programs are certainly important, and every community should be launching one, but such programs amount to paddling upstream if they are not built on a well-designed conservation rate structure!

To help clarify just what is needed, we have attempted to boil the business of water conservation rate design into nine recommendations. These recommendations provide a roadmap for implementation, and most are dependent on implementing the preceding recommendations. Even if not followed exactly, the essence of each recommendation needs to be dealt with by all utilities. Some utilities face exceptional circumstances –perhaps having a large quota of transitory millionaires–but in the end, people are still people–who will not want to squander their money, even if they don’t care about wasting a little water.

Our recommendations are based on more than 30 years of researching, observing, and participating in local water conservation rate making. We found that if incomes are high, water prices will appear low;

if incomes are low, water prices will appear higher. If water prices increase at a rate greater than inflation, then demand will generally diminish. So, changes in the relative price of water in any community will have important implications for water demand, and will provide incentives for demand management. Bearing this in mind, let’s continue with the recommendations.

1. Bill All Water Distribution Volumetrically–Meter Everyone and Bill Monthly
Studies have shown when water systems are converted to metered service from non-metered service, there is usually a 20–30% decrease in use, apparently just from the conversion to volumetric billing (billing is tied to volume used). Suddenly, it matters how much water is used. Metered billing gives the householder an accounting of water used and an implacable bite on his wallet. Volume-based billing offers the possibility for rapid feedback on consumption–and its cost–along with immediate payment due. Thus, the incentive to reduce water use is ever present. Also, without metering, many people would never notice leaking irrigation systems or indoor plumbing fixtures.

2. Water Rates Are the Foundation of Any Conservation Program; They’re Not Just for Revenue Recovery
Every economic study of water demand we are aware of has shown a definite elasticity on price. In most cases, the range is from -0.1 to -0.9 in the “inelastic” range (not to be confused with not having elasticity), meaning that increasing price will increase revenue. But it also means that price increases will not bring in the expected revenues. In fact, it is almost inevitable that a rate increase will bring in less revenue than is “requested.” However, the result is also almost invariably a conservation effect; sometimes a substantial reduction in demand.

Specific studies have shown there are fairly predictable patterns in that larger users tend to reduce use more than smaller users, especially with increasing blocks. Also, rate structure sensitivity is more acute with an increasing percentage of income expended for water. Important consideration needs to be given to users in each block of an increasing block rate structure as well. The steeper the block structure, the greater the tendency for users to “fall” out of the upper blocks (into lower blocks), which blocks, therefore, are more price sensitive, recovering less revenue, yet are nonetheless better sources of conservation.

A simple example from Community B illustrates the variability between rate blocks (and, incidentally, shows little of the feared “hardening” of demand, even after decades of increasing block rate discipline). In 2012 there was a rate restructuring and a “requested” 8.3% overall revenue increase. A simple year-over-year comparison illustrates that the lower blocks were fairly stable, but the upper blocks were very unstable, with one block having a -0.92 price elasticity, resulting in 1% revenue increase from a 12% rate increase–and a corresponding 11% conservation increase! (See the table on the next page.) Please note that it is unknown exactly how the conservation took place, but customers quickly made choices to reduce their consumption, most likely reducing landscape irrigation. This illustrated how effectively price changes can motivate efficiency, and why analysis of rate block sensitivity is so important!

3. Indoor Uses Should Be Somewhat Protected, but Other Outdoor Uses Should Be Charged at or Above Cost-of-Service
There is a common tendency to allow residential customers to buy 5,000 to 10,000 gallons a month for basic needs for their indoor uses, such as washing, bathing, cooking and laundry, at low rates (sometimes referred to as a lifeline rate). However, these rates are commonly below cost-of-service (COS), which doesn’t promote efficiency, since payback on efficient fixtures is much longer and much less likely to happen than if water is priced at what it costs to produce and deliver. Therefore, care should be taken to subsidize only what is the minimum needed for indoor uses. Some utilities allow a majority of their sales at such discounted rates to balance out large upper block revenues. If more than half of sales are below COS, then rate blocks should be adjusted for COS for at least 50% of sales, and any resulting excess revenues should be put in a maintenance fund, or directed to efficiency incentives and conservation programs.

