Misconceptions About Water Pricing

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Throughout the United States, water management has been approached primarily as an engineering problem, rather than an economic one. Water supply managers are reluctant to use price increases as water conservation tools, instead relying on non-price demand management techniques, such as requirements for the adoption of specific technologies and restrictions on particular uses. In my March 3rd post, “As Reservoirs Fall, Prices Should Rise,” I wrote about how — in principle — price can be used by water managers as an effective and efficient instrument to manage this scarce resource.

In a white paper, “Managing Water Demand: Price vs. Non-Price Conservation Programs,” published by the Pioneer Institute for Public Policy Research, Professor Sheila Olmstead of Yale University and I analyzed the relative merits of price and non-price approaches to water conservation. We reviewed well over a hundred studies, and found strong and consistent empirical evidence that using prices to manage water demand is more cost-effective than implementing non-price conservation programs.

Despite such empirical evidence regarding the higher costs of non-price approaches to water conservation, many constituencies continue to prefer them. Professor Olmstead and I believe that this reliance on inefficient command-and-control approaches to water management may be due — in part — to several common and influential misconceptions regarding the use of water pricing.

One misconception is that “because water prices are low, price cannot be used to manage demand.” This misconception that low prices somehow obviate the use of price as an incentive for water conservation may stem from economists’ definition of a price response in the range observed for water demand as “inelastic.” There is a critical distinction between the technical term “inelastic demand” and the phrase “unresponsive to price”. Inelastic demand will decrease by less than one percent for every one percent increase in price. In contrast, if demand is truly unresponsive to price, the same quantity of water will be demanded at any price. This may be true in theory for a subsistence quantity of drinking water, but it has not been observed for water demand in general in 50 years of published empirical analysis.

A second misconception is that “water customers are unaware of prices, and therefore price cannot be used to manage demand.” If this were true, the hundreds of statistical studies estimating the price elasticity of water demand would have found that effect to be zero. But this is not the case. Instead, consumers behave as if they are aware of water prices. The hundreds of studies we reviewed cover many decades of water demand research in cities that bill water customers monthly, every two months, quarterly, or annually; and in which bills provide everything from no information about prices, to very detailed information. Our conclusion is that water suppliers need not change billing frequency or format to achieve water demand reductions from price increases, but providing more information may boost the impact of price changes.

A third misconception is that “increasing-block pricing provides an incentive for water conservation.” Under increasing-block prices (IBPs), the price of a unit of water increases with the quantity consumed, based on a quantity threshold or set of thresholds. Many water utilities that have implemented IBPs consider them part of their approach to water conservation; and many state agencies and other entities recommend them as water conservation tools. But analysis indicates that increasing-block prices, per se, have no impact on the quantity of water demanded, controlling for price levels.

A fourth and final misconception is that “where water price increases are implemented, water demand will always fall.” Price elasticity estimates measure the reduction in demand to be expected from a one percent increase in the marginal price of water, all else constant. Individual water utilities may increase prices and see demand rise subsequently due to population growth, changes in weather or climate, increases in average household income, or other factors. In these cases, a price increase can reduce the rate of growth in water demand to a level below what would have been observed if prices had remained constant.

Raising water prices (as with the elimination of any subsidy) can be politically difficult. This is probably one of the primary reasons why water demand management through non-price techniques is the overwhelmingly dominant approach in the United States. But the cost-effectiveness advantages of price-based approaches are clear, and there may be some political advantage to be gained by demonstrating these potential cost savings.

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6 Responses to Misconceptions About Water Pricing

  1. Mark Palko says:

    “A third misconception is that “increasing-block pricing provides an incentive for water conservation.” Under increasing-block prices (IBPs), the price of a unit of water increases with the quantity consumed, based on a quantity threshold or set of thresholds. Many water utilities that have implemented IBPs consider them part of their approach to water conservation; and many state agencies and other entities recommend them as water conservation tools. But analysis indicates that increasing-block prices, per se, have no impact on the quantity of water demanded, controlling for price levels.”

    I was under the impression that the argument for IBPS was that it was a way of increasing average price (and thus promoting conservation) while minimizing the regressive aspects. I’m not sure I see the logic of controlling for price levels under the circumstances.

  2. Beezer says:

    Just like energy, the aim should be twofold: Increase the price and lower the bill with efficiencies. So price by itself may lower demand, but I don’t see that there will necessarily follow increasing efficiencies. As a utility, regulations should be imposed that allow the utility to make a greater profit by delivering less, not more, water.

  3. Greg Hill says:

    I don’t follow your logic in denying that increasing block rates provide a conservation incentive. Consider two alternatives that recover the same amount of total revenue: 1) a flat rate of $1/ccf; and 2) an increasing block rate under which consumers get 2 ccf at $0.50/ccf and all additional ccf at $2/ccf. Next, assume that say 85% of water users buy some water at the higher rate of $2/ccf. Which rate design would produce the most conservation?

  4. Organic George says:

    Living in CA, we conserved water during the 80′ & 90′s. Consumers did such a good job that the water companies raised the water rates. Water companies are monopolies which are one their face inefficient.

    Now that water is scare again the rates are sky rocketing, as the water companies maximise their returns based on a 20% annualized rate.

    Fix the monopolies and the water problems will take care of themselves.

  5. Greg says:

    The purchase cycle for residential water can be so long (one or three months) that the relationship between consumption and expense is lost to the consumer. Commercial customers will respond to the price signal much more directly because of the practice of following expenditures closely.

    The cost and consumption link must be made much shorter for residential customers, or they will be erratic in their response.

  6. stickman says:

    Mark and Greg (Hill),

    I think the point about IBR pricing not necessarily reducing water demand, is that much demands on the structure of the blocks themselves and the fixed costs of supply. Looking at the actual report that Rob refers to in this post:

    “From an economic perspective, it is certainly desirable to increase the fraction of consumption that faces efficient prices. But even if the highest-tier price in an IBP schedule reflects LRMC, some welfare losses result from infra-marginal “subsidies” – the lower prices offered on the earlier units of water purchased. Thus, the relative efficiency of uniform and IBP structures depends on a variety of factors. In general, an IBP structure in which the upper tiers approach efficient prices may compare very favorably, on efficiency grounds and in terms of conservation incentives, with a uniform marginal price that is well below the LRMC of supply.” (Pg 18)

    In other words, we could be giving too much away on the lower tiers – relative, I think, to the fixed costs of supply – which undermines the effectiveness of IBR. I think a neat way around this problem is to look at incorporating a two-part tariff system (a la cell phones): http://goo.gl/KUp9

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