The Los Angeles Times published an article yesterday on the water rate challenge ongoing in San Juan Capistrano, California. Not just any water rate challenge, a challenge to a rate design that includes rates that increase the price of water the more water that a customer uses, known as inclining block rates or tiered rates. In an age where water conservation is promoted as being good public policy, one of the best and most effective ways to promote conservation is using price as a signal, right? So rate designs such as these seem entirely consistent with good economics and public policy.
The problem in California arises with what’s known as Proposition 218. Adopted in 1996, Prop 218 protects taxpayers from revenue hungry local governments charging more than a service costs.
The lawsuit is presently on appeal after the trial court ruled in favor of the complaining customers. As the article reports, an appellate ruling is expected soon.
I have not studied the rates at issue in the lawsuit, so I am analyzing the situation from afar. (I’m also not providing legal advice). My baseline assumption is that the utility is not over-collecting its overall revenue requirement. Essentially, if the utility needed $100 Million in revenue to cover its costs, then that’s what it is earning through the collection of its rates. On the macro level, again under my assumptions, the utility is not collecting more than the service costs.
Here’s what I believe the lawsuit argues: the customers whose consumption places them in the higher tiers argue they are being charged too much for water and that they are in fact subsidizing the rates of customers whose consumption places them in the lower tiers. It’s unclear from the information I’ve reviewed whether there could also be an argument that the higher tier customers’ position is that commercial or industrial rate classes are enjoying the alleged subsidy provided by those higher tier customers. Either way, this appears to be a classic issue that takes place in utility rate cases every day throughout the country. One customer class is attempting to push costs onto another customer class. It’s a zero sum game, and some class of customer needs to pay for the utility’s reasonably incurred costs.
In the trial court ruling, the judge found that the rates were not cost-based. The judge did not, however, “declare all tiered systems illegal[.]” That’s the specter being raised by some. The Orange County Register article quoted and linked earlier cited to Richard Little, a now-retired director of the Keston Institute for Public Finance and Infrastructure Policy at USC. On the idea of tiered rates, Mr. Little is quoted as stating, “Of course it’s social engineering,” and “It’s trying to achieve a social outcome – which is water conservation – and the best way to do that is send pricing signals.”
I disagree that inclining block rates cannot be cost-based. There may be policy reasons for implementing inclining block rates, but I strongly disagree with the notion that a cost basis for inclining block rates is out of reach. The challenge is coming up with a strong cost-of-service study to support the inclining block rate design.
The cost-of-service study could factor in a number of variables to support inclining block rates. The variations of the demand imposed by customer classes could support cost-based inclining block rates – akin to a demand charge in the energy sector. Customer classes whose use varies widely throughout the day and causes peak usage should be charged more for water, as they are the ones putting a greater strain on the system. These are the customers that wash clothes and dishes, take showers, and irrigate their lawns when system-wide consumption is at its highest point. This causes the need for increased pipe sizes, bigger pumps, and increased energy use, among other factors. These factors all cause the price of furnished water to increase and could support, with appropriate data of course, inclining block rates. The American Water Works Association’s M1 Manual – Principles of Water Rates, Fees and Charges (available for purchase) explains how these “capacity factors” can be calculated. (Hat tip to a friend who’s also a utility rate consultant and CPA who suggested capacity factors and the AWWA’s M1 Manual to support this argument; my friend also suggested having separate rate structures for each class of customer: residential, commercial, and industrial).
Another factor that could support an inclining block rate design is the avoided cost of additional capital construction, like new water treatment plants, water tanks, pumps and the like. By avoiding that capital cost, it helps keep rates low and customers who are using less are contributing less towards the need for new capital facilities. Recall from the earlier point that the customers whose use spikes and causes peaks will be the customers who initially cause the need for expanded system capacity. In the long run, all customers will take advantage of the expanded capacity, but in the short-run, the economic value of delaying construction of new system capacity, I would argue, can be attributed to those high volume, variable users that contribute to the peak usage of the water system. As with the prior factor, appropriate data demonstrating this will be needed to support inclining block rates.
