conservation
G . T r a c y M e h a n III a n d I a n K l in e
Pricing as a demandside management tool: Implications for water policy and governance
T Full-value or -cost pricing and conservation pricing as demand-side management tools are examined along with the benefits of maintaining responsive and transparent government and the benefits realized as a result of such practices.
here are significant benefits that can be realized from full-value or -cost pricing and conservation pricing as demand-side management tools, particularly when they complement traditional engineered approaches and other nonprice solutions. This article examines these practices and, in this context, reviews issues relating to price elasticity. The article also looks at the importance of maintaining responsive, transparent governance and managing the inevitable political pressures or imperatives militating against sufficient rates and financing to pay for not only operations and maintenance and debt service, but also life-cycle capital replacement costs over time. These approaches result in environmental and economic benefits in terms of reduced operating costs, water savings, climate adaptation, and deferral and avoidance of capital investment costs based on a review of the current literature. The great Scottish economist Adam Smith captured the difficulty in valuing water—and, by extension, water and wastewater services—by identifying the paradox of diamonds and water in his classic text, An Inquiry Into the Nature and Causes of the Wealth of Nations (1776). “Nothing is more useful than water; but it will purchase scarce anything; scarce anything can be had in exchange for it,” observed Smith. “A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.” MEHAN & KLINE | 104:2 • JOURNAL AWWA | FEBRUARY 2012
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Thus, diamonds, which most often are for mere adornment, are valued more highly than water, which is essential for life on this planet. And so it is in much of North America. Although hardly unique, the United States has some of the lowest water and wastewater rates in the developed world, resulting in what is often described as an investment “gap.” US households on average are paying only 0.5–0.6% of their total income for water and sewer bills (CBO, 2002). Indeed, the average US cost is the lowest price per unit (in cubic metres) of all 14 countries recently surveyed in Africa, the Americas, Australasia, and Europe by the International Water Report and NUS Consulting Group (Hodges, 2008). Contrast this with, for example, the city of Amsterdam, whose water and wastewater officials reported to the recent International Water Association (IWA) meeting in Montreal that the average household in their service area pays about 2% of its annual income for these services. Michael Rouse, former chief drinking water inspector for England and Wales and former IWA president, has discussed the “subsidy mentality” in the US wastewater sector, created in part by federal grants in the early days of the Clean Water Act (Rouse, 2007). Besides the growing challenge of financing and maintaining an aging water and wastewater infrastructure in the face of a growing population and robust immigration, there are large expanses of the United States experiencing drought and water shortages caused by equal parts of demographic shifts to arid regions and climate change and variability. A kind of perfect storm can be found in the Colorado River Basin that covers 240,000 square miles and seven states, including California and a portion of Mexico. Systematic study of tree-ring data going back 300, 500, and even 800 years, indicates that average annual flows vary more than previously assumed and that extended droughts are not 62
uncommon. Future droughts may be longer and more severe because of a regional warming trend. The preponderance of the evidence, according to the National Research Council of the National Academies, suggests that rising temperatures will reduce the river’s flow and water supplies even more (NRC, 2007). When the Colorado River Compact was signed in 1922, allocating water between upper and lower basin states, it was assumed that annual average river flow was close to 16.4 million acrefeet. Unfortunately, tree-ring reconstructions show that the years 1905– 20 were exceptionally wet ones. Add to this the rapid increase in population in states like Arizona (a 40% increase since 1990), and there is the potential for serious water shortages over an extended period of time. Thus, the challenges of an aging and underfinanced infrastructure interact with a growing and shifting population into arid areas in the midst of drought, climate change, and water shortages, creating major challenges to sustainable water management. Nevertheless, these challenges, although requiring a portfolio of techniques to address them, are uniquely susceptible to a demand-side management approach that uses concepts of full-value and -cost pricing along with related techniques sometimes referred to as conservation pricing. This latter approach involves the design and implementation of pricing and rate structures to meet the more specific goal of stewardship (i.e., conservation and efficient use) of the resources themselves. Although the United States is used here to illustrate the issues, the challenges and the approaches hold true in many regions of the world.
