Reflections on Water Pricing and Tariff Design

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Reflections on Water Pricing and Tariff Design

• Prof. Dale Whittington
• University of North Carolina at Chapel Hill
• Prof. John Boland
• The Johns Hopkins University
• April 3, 2001

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Outline of Presentation

• Objectives of water pricing and tariff design
• Alternative Tariff Structures - Definitions
• Observations on Increasing Block Tariffs (IBTs)

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Water Tariff

• The set of prices, charges and taxes used to
  generate revenue and
• The rules and regulations which govern their use

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Average Residential Water Tariffs - Selected
Asian Cities (US / m3 ,1997)
Price US/m3
Cities
0.70
Jakarta
Singapore, Hong Kong
0.50
Bangkok, Kuala Lumpur, Taipei
Manila, Seoul
0.20
Ho Chi Minh, Colombo, Lahore
Calcutta, Delhi, Beijing, Mumbai, Shanghai,
Karachi, Dhaka
0.00
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Functions of the Tariff

• Determines level and pattern of revenue
• Contributes to ability to attract capital
• Creates incentives affecting the production and
  use of services
• Influences the value of the services received and
  the total cost of production
• Allocates cost among customers, groups of
  customers, and over time

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Purposes of the Tariff

• Economic Efficiency
• Fairness (a perception)
• Equity (a testable hypothesis)
• Revenue sufficiency
• Net revenue stability
• Simplicity and understandability
• Resource conservation

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Additional Considerations in Tariff Design

• Public acceptability
• Political acceptability
• Ease of implementation
• Enhancement of credit rating

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Criteria versus Average Tariff
who can afford a private water connection
Water consumption by hhs with private water
connection
Economic benefits received by hhs with private
water connection
Low Medium
High Very High
Low Medium
High Very High
Low Medium
High Very High
US1.00/m3
US0.50/m3
US0.05/m3
0.00
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Criteria versus Average Tariff
Revenues received by water utility
Costs to water utility to deliver water supply
Economic costs paid by others (e.g., subsidies
needed by water utility)
Medium High
Low Zero
Low Medium
High Very High
Low (None?) Low (None?)
High Very High
US1.00/m3
US0.50/m3
US0.05/m3
0.00
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Hierarchy of Objectives

• Most restrictive
• Least restrictive

• Economic Efficiency
• Equity
• Simplicity, transparency
• Fairness
• Resource conservation
• Net revenue stability
• Revenue sufficiency

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Service Quality vs. Cost Recovery
Asian Water Utilities Handbook,1997 Good Service Poor Service
Costs Recovered Kuala Lumpur Seoul Singapore Taipei Colombo Hanoi Jakarta Lahore
Costs Not Recovered Beijing Hong Kong Shanghai Kathmandu Dhaka Manila
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Some Basic Tariff Options

• Single part tariff, consists of either
• Fixed charge (not based on measured water use)
• Volumetric charge (based on measured water use)
• Two part tariff, includes both fixed and
  volumetric charges

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Volumetric Charges

• Uniform price - all units of water billed at same
  price
• Block-type structures - two or more prices, each
  applies to use within a defined segment (block)
  of monthly use
• Decreasing block - block price falls as use rises
• Increasing block (IBT) - block price rises as use
  rises Note first block price usually set below
  cost

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Tariff Design - Uniform Price

• Periodic fixed (service) charge, e.g.,
  US/month/connection
• Single commodity price, e.g., /m3
• Example (in US)
• 5.00/month for residential connection, plus
• 1.00/m3 for all water use

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Tariff Design - Decreasing Block

• Periodic fixed (service) charge
• Two or more commodity prices (/m3), decreasing
  with use
• 5.00/month for residential connection, plus
• 1.50/m3 for all water used up to 15 m3/month
• 1.00/m3 for all water used in excess of 15
  m3/month, up to 30 m3/month
• 0.75/m3 for all water used in excess of 30
  m3/month

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Tariff Design - Increasing Block (IBT)

• Periodic fixed (service) charge
• Two or more commodity prices (/m3), increasing
  with use
• 5.00/month for residential connection, plus
• 0.75/m3 for all water used up to 15 m3/month
• 1.00/m3 for all water used in excess of of 15
  m3/month, up to 30 m3/month
• 1.50/m3 for all water used in excess of 30
  m3/month

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Tariff Design - Variants

• Increasing rate designs
• Combination block designs
• Free service allowances (form of increasing
  block)
• Seasonal water tariffs
• Seasonal sewer tariffs
• Lifeline rates

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U.S. Water/Sewer Agencies

• 50,000 water utilities
• 30,000 wastewater utilities
• Urban places with 100,000 population
• 300 water utilities
• 200 wastewater utilities

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U.S. Government-Owned Water Utilities

• 80 percent of total
• 85-90 percent of large systems
• Very few subject to tariff regulation by State
• Only 12 of 50 states with laws restricting
  pricing practices

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U.S. Investor-Owned Water Utilities

• 10-15 percent of large systems
• Subject to tariff regulation by State agency,
  based on rate-of-return

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U.S. Water Tariffs
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Commonly Overlooked Facts I

