Reflections on Water Pricing and Tariff Design

Prof. Dale WhittingtonUniversity of North Carolina at Chapel Hill

Prof. John BolandThe Johns Hopkins University

April 3, 2001

Outline of Presentation Objectives of water pricing and tariff

design Alternative Tariff Structures -

Definitions Observations on Increasing Block

Tariffs (IBTs)

Water Tariff The set of prices, charges and taxes

used to generate revenue and The rules and regulations which

govern their use

Average Residential Water Tariffs - Selected Asian Cities (US$ / m3 ,1997)

0.00

Price US$/m3 Cities

0.70

0.20

0.50

Calcutta, Delhi, Beijing, Mumbai, Shanghai, Karachi, Dhaka

Ho Chi Minh, Colombo, Lahore

Manila, Seoul

Bangkok, Kuala Lumpur, Taipei

Singapore, Hong Kong

Jakarta

Functions of the Tariff Determines level and pattern of revenue Contributes to ability to attract capital Creates incentives affecting the

production and use of services Influences the value of the services

received and the total cost of production Allocates cost among customers, groups

of customers, and over time

Purposes of the Tariff Economic Efficiency Fairness (a perception) Equity (a testable hypothesis) Revenue sufficiency Net revenue stability Simplicity and understandability Resource conservation

Additional Considerations in Tariff Design Public acceptability Political acceptability Ease of implementation Enhancement of credit rating

Criteria versus Average Tariff

0.00

US$0.05/m3

US$0.50/m3

US$1.00/m3

% who can afford a private water connection

Low

Medium

High

Very High

Water consumption by hh’s with private water connection

Low

Medium

High

Very High

Low

Medium

High

Very High

Economic benefits received by hh’s with private water connection

Criteria versus Average Tariff

0.00

US$0.05/m3

US$0.50/m3

US$1.00/m3

Revenues received by water utility

Medium

High

Low

Zero

Costs to water utility to deliver water supply

Low

Medium

High

Very High

Low (None?)

Low (None?)

High

Very High

Economic costs paid by others (e.g., subsidies needed by water utility)

Hierarchy of Objectives

Most restrictive

Least restrictive

Economic Efficiency Equity Simplicity,

transparency Fairness Resource

conservation Net revenue stability Revenue sufficiency

Service Quality vs. Cost Recovery

Asian Water Utilities Handbook,1997

Good Service Poor Service

Costs Recovered

Kuala Lumpur

Seoul

Singapore

Taipei

Colombo

Hanoi

Jakarta

Lahore

Costs Not Recovered

Beijing

Hong Kong

Shanghai

Kathmandu

Dhaka

Manila

Some Basic Tariff Options Single part tariff, consists of either:

Fixed charge (not based on measured water use)

Volumetric charge (based on measured water use)

Two part tariff, includes both fixed and volumetric charges

Volumetric Charges Uniform price - all units of water billed at

same price Block-type structures - two or more

prices, each applies to use within a defined segment (block) of monthly use Decreasing block - block price falls as use

rises Increasing block (IBT) - block price rises as use

rises [Note: first block price usually set below cost]

Tariff Design - Uniform Price Periodic fixed (“service”) charge,

e.g., US$/month/connection Single commodity price, e.g., $/m3

Example (in US$):$5.00/month for residential

connection, plus$1.00/m3 for all water use

Tariff Design - Decreasing Block Periodic fixed (“service”) charge Two or more commodity prices

($/m3), decreasing with use:$5.00/month for residential connection, plus$1.50/m3 for all water used up to 15

m3/month$1.00/m3 for all water used in excess of 15

m3/month, up to 30 m3/month$0.75/m3 for all water used in excess of 30

m3/month

Tariff Design - Increasing Block (IBT) Periodic fixed (“service”) charge Two or more commodity prices

($/m3), increasing with use:$5.00/month for residential connection, plus$0.75/m3 for all water used up to 15

m3/month$1.00/m3 for all water used in excess of of

15 m3/month, up to 30 m3/month$1.50/m3 for all water used in excess of 30

m3/month

Tariff Design - Variants Increasing rate designs Combination block designs Free service allowances (form of

increasing block) Seasonal water tariffs Seasonal sewer tariffs Lifeline rates

U.S. Water/Sewer Agencies 50,000+ water utilities 30,000+ wastewater utilities Urban places with 100,000+

population 300 water utilities 200 wastewater utilities

U.S. Government-Owned Water Utilities 80 percent of total 85-90 percent of large systems Very few subject to tariff regulation

by State Only 12 of 50 states with laws

restricting pricing practices

U.S. Investor-Owned Water Utilities 10-15 percent of large systems Subject to tariff regulation by State

agency, based on rate-of-return

U.S. Water Tariffs

1982 Survey 1992 SurveyDecreasing Block 60% 45%Uniform Price 29% 37%Increasing Block 11% 18%

Commonly Overlooked Facts I Water and sewer services are

bundled commodities Users respond to the sum of water

and sewer tariffs Developing tariffs separately

according to different criteria is illogical

Commonly Overlooked Facts II Prices determine water use, not tariff

design Each user responds to his/her last block

price regardless of what other prices may be, or what other users may do.

