29 September 2011

Time to dump increasing block rates?

In "Distributing Water's Bounty" [PDF], Ron Griffin and James Mjelde argue that increasing block rates (IBRs) are less fair to the poor than Uniform Rates (URs) [1]. Their argument goes like this:
  1. Start with a $10/household fixed service fee plus $4/unit volumetric charge equal to the delivery cost.
  2. Assume a poor household consuming 2 units pays $10 plus $4*2 ($18); a rich one consuming 6 units pays $10 plus $4 *6 ($34). Total revenue = $52 covers total cost of $32 + $20.
  3. Now create an IBR by reducing everyone's price for the first 4 units to $2/unit. The rich don't use more [2], but the poor household now uses 3 units of $2 water.
  4. Under the new rates, the rich pay 4*$2+2*$4 = $16 for water. The poor pay 3*$2 = $6 for water. Variable revenue is $22, but cost of delivery is 9*$4 = $36. Fixed charges need to rise by $14 to cover that gap. Since customers pay fixed charges per meter, each one pays $7 MORE. So now the rich pay $33 (less than before to consume the same amount of water) and the poor pay $17+$6 = $23 (greater than $18 from before). 
  5. Sure they are using more water, but the new tariff structure means that extra unit is costing them $5 instead of $2.
This argument makes one pause to consider the "fairness" of IBRs that not only increase consumption (!) but also shift more of the financing burden to the poorer (or lower water consumption) household.

I noted this problem in my book [3], but spent more time trying to design an IBR scheme (Some for Free, Pay for More) that would be more effective -- on the assumption that IBRs were here to stay.

Although I don't agree with everything Griffin and Mjelde say [4], this paper pushed me to reconsider IBRs; they seem to be more about engineering "proper" behavior than recovering costs or limiting demand [5].

At a minimum, I think we need to stop using IBRs. They are complicated to set up, may not be fair and may not even be efficient. It makes more sense to use URs (many "IBR" tariff structures are defacto URs structures) that are high enough to encourage conservation. In fact, I think it's worth looking into covering ALL costs with one tariff (no fixed charge per month), except that method would exacerbate the mismatch between the cost and revenue structure.

Note that the oil industry has VERY LARGE fixed costs but sells gasoline with URs. Water managers also prefer them. Half of the 308 cities in a recent global survey of tariffs (post coming soon!) used URs. Most of the others used IBRs (of which at least some were "de facto" URs).

I guess that my preferred alternative would have a fixed charge to cover fixed costs plus a UR to cover variable costs AND reflect water scarcity. Refunds of excess revenue (per meter, not per person) would transfer money from heavy to light water using households.

What about human rights, social equity and per person allocations? Those may be important in developing countries, but they are irrelevant in developed countries where $1 per 1,000 liters (250 gallons) of drinking water is still pretty damn cheap.

What do you think?

Bottom Line: IBRs do not deliver benefits in proportion to their complications. Better to charge a uniform price for water (as in a market) and promote conservation via a single, simple lever: higher prices.

Notes:
  1. The volumetric price per unit rises as you use more with IBRs; it does not with URs. RM sent this example of "innovative rate designs" as an example of the conventional wisdom.
  2. Since they face the same price "on the margin."
  3. See note on page 242 ("They prefer IBRs...") as well as Young and McColl [DOC]
  4. Their assumptions drive their results (it's possible to design "progressive" IBRs by increasing LATER blocks); their discussion of utility and social welfare does not match my experience in the water sector.
  5. See this post questioning their very existence.

16 comments:

  1. Your logic is reasonable, but people usually aren't. IMHO - IBRs are more complicated, but there is a psychological factor to IBRs (even the ones that are de facto URs) that helps shape *some* decisions about use. As you have noted, most folks have no idea how much water they use or what it costs. They may have a vague awareness that rates increase as they use more and almost certainly know whether their area faces any kind of scarcity. If IBRs for water were more like those of electricity - including how they are shown on the customer bills - the intended effects of IBRs would be seen in more places.

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  2. Sheesh. This is why economists shouldn't be let out of the house, or allowed internet connections. You hint in a footnote "Their assumptions drive their results..." but fail to show that a completely different story results from even modest changes in assumptions about the size of the block rate jumps, the actual consumption per block, the size (or even existence) of a fixed charge, the assumptions about how consumption changes with the increasing blocks... Equitable and efficient IBR designs are certainly possible. Why didn't you make even the slightest effort to play some games with the assumptions to show that massively different results can come out? This is lazy.

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  3. How about a variation on the base fee/water-used fee pairing?

    1. A base fee that goes toward operating costs calculated as a percentage of the amount used;

    2. A water-used UR for conservation-minded reasonable use (defined by a water budget) that changes to steeply increasing tiers for excessive use.

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  4. Peter,

    I'm wondering if the "lazy" and anti-economist comments are directed at David Z's abbreviated example or at my paper. The paper is anything but lazy (if you can take the time to dismount and look at it), and it seems reasonable to allow economists to research and speak about economics. Is "rate making" off limits?

