Pricing Water is a Difficult Task

There are many reasons to get water prices right, but pricing water is a difficult task. The design of municipal water tariffs requires balancing multiple criteria such as financial self-sufficiency for the service provider, equity among customers, and economic efficiency for society.

Policymakers and water professionals often rely too heavily on their intuition to assess how changes in water tariffs affect the criteria mentioned above.

Quantitative assessment of the three impacts requires the specification of a set of nonlinear relationships with numerous parameters, and then formal simulation procedures to analyze how changes in the tariff structure and price levels can lead to the desired policy outcomes.

Specifically, three parameters have received insufficient attention:

1. Correlation between household income and water use. Water professionals typically assume that the correlation between household income and water use is high, i.e., that rich households use more water than poor households. There is, however, surprisingly little empirical evidence reported in the literature to support this assumption.

2. Relationship between marginal and average cost. Efficient water pricing requires that households face a price that reflects the opportunity costs that their incremental use imposes on the water utility (and society), i.e., the full social marginal cost. However, water utilities often do not know the relationship between their average and marginal costs. Textbook expositions of natural monopolies present marginal costs below average costs, with increases in output that result in falling marginal costs, which pull down average costs.

In reality, some components of the water and wastewater delivery system may exhibit economies of scale and falling marginal and average costs, but others may exhibit diseconomies of scale and increasing marginal costs. For example, as water scarcity increases and water utilities go farther from urban centers to find new raw water sources, the costs of the incremental water supply will increase. Similarly, adding desalinization facilities increases the cost of raw water supplies.

3. Lastly, customers’ response to marginal vs. average prices. There are three main reasons why customers might respond to average prices rather than marginal prices. First, complex tariff structures can be difficult to decipher for customers, and it may be too much trouble for households to try to figure out how to respond to marginal prices. Second, many utilities charge such low water prices (i.e., both average and marginal prices are low) that households simply may not find it worth the trouble to think about adjusting their water use to marginal prices. Third, households may have difficulty controlling the aggregate use of multiple household members, and thus the household unit may fail to respond to the marginal price signal.

This capability to model the full array of consequences of a tariff reform process is currently not well developed in either water utilities themselves or in the community of consultants who support them.

This study aims to correct some of such gaps in knowledge and creates a modelling framework for analyzing how alternative municipal water tariff designs affect the criteria of financial self-sufficiency, equity and economic self-sufficiency. The modelling framework is then applied to a hypothetical community in which a municipal water utility provides metered, piped water, and wastewater services to 5,000 households.

The study models a shift from a uniform volumetric tariff to different increasing block tariff (IBT) as IBTs are currently the most popular tariff structure. Further, the model attempts to analyze how the shift from an UP tariff to different IBT designs affects households’ water use and water bills, and how these changes, in turn, affect measures of equity and economic efficiency for different cost recovery constraints.

This summary is based on the research paper Evaluating the Performance of Alternative Municipal Water Tariff Designs: Quantifying the Tradeoffs between Equity, Economic Efficiency, and Cost Recovery. 

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