4. Reclaimed Water Should Be Subsidized According to Its Established Replacement Value (i.e., Long-Term Augmentation Cost)
Each gallon of water reclaimed is a gallon that doesn’t need to be developed from available water resources, or possibly from unavailable or undeveloped sources. Many utilities have reached the point where processing wastewater is less expensive than importing from new sources, but with a parallel delivery system to maintain, it may cost more to individuals than drilling a well and pumping local groundwater. Thus, recycled water is conserved water which potentially will save local, preserved waters, or the utility having to develop an expensive, remote source in the future, and therefore it represents an implicit future savings to the utility. Because of the savings potential, it should be priced to reflect future savings, and be subsidized sufficiently to cost no more than least-cost developed sources, to insure it is used in their stead. In some areas, for instance, reclaimed water needs to be sold at prices low enough to make pumping protected groundwater sources less attractive than using reclaimed water.

5. Increasing Block Rates Should Be Universal, Steeply Incremented, and Marginal Cost-Oriented
Aside from implementing increasing block rates to encourage water conservation, if serious conservation is needed, then rate blocks should be steeply inclined accordingly. As an ideal, the central price point should be the price of new production or long-run marginal unit cost. Using this as the Cost-of-Service reference will skew the revenues above required levels to support the utility, but it will give an appropriate conservation signal. To the degree this produces excessive revenues (as discussed above), they should be channeled to productive uses in subsidizing efficiency-producing fixtures, facilities or maintenance programs for the utility, or for reclaimed water. Considering water treatment costs of reclaimed water, even for irrigation, and the cost of a second delivery system, reclaimed water may require large subsidies (as do reasonable life-cycle main replacement programs).

6. Rate Steps Should Be Carefully Analyzed to Determine Price Sensitivity and Revenues Recovered From Stable Blocks
While steeply inclined rate blocks are good for squeezing demand down to lower levels, they simultaneously squeeze revenues. Generally, upper blocks see the most loss and lower blocks see less loss in demand, and therefore revenues. Utilities must anticipate such revenue slippage. By observing past slippage in the blocks, they can reasonably anticipate future losses, and price water accordingly. Rates can be set to rely less on recovering revenues from blocks with demonstrated revenue softness. If this is not adjusted for in setting rates, the utility should have a contingency fund to rely on to make up the shortage, thus making the marginal-cost pricing approach even more important.

7. Fixed Fees Should Be Modest (Less Than 30% of Revenues) and Relied on Only As a Last Resort–for Revenue Stability
Some would point to the large proportion of fixed costs in a utility’s budget, and say that having a large fixed portion of the water bill is well-justified, and even necessary, to maintain revenue stability. Using this rationale makes it easy to avoid proper analysis, and even to seriously mute the vital conservation message. With 70 to 80% fixed costs, most utilities could justify raising the fixed charge to cover more than 50% of costs, thereby forcing customers to pay for half of their expected use–whether they use it or not–while greatly diminishing the volumetric price for over-consumption at the expense of those who use smaller amounts.

What seems fairer and more reasonable is to keep fixed charges at less than 30% of total utility costs, carefully analyze block responses, and set unit prices at levels anticipated to generate sufficient revenues–or even excess revenues– to provide revenue sufficiency. (Larger, fixed charges would then only be justified in the case of drought emergencies, when allowed consumption is greatly reduced, and surcharges might be a better option.)

Also, somewhat higher pricing will allow for weather variability, or other demand variability. It should be mentioned that nationwide real income slippage since 2000, and more rapid slippage since 2007, have revealed widespread negative income elasticity in water demand (which has reduced demand), and has set off a movement to increase fixed fees to counteract demand, and related revenue, reductions. Finally, after five years of economic recovery, it hardly seems a good time to increase fixed charges, and thereby jeopardize the conservation message being sent by volumetric pricing, especially since incomes are rising modestly, and spurring demand.

