AWWA Journal - February 2012

The Ironic Economics and Equity of Water Budget Rates

Janice A. Beecher 0000-00-00 00:00:00

Water budget rates are gaining attention in the water sector. Although clearly well-intended, the water budget approach to rates raises serious theoretical and practical issues familiar to applied regulatory economics. In essence, water budget rates exemplify “social ratemaking,” that is, a system of pricing that departs from traditional economic standards in the interest of serving social goals—in this case water conservation. The inherent problem with this particular rate structure, however, is not its good intentions but its disconcerting implications. The troubling irony of water budget rates appears to be lost in the deliberation. Water budget rate-making is a method whereby the utility provider establishes individual household water allowances (subject to adjustments and variances) and fixes water prices for allowed usage blocks. In other words, a water tariff based on a water budget is a customized rate form that takes into account not just the cost of service but the presumed need for service. Water budget rates elevate rationing as a rate-making principle, adding a strong element of command and control to the otherwise incentive-oriented tool of pricing. Moreover, in a role generally reserved for the state as a way to ensure safe subsistence or in times of crisis, the water utility monopoly positions itself to determine need. A water budget rate (also known as an individualized, goal-based, or customer-specific rate) “is an increasing block rate structure in which the block definition is different for each customer based on an efficient level of water use by that customer” (Mayer et al, 2008). Proponents assert that “water budget–based rate structures are one of the most effective tools available to water providers to provide a meaningful price signal, reduce water waste, increase efficiency, and manage drought response in a sensible and equitable manner” (Mayer et al, 2008). As typically conceived, rates are designed for four or five rate tiers that vary with usage blocks and are based on a household’s given “needs” or, perhaps more accurately, its “wants,” reflecting individual consumer preferences and lifestyle choices. In fact, the individualized thresholds of water budgets may bear little or no relationship to the household’s actual contribution to system load and associated costs in the short or long run. The focus of water budget rates on individual use may also deflect attention from the collective and coincidental effects of consumption on the system. Efficiency is better served by allocating costs to all peak usage, rather than to select users when they happen to peak. Relying only on objective cost data, the analyst can be indifferent about water users and their usage habits. Applied microeconomic theory dictates that when water rates reflect the full cost of service (which takes system conditions into account) discretionary use by customers will be driven by price (relative to income). On the surface, and perhaps even intuitively, water budgeting may seem “fair” because it recognizes variations in household circumstances. Indeed, this appears to be the leading argument for its adoption. What may be difficult to grasp, however, is that the customized water use allowance is every bit as consequential for efficiency and equity as the unit rate charged for each usage block; in other words, the customer’s bill is a mathematical product of the block width (usage) and height (unit price). Efficiency requires a cost rationale for both multipliers, which should be informed by analysis; if either is weak, so is the price signal. Any rate that selectively extends the allowed usage block individually based on noncost criteria is effectively a preferential discount (or cross-subsidy) with distributional consequences for water customers—some pay less and some pay more than the cost of service. Any intraclass subsidies from small- to large-volume users already embeded in rates would be exacerbated. This puts the rate at cross-purposes with efficient and equitable prices based on market theory and generally accepted rate-making principles that align value, cost, and price. From an efficiency standpoint, the customized accommodations for household size and lot size in water budget rates will—at least in the short term—fix an amount of legacy use for each customer, not unlike appropriative water rights. The method will tend to reinforce a sense of water entitlement, if not reward conspicuous consumption, even during dry periods. Allotments will also reinforce system peaking factors based on established patterns of water use. In terms of equity, lot size is an imperfect measure of water need and presumably an inverse measure of financial need, at least for many desirable urban and suburban developments. Taking family size into account in rate-setting admittedly is more nuanced. Of the various elements of water budget rates, the case for progressive consideration of family size in rate-setting is perhaps the most compelling. Basic human water requirements for a healthy and sanitary existence are largely determinate and invariable. Social safety nets are needed to ensure provision of essential services, particularly to children. Should a community choose to define “essential” use for lifeline purposes, it would seem more appropriate to inform the determination on the basis of accepted public health standards than on local norms and perceptions. In fact, a simple