Some cautionary notes: I have not seen a utility undertake to use these elements when supporting an inclining block rate structure with a cost-of-service study. Support of this nature requires a substantial commitment to data capture, scrubbing and analysis. That kind of support won’t come cheaply. My suspicion is that until now, there has not been a need to expend the funds for that analysis because in jurisdictions where inclining block rates had been implemented, they had not been challenged. That obviously has changed, and the LA Times article notes that other lawsuits have been filed based on the tiered rate structure in other California communities.
Another cautionary note concerns rate-making for utilities regulated by state public utility commissions. In my experience, the burden of proof is much higher for the regulated utility than it is for an unregulated utility, like many municipal utilities. While I’ve heard an interest in cost-based conservation rates from regulators, I have not seen an inclining block rate successfully proposed in a regulated utility setting. Part of the problem is using the delayed or avoided cost of future capital expenditures component because it would depart from traditional utility rate-making. Accordingly, without statutory support, I doubt such delayed or avoided costs for water utilities (in contrast to the electric sector) will be proposed in the regulated water utility sector. We’ll need to see unregulated water utilities succeed in utilizing such a delayed or avoided cost framework before commissions (or legislatures looking to provide statutory support) begin to look at water rates supported by a delayed or avoided cost framework, at least in my view.
This blog post is not meant to be a treatise on rate design, and the factors identified are my initial thoughts on evidence that might support an inclining block rate design. I’m certain other arguments may be developed to support it, and probably have been advanced in the San Juan Capistrano case. My hope is that if the San Juan Capistrano rates are ultimately defeated, that any bad facts in that case do not translate into bad law and the death of inclining block rates. I believe that with the proper evidentiary support, an inclining block rate structure can survive a challenge such as that currently ongoing in San Juan Capistrano.
What do you think about these tiered rate structures and the future of inclining block rates?
The lawsuit is clearly directed at “price discrimination”, i.e., heavy users paying more than light users when their share of CURRENT costs is no different. I agree with you that there’s some theoretical reason to charge more on capacity (not so much peaking), but those costs are either there or not, so it’s not useful to charge on the “potential” for new capacity needs.
This lawsuit adds another reason for implementing my idea: uniform block rates, since those are not discriminatory. Scarcity surcharges on use that are rebated per meter will also — I’d argue — pass muster on a lawsuit, since everyone could be charged the marginal cost of the most expensive supply (a real cost).
http://www.aguanomics.com/2014/07/pricing-tap-water-for-efficiency-and.html
Thanks David. I think the core issue is one of state statute/law. Many states have statutes limiting how water can be priced, much like Prop 218 in California. I’m unaware of a scarcity surcharge passing regulatory muster - do you know of any? In traditional utility ratemaking, you have the test period (I’ll assume a historical test year for this example), and a 12-month (typically) adjustment period for changes that are fixed, known and measurable during the adjustment period. The problem is proving the amount of the scarcity surcharge and when it will be needed. It isn’t fixed, known and measurable for utility ratemaking purposes. I agree, however, that it would be much easier to implement a scarcity surcharge in an unregulated setting.
I agree that uniform rates are probably the best option for many if not most utilities for meeting their overall their revenue and policy goals, however uniform rates are far from perfect either and in some situations could be even less perfect than other more complicated rate structures including increasing block. I don’t know enough about the rates in question to have a strong opinion and would need to know a lot more about customer characteristics, usage history and revenue needs to take a strong stand one way or another. I do think that in general, all types of volumetric pricing struggle by trying to shoehorn a largely long term fixed cost structure into an instantaneous or at least monthly variable pricing regime. When considering fairness and cost of service, I prefer to look at the end result over a longer time period than the time it takes to consume a few 1,000 gallons. I also think that the type of fixed or base charges a utility use is incredibly important.
