Real Water Rates on the Rise

Fortnightly Magazine - July 15 1997

While the prices play catch up, utilities and regulators should start looking for ways to mitigate costs.

Water utility rate increases have outpaced those of other utilities. In fact, water rate increases since 1984 %n1%n have surpassed the overall rate of inflation. Yet among utility services, water remains a real bargain; consumers spend less on water than on any other utility.

While more stringent drinking water standards, an aging infrastructure and increasing demand have all contributed to these recent increases, rising water utility costs also stem from historic underpricing. Pricing water services at artificially low prices has harmed consumers. If water services were priced correctly, consumers would benefit through improved system maintenance and water quality, timely replacement of aging capital facilities and more reliable service. In the long term, rising prices will induce conservation and more efficient water use. New facilities will be sized more appropriately to meet demand patterns that reflect realistic prices.

In recent years, state public utility regulators have proven more willing to price water correctly. But inflationary prices also can affect how industries are regulated.

Policymakers tend to increase regulatory control when costs are increasing, and decrease control when costs are falling. %n2%n Stable or falling energy and telecommunications prices and increasing competition provide an opportunity to relax price regulation or even to deregulate. But rising costs would argue for continued regulatory oversight of the water sector, if not closer scrutiny of utilities.

Utility Spending and Historical Underpricing

Prices for electricity, natural gas and general and interstate telephone service have increased well below overall inflation rates (see Figure 1). Local telephone service prices have risen close to rates indicated by the overall Consumer Price Index. Price increases for refuse collection, cable television and water and sewer services substantially exceed the CPI. Refuse collection prices could be affected by a move toward more efficient pricing and increasing disposal costs due to limited availability and environmental regulations. Cable television prices could reflect the lack of regulatory oversight for a monopolistic service. However, cable service also has available substitutes and is less essential (although some cable fans might disagree).

Based on the 1994-1995 Consumer Expenditure Survey by the Bureau of Labor Statistics, the average four-person household spent $2,727 on utilities, which is 6 percent of total annual household expenditures (see Figure 2). This figure included $1,104 for electricity, $334 for natural gas, $105 for fuel oil and other fuels, $842 for telephone and $342 for "water and other public services" (including wastewater and solid waste charges). Water and other public services accounted only for 13 percent of annual household utility expenditures and 0.8 percent of total annual household expenditures. Real water prices, however, are beginning to move higher.

Why are real water prices on the rise? Several reasons can be proposed, but the standard trilogy is: 1) compliance with federal and state drinking water standards; 2) rehabilitation and maintenance of an aging water delivery infrastructure; and 3) meeting demand growth.

While the Safe Drinking Water Act is cited as a source of increasing costs, federal and state drinking water regulations are 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.

Price 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 may reduce their water consumption through efficiency improvements or bypass the water supplier in favor of partial or complete self-supply. In extreme cases, they may seek to relocate. Whatever the reaction, the result for the water utility is revenue instability and revenue shortfalls. These problems are magnified when price elasticity estimates are excluded from the rate design process. The interaction between price elasticities and alternative rate structures must be considered carefully. %n5%n

Industry and Regulatory Restructuring

Increases in costs and real water prices most likely will constrain regulatory options in the short run. Regulators and legislatures historically have stood reluctant to decrease regulatory controls while real prices were increasing. Deregulation has primarily occurred when real prices were declining.

During the '70s, the twin shocks of rapidly increasing energy prices and higher rates of inflation changed the passive regulation of the electricity and natural gas sectors into an active and continuous review process. %n6%n Similarly, in the '90s, rising water costs will affect the water-supply sector and potentially could transform economic regulation.

Rising costs and prices, particularly in a more competitive water sector, ashould induce water utilities to mitigate costs. Water utilities have several cost-reduction options.

Water system consolidation can help utilities achieve much-needed economies of scale in source development, water treatment and utility management and operations. Regionalization of water utility service probably is the most promising means of reducing the unit cost of water production. Consolidation or regionalization also help achieve other policy goals, such as universal service and watershed

management. Besides regional utilities, wholesale water markets also could emerge. Smaller water utilities could become resellers and pass along to customers the savings from avoided treatment capacity. Privatization or public-private partnerships may help some municipal utilities realize substantial efficiency gains.

Water utilities can adopt efficiency improvements to reduce waste, conserve resources and lower production costs. Technological innovations in water treatment and other aspects of water utility operations likely will emerge. For large systems, innovation may include automation; for small systems, it may include point-of-entry or point-of-use treatment devices.

Market forces can lower costs by fostering competition for contracts and services between equipment vendors and other suppliers. In any sector of the economy where billions of investment dollars are at stake, the rivalry for profits will likely be intense. The recent EPA Drinking Water Infrastructure Needs Survey calls for $138.4 billion investment over the next 20 years.

Strategic management by water utilities can yield savings in such areas as financing, administration and purchasing. Water utilities must become smart buyers, which will include taking full advantage of competitive energy markets (water and wastewater utilities are energy customers). Integrated resource planning by water utilities, including a balanced consideration of supply-management and demand-management options, can promote least-cost planning options. Avoided-cost analysis can help utilities compare resource options and build a flexible resource portfolio.

Finally, innovative rate design can help mitigate against rate shock and revenue instability. Single-tariff pricing, for example, would allow regional utilities to spread costs across regional service territory and enhance affordability for the customers who reside in higher-cost areas.

Although daunting, increasing water utility costs can be mitigated. Water utilities must take full advantage of the forces that can lower costs. Similarly, regulators should promote full-cost pricing of water service while also providing incentives for operational efficiency and efficiency-oriented restructuring to help lower water utility revenue requirements. t

Janice A. Beecher, Ph.D., is a senior research scientist and the director of regulatory studies at the Center for Urban Policy and the Environment, Indiana University, Indianapolis. She works with the National Association of Regulatory Utility Commissioners and the National Association of Water Companies. Patrick C. Mann, Ph.D., is a professor of economics at West Virginia University. Beecher and Mann serve as members of the Rates and Charges Subcommittee of the American Water Works Association and have written many reports and articles on water utility rates and regulation.

1As measured by the Consumer Price Index.

2"Trends in the Real Price of Water," Journal American Water Works Association, September 1983, by Patrick C. Mann and Paul R. LeFrancois.

3"The Real Price of Urban Water," January 1982 and Journal American Water Works Association, by Patrick C. Mann and Paul R. LeFrancois.

4The price elasticity of beer demand is not included in this analysis, but should be considered if the brewery plans to pass some or all of the water price increase on to consumers of beer. If the demand for beer was price inelastic, this would be an advantage to the water utility (and other providers of beer ingredients). However, demand for individual brands is not price inelastic, and the beer industry is highly competitive, leaving breweries with a powerful incentive to constrain production costs.

5"How Rate Structures and Elasticities Affect Water Consumption," Journal American Water Works Association, June 1982, by David Comer and Richard Beilock.

6"Inflation and Environmental Concern: Structural Change in the Process of Public Utility Price Regulation," Journal of Law and Economics, October 1974, by Paul Joskow.


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