cost-based increasing-block rate effectively serves the joint goals of affordability (first blocks) and efficiency (tail blocks), with far less complication or distortion. A simple illustration highlights the mathematical reality of the rate structure as practiced by one water district and revealed by its own online bill-calculation tool. By delaying the point at which the unit price increases, the rate structure has the effect of lowering unit costs for high-use water customers, particularly in the summer season. These inequities are accentuated at the higher use levels. The findings confirm that “water budgets provide more water at lower prices to those who ‘need’ more” and because ”those that need more are the big users,” it is reasonable to question the conservation value of the rate structure (LaFrance, 2010). All utility rate structures present implementation challenges. The expense of changing and complicating rate structures must be weighed against the effectiveness of the rate in achieving goals in absolute and relative terms and taking tradeoffs into account. Ultimately customer understanding and acceptance are paramount to the efficacy of any rate structure. Rate structure changes that are distributive (by collecting penalty revenues that exceed the cost of service) are subject to challenge based on regulatory law and policy. Rate structure changes that are redistributive (raising some bills and lowering others) are also vulnerable to dispute, perhaps especially if constituents recognize the rate as regressive. In sum, for ratepayers at least, a water budget bill is neither water- nor budget-friendly. Any rate structure can be designed or implemented incorrectly, but water budget rates exhibit inherent theoretical flaws that cannot be remedied by technical design. However well-intended, water budget rates seem contrary to the concurrent goals of efficiency and equity in both form and function. Consultants and advocates may be diffusing the method, and the potential for revenue stability and enhancement is a selling point to utilities. Community acceptance of water conservation may indeed be a function of rate-making politics, including negotiation, more than rate-making economics. Water budget rates simultaneously attend to the presumably more affluent (by entitling larger properties) and the presumably less affluent (by entitling larger households). Water use allowances based on lot size suggest an environment conducive to high-end development. Rates that actually provide an all-year allowance based on lot size raise the specter of political appeasement. The equity implications of water budget rates are especially perplexing because for a policy that might appear progressive, water budget rates are remarkably regressive as well as discriminatory. Water budgets delay the price point of either burden (higher rates) or sacrifice (lesser use) for high-use customers. No rate based on perceived need rather than actual cost will escape criticism and controversy. Although water budgets based on family size might be considered somewhat equitable, lot size is a dubious consideration at best. By violating cost-based pricing conventions, the rate cannot be considered economically efficient. Proponents of the water budget rate approach are emboldened by its apparent success in managing water demand, pointing to the correlation of the rate’s adoption with “substantial conservation savings” and designating it as “one of the most effective tools available” (Mayer et al, 2008). Empiricism cautions about causality, of course. The relevant research questions are whether the rate structure is exerting an independent effect on downward-trending water use relative to other influences and whether observed changes in behavior are durable. Although it is true that a budget bill can send a price signal that is more efficient than some alternatives, the signal is weaker than it could be, or arguably should be, particularly under conditions of perceived scarcity. Although the water budget rate still qualifies as an increasing-block rate, it is a rate that is far less effectual than more conventional forms that send stronger signals (i.e., the rate may suffer from opportunity costs). From an implementation perspective, the problem is not just that water budget rates are complicated, but that they are unnecessarily so because the added complication cannot be rationalized on the basis of genuine gains either to efficiency or equity. Indeed, the rate has consequences that may be quite unintended and unexpected. At the same time, water budget rates seem widely misunderstood or misrepresented. As long as their choices do not burden others, communities are largely free to determine how they allocate the cost of water service in accordance with their values and goals, but local decision-makers acting as rate regulators should be well-informed of the implications and consequences. As posited here, the water sector would benefit from applying less ironic and more iconic rate-making principles. Corresponding author: Janice A. Beecher is the director of the Institute of Public Utilities at Michigan State University, W157 Owen Graduate Hall, East Lansing, MI 48825; References LaFrance, D., 2010. Water Budget Rates—The Other Side of the Panacea. Proc. 2010 AWWA Utility Management Conf., San Francisco. Mayer, P.; DeOreo, W.; Chesnutt, T.; Pekelney, D.; & Summers, L., 2008. Water Budgets and Rate Structures: Innovative Management Tools. Jour. AWWA, 100:5:117.

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