When the smoke clears (or ripples settle), I would like to know how much more a family that requires a lot of capacity (measured in a way most relevant to the utility based on their cost drivers) here pay than a family that uses much less capacity? Would be interesting to look at the yearly charges for families that require different levels of capacity. Under the current rate structure including the base charge, does a family using twice the capacity pay twice as much? More than twice as much, less than twice as much? In our experience studying different rate structured and the impacts on customer bills, we see as many troubling cost of service problems with base charges as with block structures. Many utilities place a considerable amount of their base revenue requirements into a fixed charge and vary the fixed charge based on meter size only which for single family residences often is a very poor surrogate for capacity impact. A town house with no yard likely has yhr same meter size as large lot 3,000 s.f. house and may pay the same fixed charge. In practice, when we’ve looked at actual payments over time, we’ve seen that an increasing block structure can compensate a bit for the poor allocation done by meter based fixed charges. When we study what customers actually pay under different rate structures, increasing blocks don’t perform that much worse overall than uniform in many cases. On the other hand, as far as pricing signal goes, we’ve seen a lot of uniform rates send as strong price signals as increasing block structures in other communities. I think the most important thing is to set your overall rates at sufficient levels to cover costs. I think we can all agree that artificially low rates whether following an increasing block rate structure or uniform structure send poor pricing signals and are far from cost of service.
If a Judge decides that a utility can’t use volumetric pricing to shift costs to large users and create (at least the illusion) of a stronger price signal, than maybe we’ll see more utilities turning towards more refined use of base charges and more interesting use of demand or capacity charges.
ps/Jeff — Loved your podcast. We have a lot in common. I’ll be in touch.
@Dave — this is a good place to ask if the law is useful. If I was going to argue for a surcharge, i’d use the “marginal cost of new water” as a justification for “cost” under the current law. I’d use “not running out” (i.e., supply and demand) as a justification to politicians and the community.
@Jeff — your comment shows how complex things CAN be. I prefer simple. We don’t ask how large the family is or why people need it when selling gas. Why the social engineering. In my post above, I discuss matching costs and charges for fiscal stability and water conservation. All the other questions (family size, etc.) invite endless debate, as there’s no objective way to trade off those criteria.
The problem with inclining water rates is that they may not conserve any more water than flat rates. A pilot study I conducted indicated that flat water rates saved as much or more water, as those who used more water had to pay greater monthly water bills. See: “Are California Municipal Water Rates Too Low to Spur Conservation?” Master Resource.org Sept. 17, 2014.
For wholesale water:
Raising water rates in a drought is a pseudo-market solution that would just lead to more divvying up of excess water revenues to free riding political constituencies such as commercial fishermen, Indian Tribes, environmental studies and monitoring, and water-oriented tourist real estate development. The more free riders, the more water is politically allocated and the more farms and cities are vulnerable to drought. Long-term studies indicate raising tiered water rates for higher usage doesn’t deter water usage anyway.
Thanks for your comments, Wayne. I agree with Jeff Hughes’ comment that rate design should recover revenues to keep the utility financial stable while also sending the right price signals to customers. Conservation is one such price signal.
Demand for water is not perfectly inelastic. Therefore, the price of water will affect consumption. (As will a utility’s conservation programs and messaging). It’s just a question of where on the demand curve that supply is intersecting it. One of the issues I and others have told clients is that the problem with inclining block rates is that they might work too well (meaning that the utility under-recovers its revenue requirement and becomes financially unstable thus triggering a rate case - try convincing your constituency to conserve water and then raise rates because they conserved too much).
Through the above blog post, I am not advocating that each utility implement inclining block rates - it’s the utility’s prerogative if it wants to adopt that policy choice, assuming the rates are cost-justified. I want to see, however, the rate design toolbox kept open and not foreclosed by a bad facts case that kills inclining block rates for the wrong reasons. Essentially, if an inclining block rate can be cost-justified (and it’s a big if), it shouldn’t be foreclosed from the policy choice made by the governing body.