    Yes, assumptions always drive results, but it often seems that those groups favoring increasing block rates do so under the presumption that increasing blocks favor small water users and attack the water use of big users. Perhaps this is a pretty sweeping assumption deserving of some inquiry.

    ron

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  5. @Cambria -- you are right that psychology matter, but the IBR jump is often too abstract (vs. "water's damned expensive")

    @Peter -- Obviously. You may benefit from reading my book. The description of some for free, pay for more is just a few pages.

    @George -- your fixed rate is just an additional variable rate, so that's a pure UR.

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  6. Ron, no way to respond directly to you, so pardon this post as a comment.
    First, my apologies -- I have NOT read your paper, and my complaint WAS directed at Zetland, especially if he just gave this one example of a particular rate design and uses it to diss all IBRs. And of course rate making is NOT off the table. I'm a big fan of better ratemaking. And I guess it is ok to let economists talk about and research economics,though the dangers of that are obvious. (That's a joke Ron... sort of.)

    But let me leave it to you. Take your own example (perhaps you do this in the paper) and just by manipulating the blocks, the size of the rate differentials, the assumptions about how use changes with the different blocks (instead of one, single embedded assumption about elasticity), can't you could get a radically different result that was more efficient AND equitable AND covered fixed and variable costs. No?

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  7. Oh, and David. Stop trying to sell me your book. Remember? You sent me the proofs. I got through lots of it, and I think I got ALL your major points.

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  8. Thanks for this, I clearly need to read the referenced pdf.

    A couple of naive reactions:

    1. Any rate system can be designed so it doesn't work. The IBR in your example doesn't come close to covering costs.

    2. As you note, there are other choices than to raise the "fixed" charge. (The modifications would seem to be a second rate change.)

    3. The bigger problem seems to be with using rates that chase costs, as opposed to using prices matching value.

    4. The oil industry uses such prices to cover massive fixed costs. They do not use rates AFIK.

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  9. @Peter -- you just described my IBR design, so you apparently did not read understand the draft. The good news is that you can keep your $20 -- this material is included in the free sample chapter [pdf]. I'm sorry that you keep misunderstanding the main point here -- that IBRs are not automatically good (as they are often presented), and that URs can probably accomplish more with fewer complications.

    @David -- totally agree.

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  10. It seem obvious that higher fixed charges favor people who use more water while rates with a higher portion of the fees from volumetric charges favor people who use less water.

    But I fail to see how you can compare two rates with different fixed charges and then say that is the way the volumetric portion of the rate is calculated (UR or IBR) is a major factor in who benefits from the rate structure. I would think that an IBR that took into account the things that were added to the UR studied (scarcity of water, etc) would yield different results.

    As other people have said, you can design bad/inequitable rate structures that look fair on the surface.

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  11. Yes. In Australia we would observe that there are typically more poor people per house than there are in large houses.

    This means that from a within house perspective IBR are even more inequitable and water use per house is higher!

    It is true that richer people often have larger gardens but they also can afford water saving technologies.

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  12. Yes, but in Kazakhstan (and soon in Russia), after successful completion of the metering programs, it is considered to have IBR for all water services. Thanks to one UK consultant advisory to the Anti-monopoly committee. Also the country is returning back to cross-subsidies to domestic suppliers - U-turn from the 1997 law that prohibits price discrimination.

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  13. IBR alone is not a good social (or income distributional)tool. In many Latam countries (like Colombia, Ecuador and PerĂº) IBR are used in combination with socio-economic classification of the families.
    IBR are a very good signal for reduce the water use: In Bogota-Colombia the use per family reduced from 34 m3/month in 1995 (before tariff reflected the economic-average cost) to 16 m3 in 2005 and 13 m3/month actually. The same happened in other cities. In San Pedro Sula (Honduras) where apply IBR but not family classification, all users had moving (reduced their consumption) to the first 2 blocks, the shippers.

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  14. Dear all:

    We have the problem that fixed cost of urban water supply is 90% of the costa dnavariable cost is only 10% of water cost. Then the wtaer pricing is not reflexing this as usually fixed tariff is below 30% in most of OCDE countries.

    I agree with the unfairness of porr people paying a higher average cost (because of fixed tariff) but IN MY OPINION decisions are making in the margin (marginal cost vs marginal benefits) and Rich people are more likely to have gardens and swimmeng pools.

    Everything is GOOD AND BAD simultaneously and BLOCKS are good and bad. I believe that increasing marginal cost is good for the water saving.

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  15. @aguayaseo and julio -- The simplist IBR has zero fixed charges, some free water and pay a lot for extra units. It will be fair ONLY IF the free water allocation is per capita, which requires good records. My proposal, OTOH, is to charge for ALL water. Even with zero fixed charges, that means heavy users (often the rich) pay more. (I'd prefer to combine that with income support for the poor.)

    The addition of fixed charges means that variable charges can drop, but that can shift more burden to the poor (who use less water). The benefit is stabilized income for the utility.

    In my book, I suggest 80% of revenues from fixed (to match fixed costs), 20% from variable (per unit, not IBR) AND a scarcity surcharge when water's short, to increase conservation on the margin. That revenue (in excess of costs) can be rebated PER METER, which will end up helping the poor :)

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