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Real Water Rates on the Rise

Fortnightly Magazine - July 15 1997

Elasticity and Rate Design

In statistical studies, price does not appear as a major determinant of water usage. Admittedly, the effect of price on usage can prove minimal if there is little change in real water prices over the long term. Also, other demand parameters such as temperature, rainfall and household income can overwhelm the impact of price. In addition, the environmental ethic of consumers in a given locality can enhance or impede water usage or conservation responses. Lags in consumer responses further complicate measuring the responsiveness of water usage to changes in rates.

The implications of omitting price elasticity from the rate design process are becoming more serious. Emerging evidence suggests that the price sensitivity of water demand may increase over time (with increasing real water prices) and that conservation programs also can influence water demand patterns. Gauging how important price elasticity estimates are in designing rates is difficult; for many water systems, the price of ignorance is substantial. While not all systems can conduct detailed demand studies, existing research can help develop benchmarks for assessing the potential impact of price changes on water usage.

The impact of price changes on water usage is not always considered in the determination and allocation of revenue requirements. Treating water demand as perfectly price inelastic ignores price-induced usage changes. If price elasticity coefficients are not zero, then changes in price will affect water usage. Reasonably accurate demand forecasts that account for price elasticity are essential for developing revenue forecasts.

Example: A Case of Beer

A hypothetical example, however, can illustrate the importance of price elasticity in rate design. The water system in this example has a sizable residential customer base and one large industrial customer, a brewery. The key assumptions are that the water utility has increased its tail-block rate by 50 percent and that the tail-block incorporates 98 percent of the water usage of the brewery. Water demand analyses for the brewing industry have indicated that a 10 percent increase in rates will reduce brewery water usage by 4 to 6 percent. %n4%n

The result of the tail-block increase is a usage reduction of 20 to 30 percent. Given that the brewery annually paid $300,000 for water, the water utility cannot presume that water revenues automatically will increase to $450,000 (a 50 percent increase). Most likely, water revenues from the brewery will fall short of $400,000. If the price-elasticity effect on usage is not incorporated in the rate design, the result will be a revenue shortfall for the water utility and difficulty covering fixed costs. Future rate increases may prove necessary.

In a regulatory framework, the key price-elasticity issues center on the validity, relative importance and proper interpretation of elasticity estimates and the implications for both demand and utility revenues. Price elasticities for different customer classes also must be considered. For example, water demand for large-volume customers is generally more price elastic than water demand for residential and commercial customers. The repeal of volume discounts, combined with a rate increase, likely will trigger a substantial usage response by large-volume customers.

These large users