Instead of raising fixed charges, utilities should be allowed to utilize contingency funds and reduced fixed charges, as needed, to balance funds, and maintain revenue stability. Assuming the utility is pricing based on marginal costs, then it will be generating excess revenues, which, if residing in a contingency fund, would provide revenue stability. If this fund is deemed excessive, then a fixed charge reduction may be declared. However, truly excess revenues seem most unlikely, in an industry with massive maintenance needs for aging, and leaking, infrastructure.

8. Long-Run Marginal Cost Pricing Should Be the Standard Approach, to Assure Adequate Maintenance and Augmentation Funding for the Utility
As described above, increasing block rates which are built around the marginal cost of water, instead of the average cost of water, will tend to generate more revenues as well as more conservation. The recommended approach is to move from flat rates to moderately inclining, then to more steeply increasing blocks. Initially, average cost may be the overall revenue basis, but once analysis is done over several years of gradually increasing the blocks, it may be appropriate to shift the revenue basis gradually toward the long-term marginal cost, while implementing a contingency fund plan.

There are a number of appropriate uses for excess funds, which may not be excess in reality. Most utilities have a backlog of main replacements and other maintenance items, system efficiency or reliability upgrades, conservation incentives to fund, and of course, there’s always the question of how much to reduce the fixed charge. If revenues should slip suddenly, and the contingency fund is depleted, then there should be an automatic, temporary readjustment of the fixed charge to replenish the contingency fund or for other system priorities. Naturally, any accumulated funds need to be carefully secured, as they will inevitably attract the attention of competing financial interests. Staff responsible for maintaining the fund should have an oversight committee, publically-devised operating guidelines, and regular outside audits with rotating contractors.

Finally, affordable augmentation may depend on urban utilities agreeing to fund agricultural efficiency improvements, while farmers agree to sell water thus saved to the partnering urban utilities. Considering agricultural irrigation efficiency costs are unaffordable to most farmers, who hold about 75% of all water rights, and may benefit from system savings in water pumping or other related costs, such arrangements would be a win-win for water management.

9. Use Sophisticated, Econometric Forecasting to Avoid Over-Spending on Infrastructure and for Accurate Rate/Feasibility Studies
Appropriate analysis of the performance of the rate structure incorporates all available price, socioeconomic and climatic data, which are incorporated into forecasting models, to perform systematic analysis of water demand for short- and long-term forecasts. Short-term analysis should be focused on matching up rate block sales with past years’ sales (and in context of any other significant variables, especially rainfall and other weather variables). Not to be ignored are economic factors, especially income variables, which directly reflect customers willingness, and ability to afford, both water and other purchases. Once clear response characteristics of the community water demand are understood, the analysis for long-term forecasts will be most useful for assessing future infrastructure or augmentation proposals, and demand management options.

For instance, it would be ill-advised for a utility to implement a desalination project without determining whether its output water could be delivered at a price which would be affordable to customers (and to opt for a property tax to subsidize such augmentation would be a questionable market adjustment, as it would reduce disposable income in the community, thus making the water even less affordable).

The 10th recommendation (and you know there had to be a tenth!) is to realize the whole process requires common sense. There is little doubt that price increases result in decreased demand, whether for gasoline, milk or water–as do decreases in income. Some degree of caution and consistency should be used in rate setting, and new rates should be implemented gradually, especially with modest increases in the percentage of income required. Do not make changes which increase costs or prices by orders of magnitude, unless they are staged over several years. Avoid gross overcharges! Give ample warning of changes, and justify actions in public forums.

Remember, few people will conserve water just for the fun of it, or because it shows their community spirit. On the other hand, most people will conserve if it will save them money, and it will help if they know how to conserve, and are being urged to do it. Again, most people will lose interest unless there is a consistent, persistent reward. The price of water saved is the best reward to enforce efficiency, and it costs very little to administer.

About the Author

W. Mark Day and R. Bruce Billings

W. Mark Day, MS, MBA, a resource economist involved with water demand analysis since the 1980s, recently completed a four-year term on his local water utility’s advisory board’s rate making and conservation subcommittees. R. Bruce Billings, Ph.D., an economist who has done extensive research on urban water demand, co-authored Forecasting Urban Water Demand. He is currently serving as finance committee chairman for his local water utility’s advisory board.

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