NOT JUST AN ENGINEERING PROBLEM Recently, a group of Canadian researchers and practitioners concluded that “the era of ‘endless’ freshwater is coming to an end” and “a twenty-first century approach to
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water management must move from a focus on large centralized reservoirs, higher capacity pumps, and longer pipelines towards an emphasis on decentralized, smaller scale built infrastructure; alternative sources, such as rainwater collection; greater reliance on reuse and recycling; pricing and economic incentives; and highly improved efficiency in water use, as the starting point” (Brooks et al, 2009). They believe that cost-effective water savings of 20–40% are readily attainable by means of what they call a “water soft path,” modeled after the work of Amory Lovins of the Rocky Mountain Institute and Peter Gleick of the Pacific Institute. Many of their recommendations are controversial, e.g., no more interbasin transfers. However, they effectively articulate the benefits of nonengineering techniques, especially economic incentives. For instance, they emphasize the benefits of water metering and “realistic water pricing.” This approach, which originated in Canada, corresponds with some of the recommendations from the recent report of the Aspen Institute’s Dialogue on Sustainable Water Infrastructure. That report focused on a “sustainable path” for management of existing and future “hard” infrastructure, including a more holistic definition that encompasses both traditional human-made infrastructure and natural watershed systems. One of its key points was that utility and system managers, governing boards, and regulators must ensure that the price of water services fairly reflects their full value to human health and the environment and recovers the costs of maintaining, operating, and replacing invaluable infrastructure. The needs of low-income customers must also be addressed through equitable rate design and, where necessary, direct subsidies without doing harm to the overall rate structure itself (Bolger et al, 2009). Many practitioners view water management “as an engineering problem, rather than an economic
one” (Olmstead & Stavins, 2007). Instead of price increases to reduce water use, they tend to resort to nonprice options, such as requiring lowflow fixtures and restricting particular uses that are not as cost-effective as using prices to manage water demand, even though they may be good things in and of themselves. Non-price demand management actions are favored because many managers do not believe that consumers change their water consumption in response to changing water prices. In other words, many US water utility managers believe that water demand is inelastic. This professional preference may contribute to the challenge of ensuring adequate rate structures to allow for both financial sustainability and efficient or reduced use of water. However, a recent review of the relevant literature on pricing and elasticity by Olmstead and Stavins revealed that “On average, in the United States, a 10% increase in the marginal price of water can be expected to diminish demand in the urban residential sector by 3 to 4%.” Moreover, “Price elasticity of residential water demand is similar to that of residential electricity and gasoline demand in the United States (Olmstead & Stavins, 2007).” Although it is true that water demand is relatively inelastic, it is responsive, say these authorities. A key limitation to nonprice approaches to demand management is that water savings are often smaller than expected because of behavioral responses, i.e., customers taking longer showers with low-flow showerheads, flushing twice with low-flow toilets, or watering lawns longer under day-of-the week or time-of-day restrictions. A study of 12 US and Canadian cities suggested that replacing two-day-per-week outdoor watering restrictions with drought pricing could achieve the same level of aggregate water savings, “along with welfare gains of approximately $81 per household per summer drought” (Olmstead & Stavins, 2007).
Of course, pricing and nonpricing approaches are not mutually exclusive but complementary. There is, in fact, evidence that conservation pricing is best used in combination with nonprice demand management actions for optimal results (GEPD, 2007). So even in North America, there is an increasing appreciation of the need for new tools and multi- or interdisciplinary approaches, on the demand side as much as the supply side, for nonstructural as well as structural techniques, and engineering along with nonengineering tools. Moreover, by recognizing the full value of water and wastewater services in the prices paid for them and imposing conser-
how water consumption responds to changes in water pricing, as mentioned earlier. Certainly, numerous empirical studies have shown that residential water demand is, again, relatively price inelastic. Because there is no substitute for water, this inelastic response is characterized by relatively small changes in the amount of water purchased or used given an increase in price. Estimates of the price of elasticity of demand for residential water have a wide range from –0.02 to –3.33, with 90% of all estimates between 0 and –0.75 (Dalhuisen et al, 2003; Espy et al, 1997). Inelastic is not the same thing as unresponsive. Rather, it means that
Although hardly unique, the United States has some of the lowest water and wastewater rates in the developed world, resulting in what is often described as an investment “gap.”
vation-based pricing on a permanent, seasonal, volumetric, or increasingblock rate as necessary, while allowing for a basic household or “lifeline” rate that is affordable, a variety of economic and environmental benefits may be obtained.