Block type rates permit price discrimination, individual users respond to the price in specific block(s)

Increasing Block Tariffs (IBTs)

Still actively promoted in developing countries

Water pricing is an important instrument for stimulating efficient use of water. A basic amount could be used at a relatively low rate, while water consumption beyond that amount could be charged with progressively higher rates. (Urban Water Resources Management, UN, 1993, p 19).

Widely used in OECD countries

IBT Example: La Paz, Bolivia

(US$/cu.m.) Domestic User Commercial User Industrial User1.19 Above 300 cu.m./mo Above 20 cu.m./mo. All use0.66 151-300 cu.m./mo. 1-20 cu.m./mo.0.44 31-150 cu.m./mo.0.22 1-30 cu.m./mo.

Examples of IBTs

What is Rationale for IBTs? Claimed to transfer income from rich to poor Claimed to transfer income from firms to

poor HHs Very high prices in top blocks claimed to

discourage “extravagant” and “wasteful” use

IBTs are said to implement marginal cost pricing principles

IBTs are said to reflect assumed rising marginal cost curves

IBT Rationale Revisited I

Rich subsidize the poor Average price rises with HH use.

Therefore, to the extent that water use is correlated with income, subsidy occurs.

Maximum possible subsidy is small (typically US$1 to US$3 per month)

Subsidy is regressive within the lower blocks

IBT Rationale Revisited II

Firms subsidize poor households IBTS produce such a subsidy Subsidy is regressive within the lower

blocks If subsidy were desirable, it could be

achieved more easily by sectorally differentiated prices

Subsidy may not be desirable: large users may exit system, increasing average costs for residential users

IBT Rationale Revisited IIIIBTs discourage “extravagant” or “wasteful”

use No clear what “extravagant” means If “wasteful” means uses that do not justify

the resource cost of the water, then: Setting price equal to marginal cost means that

every customer pays to replace every unit of water taken, regardless of the type of use

No further incentive is necessary or desirable

IBT Rationale Revisited IVIBTs are consistent with marginal cost pricing There is only one marginal cost for a given

class of customers at a given time IBTs result in different customers within the

class paying different prices at any given time, based on their total monthly use

At most one of these prices can equal marginal cost; all others represent a divergence from marginal cost pricing principles

IBT Rationale Revisited VIBTs track rising marginal costs Marginal cost is not necessarily rising, even in

developing countries If marginal cost is rising, it rises as a function of

aggregate water use; it does not change perceptibly with changes in water use by a single HH

Prices are meant to reflect the costs imposed by additional water use by the HH. These are the same for all HHs in a given class at any given time.

Marginal cost may rise over time; then prices should also rise over time, but for all uses

Limitations of IBTs in Practice Difficulty in limiting size of the first block Difficult to provide proper economic incentives to

most customers Difficult to meet revenue target without large

departures from marginal cost Lack of transparency and difficulty of

administration In the case of shared connections, or where

connected HHs resell water to vendors, IBTs increase cost to the very poor

An Alternative to Increasing Block Tariffs Use lump-sum transfers for income

redistribution and other fairness objectives

This allows the choice of a uniform price design, preferable according to all other criteria

Lump-sum transfers can lead to negative fixed charges for some users

A Practical Alternative to IBTs: Uniform Price with Rebate (UPR)

Two-Part Tariff IBT DesignFixed Charge (US$/mo) -6.69 0.00

Minimum Charge (US$/mo) 2.50 2.50US$/cubic meter

0-15 cubic meters/month1.00 0.50

US$/cubic meter>15 cubic meters/month

1.00 1.00

Household Water Bill: UPR vs. IBT

Household’s Monthly Water Use (m3)

Uniform Price with Rebate

Increasing Block Tariff

5 US$2.50 US$2.50

10 US$3.31 US$5.00

15 US$8.31 US$7.50

20 US$13.31 US$12.50

25 US$18.31 US$17.50

Two-Part Tariff: Evaluation Both tariffs produce the same revenue Two-part tariff provides improved

incentives: More HHs face full marginal cost with a UPR

than with a IBT. Only the smallest, most price inelastic HHs face a zero incremental price

Two-part tariff more effective in transferring income: Per-HH transfer is larger Transfer is not regressive

Two-Part Tariff: Evaluation Two-part tariff is simple and

transparent Two-part tariff is more equitable Advantages of two-part tariff even

greater when compared to a multi-step IBT

Conclusions Usual rationales for employing IBTs are either

incomplete or incorrect There are significant practical difficulties with the

application of IBTs in developing countries If the purpose of an IBT is to redistribute

revenue, alternative tariff designs can do so more effectively

IBTs, on the other hand, introduce inefficiency, inequity, complexity, lack of transparency, revenue instability, and forecasting difficulties

Conclusions (cont.) Properly designed tariffs are powerful

management tools Comparisons of alternative designs can

be complex No single design fits all circumstances Increasing block designs, though widely

used, have many disadvantages Better tariff design is possible