• Water and sewer services are bundled commodities
• Users respond to the sum of water and sewer
  tariffs
• Developing tariffs separately according to
  different criteria is illogical

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Commonly Overlooked Facts II

• Prices determine water use, not tariff design
• Each user responds to his/her last block price
  regardless of what other prices may be, or what
  other users may do.
• Block type rates permit price discrimination,
  individual users respond to the price in specific
  block(s)

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Increasing Block Tariffs (IBTs)

• Still actively promoted in developing countries
• Water pricing is an important instrument for
  stimulating efficient use of water. A basic
  amount could be used at a relatively low rate,
  while water consumption beyond that amount could
  be charged with progressively higher rates.
  (Urban Water Resources Management, UN, 1993, p
  19).
• Widely used in OECD countries

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IBT Example La Paz, Bolivia
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Examples of IBTs
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What is Rationale for IBTs?

• Claimed to transfer income from rich to poor
• Claimed to transfer income from firms to poor HHs
• Very high prices in top blocks claimed to
  discourage extravagant and wasteful use
• IBTs are said to implement marginal cost pricing
  principles
• IBTs are said to reflect assumed rising marginal
  cost curves

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IBT Rationale Revisited I

• Rich subsidize the poor
• Average price rises with HH use. Therefore, to
  the extent that water use is correlated with
  income, subsidy occurs.
• Maximum possible subsidy is small (typically US1
  to US3 per month)
• Subsidy is regressive within the lower blocks

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IBT Rationale Revisited II

• Firms subsidize poor households
• IBTS produce such a subsidy
• Subsidy is regressive within the lower blocks
• If subsidy were desirable, it could be achieved
  more easily by sectorally differentiated prices
• Subsidy may not be desirable large users may
  exit system, increasing average costs for
  residential users

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IBT Rationale Revisited III

• IBTs discourage extravagant or wasteful use
• No clear what extravagant means
• If wasteful means uses that do not justify the
  resource cost of the water, then
• Setting price equal to marginal cost means that
  every customer pays to replace every unit of
  water taken, regardless of the type of use
• No further incentive is necessary or desirable

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IBT Rationale Revisited IV

• IBTs are consistent with marginal cost pricing
• There is only one marginal cost for a given class
  of customers at a given time
• IBTs result in different customers within the
  class paying different prices at any given time,
  based on their total monthly use
• At most one of these prices can equal marginal
  cost all others represent a divergence from
  marginal cost pricing principles

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IBT Rationale Revisited V

• IBTs track rising marginal costs
• Marginal cost is not necessarily rising, even in
  developing countries
• If marginal cost is rising, it rises as a
  function of aggregate water use it does not
  change perceptibly with changes in water use by a
  single HH
• Prices are meant to reflect the costs imposed by
  additional water use by the HH. These are the
  same for all HHs in a given class at any given
  time.
• Marginal cost may rise over time then prices
  should also rise over time, but for all uses

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Limitations of IBTs in Practice

• Difficulty in limiting size of the first block
• Difficult to provide proper economic incentives
  to most customers
• Difficult to meet revenue target without large
  departures from marginal cost
• Lack of transparency and difficulty of
  administration
• In the case of shared connections, or where
  connected HHs resell water to vendors, IBTs
  increase cost to the very poor

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An Alternative to Increasing Block Tariffs

• Use lump-sum transfers for income redistribution
  and other fairness objectives
• This allows the choice of a uniform price design,
  preferable according to all other criteria
• Lump-sum transfers can lead to negative fixed
  charges for some users

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A Practical Alternative to IBTs Uniform Price
with Rebate (UPR)
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Household Water Bill UPR vs. IBT
Households Monthly Water Use (m3) Uniform Price with Rebate Increasing Block Tariff
5 US2.50 US2.50
10 US3.31 US5.00
15 US8.31 US7.50
20 US13.31 US12.50
25 US18.31 US17.50
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Two-Part Tariff Evaluation

• Both tariffs produce the same revenue
• Two-part tariff provides improved incentives
• More HHs face full marginal cost with a UPR than
  with a IBT. Only the smallest, most price
  inelastic HHs face a zero incremental price
• Two-part tariff more effective in transferring
  income
• Per-HH transfer is larger
• Transfer is not regressive

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Two-Part Tariff Evaluation

• Two-part tariff is simple and transparent
• Two-part tariff is more equitable
• Advantages of two-part tariff even greater when
  compared to a multi-step IBT

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Conclusions

• Usual rationales for employing IBTs are either
  incomplete or incorrect
• There are significant practical difficulties with
  the application of IBTs in developing countries
• If the purpose of an IBT is to redistribute
  revenue, alternative tariff designs can do so
  more effectively
• IBTs, on the other hand, introduce inefficiency,
  inequity, complexity, lack of transparency,
  revenue instability, and forecasting difficulties

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Conclusions (cont.)

• Properly designed tariffs are powerful management
  tools
• Comparisons of alternative designs can be complex
• No single design fits all circumstances
• Increasing block designs, though widely used,
  have many disadvantages
• Better tariff design is possible