DESIGNING CONSERVATION RATES Setting conservation prices is a critical task given its inherent relationship with questions of affordability, full-cost recovery, and potential revenue loss caused by decreased water demand. Still, carefully setting water rates can actually decrease customer water bills (rate increases offset by decreased consumption) and reduce long-term utility costs because water efficiency and conservation can become low-cost alternatives to supply augmentation. Critical to the proper setting of water rates for the purpose of water efficiency or conservation, is the concept of price elasticity of demand, i.e.,
the degree of demand response is less than proportionate to the price change. For instance, a price elasticity of demand of –0.3 means that for a 10% increase in price, demand can be expected to decrease by 3%. All else being equal, elasticity can be expected to be greater under higher prices (Olmstead & Stavins, 2007). In other words, elasticities are higher with nonlinear, increasingblock prices (IBPs) than under linear, uniform prices. In terms of using rates as a mechanism for influencing demand, IBPs are the most frequently advocated structure. IBPs may simply make prices more salient to consumers. That said, price structure, income, demographics, rainfall and weather, and other seasonal factors appear to influence price responsiveness (elasticity of demand). Therefore, when setting conservation prices or rates, it is important to use background elasticity information from studies with similar local or regional demograph-
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ics, geographic conditions, and prices if possible. Conservation pricing may be more effective and efficient if winter and summer demands are addressed separately. Espy and coauthors found in their study that summer demand was more elastic. So imposing water conservation pricing at that time would be more effective. Prices would not have to be raised as much to achieve a given percentage reduction in water use. Other researchers have noted that aggregate demand was 25% more price responsive in summer months, reflecting the more discretionary nature of outdoor water use (Renwick & Green, 2000). Households can exercise greater discretion in the summer relative to activities such as filling swimming pools, washing cars, and watering lawns. This is especially significant in light of predicted effects from climate change, i.e., less water available in reservoirs in the summertime because of a decrease in snowpack and an increase in precipitation in the spring (Miller & Yates, 2006). Moreover, price policies can be significant in combating droughts. The influence that price has on consumption has been shown to be greater in periods of drought, although it is uncertain whether this occurs because consumers perceive a change in price policy as a drought signal or whether it represents a price effect in and of itself. Moreover, experience from the San Francisco Bay area demonstrates that an appropriate mix of market and nonmarket policies during droughts can induce conservation behavior (Corral et al, 1999). Also, modest (5–15%) reductions in aggregate demand can be achieved through modest price increases and voluntary demand-side management approaches such as public information campaigns. Yet, larger reductions in demand (greater than 15%) necessitate relatively large price increases, more stringent mandatory policies, or a package of policy instruments (Renwick & Green, 2000). 64
SHORT-TERM VERSUS LONG-TERM EFFECTS OF PRICING POLICIES A utility manager looking to implement conservation pricing must recognize the likelihood of short-term declines in revenue. Short-term or emergency responses to scarcity or conservation programs may result in revenue declines for which there is no compensation and may not result in permanent or long-term changes in customer water use patterns. To ensure revenue neutrality or stability, the effects of conservation pricing must be factored into the rate-making process. Attaining the same level of revenue entails imposition of a higher rate per unit of water on the anticipated sales volume, taking conservation into effect. However, it is imperative that a utility manager not focus too narrowly on the short-term revenue effects of conservation pricing. Otherwise, he or she may overlook the lessening of the variability of costs in the short-term and a reduction of fixed costs in the long run. This is because revenue instability imposes direct costs of its own on water suppliers through increased borrowing and more complicated planning to ensure adequate supply for current and future customers. Chesnutt and Beecher note that there is a premium on being able to model the seasonal fluctuation on demand with as much precision and accuracy as possible in order to minimize uncertainty about water utility revenues in the near-term. In addition, because the different rate structures can have significant effects on revenue stability, there is a need for empirically based re search that maps out the extent of the instability. Thus, it is critically important to develop the quantitative tools needed to explicitly depict the tradeoffs between revenue sufficiency, revenue stability, equity, and the incentives necessary for efficient resource use (Chesnutt & Beecher, 2004). Chesnutt and Beecher also note that water efficiency and conserva-
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tion will help reduce the variable costs of operations, particularly in the areas of energy and chemicals. The same approach will allow the utility to avoid both fixed capital and variable operating costs caused by inappropriate investments in unnecessary capacity to meet inflated demand for water services. The goal is to lower a utility’s long-term cost structure and thereby reduce its revenue requirements, which will yield lower utility bills over time. The challenge is educating customers about the long-term benefits of water conservation in general. The imperative of full-cost and conservation pricing, IBPs, and other pricing structures lead to greater use of metering as an essential tool to implement these policies and programs. For instance, smart meter technologies, as a component of a smart grid, enable two-way communication between the meter and the water utility that allows the utility to obtain interval meter readings on demand and issue commands to the meter for remote disconnects and/or reconnects (Oracle Utilities, 2010). In its 2010 survey of water consumers in the United States, Oracle Utilities determined that 71% of respondents believed having access to more detailed data on their water consumption would encourage them to take steps to lower their water use. Not surprisingly, 68% of water utility managers believe it is critical that water utilities adopt smart meter technologies. An average US city loses 20–30% of its water production in transit from treatment plants to consumers. If its system is old, it can lose almost half of its treated drinking water. Moreover, 22 gallons of water per person are lost to leakage each day. Therefore, one of the best ways to save water is through the water meter—the “cash register” for utilities. As it turns out, only 22% of water utilities use automatic meter reading (AMR) systems; but 68% would upgrade to AMR if they could save money and water (Kelly, 2008).
