Reflections on Water Pricing and Tariff Design

1. 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

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

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

4. 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

5. 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

6. Purposes of the Tariff • Economic Efficiency • Fairness (a perception) • Equity (a testable hypothesis) • Revenue sufficiency • Net revenue stability • Simplicity and understandability • Resource conservation

7. Additional Considerations in Tariff Design • Public acceptability • Political acceptability • Ease of implementation • Enhancement of credit rating

8. Criteria versus Average Tariff % who can afford a private water connection Water consumption by hh’s with private water connection Economic benefits received by hh’s with private water connection Low Medium High Very High Low Medium High Very High Low Medium High Very High US$1.00/m3 US$0.50/m3 US$0.05/m3 0.00

9. 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 US$1.00/m3 US$0.50/m3 US$0.05/m3 0.00

10. Most restrictive Least restrictive Economic Efficiency Equity Simplicity, transparency Fairness Resource conservation Net revenue stability Revenue sufficiency Hierarchy of Objectives

11. Service Quality vs. Cost Recovery

12. 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

13. 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]

14. 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

15. 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

16. 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

17. Tariff Design - Variants • Increasing rate designs • Combination block designs • Free service allowances (form of increasing block) • Seasonal water tariffs • Seasonal sewer tariffs • Lifeline rates

18. 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

19. 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

20. U.S. Investor-Owned Water Utilities • 10-15 percent of large systems • Subject to tariff regulation by State agency, based on rate-of-return

21. U.S. Water Tariffs

22. 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

23. 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)

24. 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

25. IBT Example: La Paz, Bolivia

26. Examples of IBTs

27. 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

28. 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 US$1 to US$3 per month) • Subsidy is regressive within the lower blocks

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. A Practical Alternative to IBTs: Uniform Price with Rebate (UPR)

36. Household Water Bill: UPR vs. IBT

37. 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

38. 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

39. 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

40. 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