26 Mar 2014

Water Shortage and Rates in California

Chris Scott writes:*

The extreme water supply shortage in California has to be addressed by water managers and the rates need to reflect the current cost to supply the resource. The picture above of the Folsom Lake Reservoir, which provides water for nearly 500,000 people in California, illustrates the severity of the drought currently taking place. The picture on the left shows the reservoir on July 20, 2011 at 97% of its total capacity compared to the picture on the right of the reservoir just over a month ago at 17% of its total capacity. Folsom Lake and every other major water reservoir in California is currently significantly under their historical averages of water capacity for this time of year. With this trend showing up over the past few years, it has me wondering why the prices or rate structures have not changed drastically.

In California the two most popular water rate structures are “uniform rates” and “increasing block rates”. I agree that both of these structures are good in the sense that the people that are consuming the most water have the highest bills. What I disagree with is that in most cases in California it is the commercial and industrial customers, who use significantly more water than the residential customers, that pay the uniform rates and it is the residential customers that pay the increasing block rates. This means that for residential customers, who use far less compared to commercial customers, have increasing per unit costs, therefore decreasing demand for water the more they consume. Commercial customers on the other hand, have the same per unit cost no matter how much water they consume, therefore the same demand for water regardless of consumption level. This constant per unit cost for commercial customers gives no incentive to use less water during a drought because their variable costs remain the same regardless of consumption.

Bottom Line: Since water is a finite resource, especially in California, it only makes sense to have increasing block rates for everyone. Since the more water you consume the less is available for everyone else, your per unit rate for water should increase the more water you consume to reflect the water you are taking away from others consuming. If commercial customers see their variable costs going up and their margins going down, this gives them an incentive to be more efficient with their consumption or face diminishing returns.

* These guest posts are from students in my resource economics class at Simon Fraser University. Please leave feedback on their logic, ideas and style and suggestions of how to improve.


Joe Villani said...

This brings up a very good point and the solution presented is quite an interesting one. This may end up helping water supply as well. If these costs go up for commercial consumers they may end up using water more efficiently.

David Zetland said...

As prof, I did not comment on this post, but I will as a blogger. Businesses pay uniform rates because it's not clear where block rates would be set. For homes, it's *reasonably* clear that 100 or 300 gallons/day should be in a cheaper block, but how to you set rates for one business that uses 20,000 gallons/day and another that uses 200? What if the first is a 50 bed hospital and the second is a law office? The easiest -- and fairest -- way to price commercial water is via uniform rates. (That also happens to be the best way to price residential water.) If water is scarce, raise the one and only price, don't muck around with blocks and thresholds.

Daniel Hall said...

Joe is my student, but David I wanted to follow up on your comment that it may be easier to set uniform rates and raise the price when water is scarce than use increasing block rates. I would agree that this would be easier IF the rates increase automatically as water becomes scarce. It seems to me that increasing block rates is a second-best solution because prices often do not increase instantly as water becomes more scarce. Is this because most public water utilities use average-cost pricing instead of marginal-cost pricing, public resistance to price increases, or am I missing something else?

David Zetland said...

@Daniel -- That's a good point, except that IBRs would then need to *contract* if they were to reflect an increase in scarcity (without that, they merely discourage extra use). So (1) I agree that price increases should be agreed in advance (I discuss this in my book :), but (2) lots of people oppose price increases and IBRs make it easier to "soak the rich" by getting disproportionate revenues from them. That's one reason utilities and politicians like them: revenues plus redistribution of system costs from "average" people to heavy water users (who may be poor, large families).

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