GOVERNANCE AND IMPLEMENTATION OF EFFECTIVE PRICING Successfully implementing fullcost, conservation, and other pricing policies and programs such as IBPs and decoupling requires more than just sound technical and economic analysis. Issues of governance, political legitimacy and transparency must be attended to if water and wastewater managers are to successfully engage ratepayers, citizens, and government leaders on the subject of pricing and demandside management. Rouse is instructive on this point. He has studied the successes and failures of governance, regulation, and financing of water systems in Australia; Jakarta, Indonesia; Ghana; Seattle, Wash.; Tanzania; China; Singapore; Ontario; the United Kingdom; and other parts of the United States. Although his work and observations examine governance and equity in relation to sustainable cost recovery, his conclusions are equally applicable to demand management and conservation pricing. Rouse is relatively indifferent about whether a water system is owned or managed by a public or private entity as long as certain conditions are in place. These conditions include good governance, independent environmental and economic regulation, transparency (to air “politically unpalatable information”), accountability, and “sustainable cost recovery,” or full-cost pricing as it is called in the United States. The costs to be recovered include startup costs, operating costs, and “provision for the renewal of the infrastructure.” Rouse uses the IWA’s definition of sustainable cost recovery: “Costs that are recovered so that a water services undertaking can achieve and maintain a specified standard of service, both for the present and future generations.” Rouse believes that expert scientific and technical knowledge are necessary, but not sufficient for the
task of sustaining a water or wastewater system if these other elements are missing. He maintains that separation of policy, regulation, and delivery of services is a prerequisite of successful water management. His aim is to inhibit government officials—who he believes are good at policy but not at running things— from interfering in operational matters such as staffing and rate structures or tariffs. Although a private arrangement can achieve this goal, Rouse supports the successful governance model for Seattle Public Utilities (SPU). “Seattle has achieved full cost recovery of capital and operating costs, including the investment necessary to refurbish the infrastruc-
from a current low tariff situation requires political courage,” Rouse says. “Low tariffs do not help the poor; on the contrary they deny them a decent water supply. So what is necessary to help the poor? Firstly, general subsidies should be phased out, with an associated increase in tariffs towards sustainable cost recovery, and available external funds should be directed to refurbishing and extending distribution systems.” Regarding subsidies—the destructive counterpart to below-cost water rates—Rouse believes them to be “poor practice” because they “rarely make sufficient provision for infrastructure refurbishment.” They also
Nonprice demand management actions are favored because many managers do not believe that consumers change their water consumption in response to changing water prices.
ture,” Rouse says. SPU uses subsidies to protect low-income consumers while it increases prices 10% per year, for 10 years, to overcome a billion dollar backlog that existed before its 1997 reorganization. SPU created a “water enterprise” within its administrative structure with laws ensuring that the water budget would be “ring-fenced,” i.e., it would maintain a “separation between policy and delivery” of services. Seattle’s mayor is the chief operating officer, the council is the board of directors and the regulator, so to speak, and SPU is responsible for the actual delivery of services. Notwithstanding the reluctance of politicians to raise water rates because of fears about the political unpopularity of such move, fullcost recovery is essential for sustainability and should be part of a policy of effective provision of services for the poor. “Increasing charges is unpopular, and moving
“provide greater benefit to the more wealthy consumers, who use more water, than to the poor.” Any subsidies should be focused on the needs of the poor. What Rouse says about governance and equity issues in the context of sustainable cost recovery applies with equal force to demandside or conservation pricing. Implementing a regime, of IBPs or seasonal pricing, for example, to achieve the social good of water use reduction requires trust among the utility, the ratepayers, and community leaders.
CONCLUSION Although the quest for full-cost and conservation-based pricing has been a hard slog in the United States, there are signs of progress driven by population growth and distribution, climate change and variability, and the need to refurbish an aging infrastructure.
