21 Apr 2015

How to price water for conservation in California

Yesterday, a California court ruled that tiered water prices (increasing block rates, or IBRs) were "unconstitutional" because the rates were not based on the cost of service at each tier.

This does not surprise me, as tiered rates were originally designed (as I heard from Professor Michael Hanemann, my UC Berkeley advisor and an early consultant for LA's IBRs) to allow politicians to choose the break between the cheap price for most and higher price for "heavy users." (The higher price was supposed to be based on the marginal cost of additional water supplies, but that target is often missed, sometimes in brutally unfair ways.)

The main idea was that politicians could "move the lever" between blocks and tiers. For example:

Politicians choose the "cut off" between blocks. Red+yellow areas are same in each figure. 
The trouble is that people do not "behave" the same when facing different pricing structures.
In theory, water managers should not care where the line is, since prices would be set (once politicians chose the break between blocks) to recover their full costs, but that target is very hard to achieve. People do not behave as models predict. That's why utilities pay $40,000+ to consultants with complex spreadsheets (sample crazy XLSX) who try to make sure that all the customer "buckets" generate the correct revenue.

So that's why IBRs are so complex to design, destabilize utility finances, do not reflect actual costs, and confuse customers.

It's for these reasons that I decided to end my support of  "some for free, pay for more" water pricing (and all other types of IBRs) a few years ago. IBRs are too complex at the same time as they are ineffective. They are also, of course, unfair when you consider that the number of cheap blocks usually ignores the number of people (i.e., the excuse for "cheap" water).

Instead, I went back to the future, to a single volumetric charge that reflects the cost of water sourcing and delivery and fixed monthly charge that reflects the cost of the water system. Those charges were used for years without many problems before IBRs became trendy in the 1980s.

The only addition I made was of a "scarcity surcharge" that would reflect the cost of getting new water (e.g., desalination).* That charge would be added to the volumetric charge whenever a utility was running out of its "normal" supplies, e.g., California now. This surcharge would apply to ALL water and it would reduce demand in the same way that higher prices reduce demand for any commodity (e.g., coffee, gasoline, etc.).

Let me repeat here the fact that higher prices are also more effective at reducing demand than the very unpopular command and control regulations California has implemented.

* My key innovation was to rebate the resulting excess revenues back to customers. (There are excess revenues because the higher price -- based on the cost of new water -- is charged against ALL consumption, some of which comes from cheaper sources, e.g., groundwater) The rebates would not be in proportion to consumption (as that would cancel the increase) but per meter. What does that mean? It means that heavy users would end up reducing the service cost of light users who tend to be poorer or more careful with water.

For example (from a presentation I am giving next week in London):

My design, therefore, does not destabilize utility finances and promotes water conservation without hurting the poor. Read more about it here.

Would this design be "constitutional"? I would say yes, in the sense that the utility would not retain any revenue. If that doesn't work, then I'd recommend that every utility build a small (100,000 gallons/day) desalination plant that costs $10/1,000 gallons to run and use that marginal "cost of service" to set their rates. (San Diego could do this NOW with its 56 MDG plant that will provide water for 7 percent of the population at three times the average cost of water.) If that doesn't work, I suggest they get smarter lawyers or pack their bags. Californians cannot continue to ignore common sense if they want to avoid drying up and blowing away.

Bottom Line: There are many ways to charge more for water if you need to pay for your water system or protect your limited water supplies. Choose a simple, fair way.

H/Ts to LH, SK, RM and JR


Jordan said...

I'm liking the solution you're proposing here - one that would help conserve water without harming the poor. Here's hoping California can find a solution that works for it soon. Thanks so much for sharing this!

JBD said...

I do like your solution but since it does involve a subsidy to Mr Green (out of the rate generated funds) it may not fly constitutionally in California. I know on sewer rates such subsidies are not allowed as we've looked into this alot with the cost of treatment to meet ever more stringent requirements hitting fixed income folks disproportinately. This is why on things like power and some water/sewer bills there is a solicitation for a donation to a fund to assist low income users. The other option is to use general fund sources to grant rebates/assistance with eligibility defined as the politicians/voters deem fair.

The hardest part for me is how to assign a rational value to something no one can own. (Only be licensed to use....in approved ways....that change based on what politicians/voters deem fair at any given moment)....which brings us back full circle to hoping the voters/politicians are rational/transparant.

I think the basis of your solution to charge rates that reflct the true marginal costs is solid even without the direct ratepayer subsidy, and although using general/donated funds for any desired subsidies isnt as efficient, it may be the best that can be done without changing the State Constitution.

David Zetland said...

Sounds like the painful impact of yet another poorly understood (in terms of implications) laws. I guess that it would then be allowed/easier to ONLY charge volumetrically, but that would mess up utilities even more.

Or... can't the voters just approve the rates, based on Pro 218 "voter exceptions"?

Giel Verbeeck said...

Is there any real life experience with equalising the total of the surcharge to the size of the rebate? What is the rational for equalising them other than political acceptability and making it financialy neutral for the utility. I know rabates only as a social measure but want to learn more. I'd be very interested also in case studies from US cities with rebating for social purposes. Who is paying for it? What are the options (vouchers, automatic rebates). How is eligibility for rebates set? Who is deciding on it? Can it be adjusted without harming the utility?

David Zetland said...

@Giel. Good questions. The surcharge falls on all, by use, and rebates go to all, by meter. They offset in total but are a net cost to heavy users and net rebate to light users. These are used often in regulated industries. The Dutch use this with energy charges and the tax rebate to households. US cities raise/lower charges based on Rate Stabilization Funds but these are not used for conservation. I'd make them automatic and base the surcharge (thus rebate) on the degree of scarcity (eg, falling groundwater)

Andras Kis said...

I think this is a good regime, with some caveats.

Meter based rebate favours small families / individual consumers. Rebate that is proportionate to the number of inhabitants seems more of a fair solution, but also costlier to administrate. And while this may work for residential customers, it is more difficult to apply to commercial water users, some of which are small, others are large.

My bigger concern is that utilities may view the additional revenue as “free money” to spend on whatever extravagance they like or unjustified investments, leaving less for rebate. Of course this depends on (corporate) culture and whether there is proper regulatory oversight.

The principle itself definitely seems worth further contemplation. Thanks for sharing.

David Zetland said...

@Andras -- you have a point on the rebate, but you ignore the "fact" that the fixed cost/person is lower for larger families, which does a bit to reduce their burdens. BUT, on the whole, my idea is NOT aimed at welfare (direct $ transfers are better), but encouraging less water use.

Oh, and NONE of this applies to non-residential users, who would face (the same) higher prices but get no rebates.

I agree on your "free money" comment, but I was assuming that (a) it would be clearly marked as excess for rebates and (b) closely watched by people expecting to be paid.

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