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Real Water Rates on the Rise

Fortnightly Magazine - July 15 1997

not the main culprits, except for some small systems. Even for small systems, the inability to achieve economies of scale is the chief driver of higher costs. In reality, for most water systems, SDWA compliance costs pale in comparison to the price of infrastructure replacement.

Another important reason for the trend in water prices, which is left out of the usual trilogy of reasons, is the historical underpricing of water and wastewater services. %n3%n Historical underpricing can be attributed to:

• Use of average (embedded) costs in ratemaking;

• Neglect of marginal-cost pricing principles;

• Failure to create depreciation reserves adequate to finance inevitable system replacements;

• Deferral of needed capital improvements to maintain the integrity of existing systems;

• Subsidization of water resource projects by various levels of government; and

• The politicization of ratemaking, meaning that decision-makers are highly sensitive to the willingness of constituents to pay higher water prices (versus their ability to pay, which rightly is a political concern).

Obviously, these factors affect systems differently. It's possible that some issues (em particularly deferrals, subsidization and politicization (em caused greater underpricing by municipal water utilities than by regulated, investor-owned utilities. The large IOUs have more incentive to price the commodity correctly and fewer opportunities to do otherwise. Because most

customers receive their water service from publicly owned utilities, the CPI data are weighted heavily toward publicly owned systems.

Rate Shock and Affordability

As water rate increases loom on the horizon, the potential consequences deserve careful consideration. Increasing nominal and real water prices will cause customers to experience rate shock. The effects of rate shock include reductions in consumer usage (an "unwillingness to pay") and for large commercial or industrial users, partial or complete bypass of utility service. Rate shock can cause substantial revenue instability and short-term shortfalls.

The consequences of rate shock can be measured in terms of the price elasticity of demand. The demand for water is price elastic, because water usage by customers is inversely related to the price charged for water service. Although water is relatively price inelastic, changes in price can induce meaningful changes in water usage. In assessing the impact of pricing on usage, the real price (the nominal price adjusted for inflation) of water is more important than the nominal or actual price of water.

Price increases also have important distributional consequences. Demand for utilities services, including water, also is somewhat income-elastic; that is, customers with higher incomes tend to purchase more. However, the rate that usage increases is slower than the rate that overall expenditures increase (see Figure 3). At lower expenditure (and income) levels, utility bills reflect less discretionary usage and take a much greater share of total household expenditures than at higher expenditure levels.

Understandably, basic utility services such as most indoor water usage appear less responsive to price or income changes. The regressive nature of utility bills suggests that rising water costs will raise concerns about affordability for customers in lower income brackets.

Similar concerns surfaced in the 1980s when energy prices skyrocketed. The affordability problem creates a clear tension with full-cost, efficiency-oriented pricing.