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Last year the US Conference of Mayors City Water Conservation Achievement Awards garnered 56 applicants for two awards. A review of the applications, many from the arid western states and Florida, revealed an overwhelming
There are multiple economic and environmental benefits to a regime of full-cost and conservation-based pricing that must be grasped if the world is to serve the water needs of a growing population in the face of drought, climate change, and variability. Price
Of course, pricing and nonpricing approaches are not mutually exclusive but complementary. number of affirmative responses to the question, “Does your city use water rates to achieve water conservation?” Although almost all of the respondents used a broad range of nonprice policies and programs, the significant number that indicated at least partial reliance on water rates and pricing as a demand-side management tool was encouraging.
REFERENCES Bolger, R.; Monsma, D.; & Nelson, R., 2009. Sustainable Water Systems: Step One—Redefining the Nation’s Infrastructure Challenge. A Report of the Aspen Institute’s Dialogue on Sustainable Water Infrastructure in the U.S. The Aspen Institute, Aspen, Colo. Brooks, D.B.; Oliver, M.B.; & Gurman, S. (editors), 2009. Making the Most of the Water We Have: The Soft Path Approach to Water Management. Routledge, Danvers. Mass. Chesnutt, T. & Beecher, J. 2004. Revenue Effects of Conservation Programs: The Case of Lost Revenue. A&N Technical Services, Encinitas, Calif. Corral, L.; Fisher, A.C.; & Hatch, N.W., 1999. Price and Non-price Influences on Water Conservation: An Econometric Model of Aggregate Demand Under Nonlinear Budget Constraint. CUDARE Working Papers, paper 881. Department of Agriculture & Resource Economics, University of California, Berkeley. CBO (Congressional Budget Office), 2002. Future Investments in Drinking Water and Wastewater Infrastructure. ISMBM
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and nonprice approaches to demandside management, working in tandem, are the optimal way to manage precious water resources.
ACKNOWLEDGMENT The authors acknowledge the research and editorial support of Charles Hernick and Adam Lovell, both of The Cadmus Group, Watertown, Mass.
0-16-01243-3. www.cbo.gov/doc. cfm?index=3983 (accessed Jan. 11, 2012). Dalhuisen, J.M.; Florax, R.J.G.M.; de Groot, H.L.F.; & Nijkamp, P., 2003. Price and Income Elasticities of Residential Water Demand: A Meta-analysis. Land Economics, 79:2:292. Espy, M.J.; Espy, J.; & Shaw, W.D., 1997. Price Elasticity of Residential Demand for Water: A Meta-analysis. Water Resources Res., 33:6:1369 GEPD (Georgia Environmental Protection Division), 2007. Conservation-oriented Rate structures. GEPD Guidance Document. Hodges, L., 2008. Rising Prices Reflect Increasing Awareness of Global Water Shortages. World Water & Envir. Engrg. January/February:21. Kelly, C., 2008. Automatic Meter Reading Helps Utilities Face Future Challenges. Opflow, 34:1:8. Miller, K. & Yates, D., 2006. Climate Change and Water Resources: A Primer for Municipal Water Providers. AwwaRF & UCAR, Denver.
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ABOUT THE AUTHORS
G. Tracy Mehan III (to whom correspondence should be addressed) is a principal with The Cadmus Group, 1555 Wilson Blvd., Ste. 710, Arlington, VA 22209-2405; tracy.mehan@ cadmusgroup.com. Mehan was assistant administrator for water for the US Environmental Protection Agency from 2001 to 2003 during which time he developed and launched the “Four Pillars of Sustainable Infrastructure,” a plan to address the challenge of infrastructure finance. Mehan received his bachelor’s and juris doctorate degrees from Saint Louis University in Saint Louis, Mo. Ian Kline is president and chief executive officer of The Cadmus Group in Watertown, Mass. http://dx.doi.org/10.5942/jawwa.2012.104.0011
NRC (National Research Council), 2007. Colorado River Basin Water Management: Evaluating and Adjusting to Hydroclimatic Variability. The National Academies Press, Washington. Olmstead, S.M. & Stavins, R.N., 2007. Managing Water Demand: Price vs. NonPrice Conservation Programs. A Pioneer Institute White Paper. No. 39. Pioneer Institute, Boston, Mass. Oracle Utilities, 2010. Testing the Water: Smart Metering for Water Utilities. Woolcott Research, North Syndey, NSW. Renwick, M., & Green, R.D., 2000. Do Residential Water Demand Side Management Policies Measure Up? An Analysis of Eight California Water Agencies. Jour. Envir. Economics & Mngmnt., 40:1:37. Rouse, M.J., 2007. Institutional Governance and Regulation of Water Services. The Essential Elements. IWA Publishing, London. Smith, A., 1776. An Inquiry Into the Nature and Causes of the Wealth of Nations. Methuen & Co. Ltd., London.
