Market Responsive Pricing for Water Utilities

Adam Smith in the 1760s suggested that the price of a commodity must depend on what that good is worth to consumers — on the utility that the commodity offers. Yet, there are situations in which a good’s utility has little influence on its price.

The two examples that Smith used were diamonds and water. Water, which is essential to life and therefore of tremendous value to most consumers, usually sells at relatively low prices, while diamonds are normally very expensive even though their uses such as for jewelry are quite limited. This situation is referred to as the diamond-water paradox.

The paradox can be explained based on the economic concepts known as marginal utility and scarcity. Marginal utility is the satisfaction realized from consuming an additional unit of a good while scarcity is how much of a good is readily available.

Water is normally abundant and relatively inexpensive in most places, which means that consumers obtain low marginal utility from consuming additional units of water. As more water is consumed, each additional unit provides less and less utility to the consumer.

Diamonds, on the other hand, are scarce and therefore expensive. Because of scarcity, most consumers cannot afford to purchase diamonds to the point that the marginal utility of acquiring additional diamonds declines significantly.

Solution to the Diamond-Water Paradox

The foregoing illustration of marginal utility and scarcity suggests that there are times when water should be priced more like water while at other times water should be priced more like diamonds. The different prices should depend on supply and demand conditions in the market for water.

There are times when water is plentiful and literally going over the dam and ending up in the ocean. This is like the unused power from a hydroelectric plant, which could not be sold; one of the reasons aluminum plants were built in the Northwest was to take advantage of cheap electricity. More recently, crypto-currency mining has taken the place of aluminum smelting.

Conversely, there are times when water is more like diamonds and is extremely dear; think of a prolonged drought or hot spell when a common way to ensure supply and demand are in balance is to artificially restrict demand such as by the inefficient process of rationing. Gas lines in the 1970s were caused by rationing.

The cost-of-service method of pricing water, under which appropriate operating expenses, depreciation, and taxes plus a fair return on invested capital are aggregated and spread over units sold, often segregated by tariff classifications, may not always be optimal.

In fact, other more market responsive pricing mechanisms are possible, which could lead to higher value for the consumer and a better allocation of resources. The use of the price mechanism to encourage the sale of additional water at times when water is plentiful and discourage its use when it is scarce makes sound economic sense.

Water Economics

The cost of water provided by many companies is comprised of a high percentage of fixed costs versus a low percentage of variable costs. Fixed costs are incurred whether or not any water is consumed, while variable costs depend on the volume of water sold.

Given the cost characteristics of the water industry, it makes sense to spread the fixed costs over as large a volume of sales as possible to lower the unit cost of water to the consumer, provided this can be accomplished in a manner consistent with conservation and environmental goals.

Water utilities can sell more water at a lower price than at a higher price, which accounts for the negative slope of the demand curve. If prices can be used to encourage or discourage the consumption of water, profits and consumer surplus can be increased. Any price above variable costs contributes to profits in the short run.

Higher prices that discourage consumption at times of shortage, reduce the need for additional capital spending, which would increase fixed costs (and sometimes cause environmental concerns associated with construction) and thereby reduce costs for all customers.

While capital spending to increase capacity would be reduced under this plan, capital spending to replace old leaking pipes and improve water quality likely would not be reduced. This proposal ameliorates, but does not solve, the problem of the need for expensive infrastructure in the water industry.

Common sense suggests the demand for water is relatively price inelastic at low levels of consumption, which includes such uses as washing, cooking and cleaning, but relatively price elastic at higher levels of consumption, which include such uses as extensive landscape watering, car washing, and pool filling.

In some areas, water utilities compete with trucked-in water for pool filling. The consumption of water by consumers who use a lot of it may be quite price elastic.

Market Responsive Pricing

The goal thus becomes to develop a pricing methodology or tariff that reflects these market realities, which can be administered at a reasonable cost and is advantageous to consumers.

Since real-time pricing is not practical or cost-effective for water companies, the question is whether some other sort of market responsive pricing is practical for water companies. The answer would appear to be yes.

Each quarter or other time interval, the company would determine anticipated supply and demand conditions and notify its customers that prices would be higher or lower by a certain percentage for the next quarter or other time interval.

Market responsive pricing is not the same as seasonal pricing used in some jurisdictions. Just as real-time electricity rates may be lower on a cool summer day than on a cold winter night when seasonal rates (or time-of-day rates) would suggest otherwise, the cost of water may be less during a wet summer than during a dry winter when seasonal rates would imply otherwise. MRP corrects for this inefficiency.

Whether prices are being increased or decreased, the goal would be to strengthen community relations for the benefit of both utility ratepayers and shareholders. There are significant societal benefits from making products more sustainable.

Consumer Education

The information provided to consumers would explain the rationale for the price changes. Marketing and educational materials would stress the importance of conservation, while making clear that increased water use at certain times is consistent with protecting the environment.

An example of the effective and efficient use of water would be to encourage the growing of fruits and vegetables on consumers’ property. The water utility could make free seeds available to customers possibly with ideas to encourage children to grow their own gardens.

Such an approach is consistent with the recent trend to local sourcing of produce by major grocers and restaurant chains to reduce transportation costs and associated energy use that contributes to global warming. This approach would take food production even closer to the consumer.

At times when water is relatively scarce, and prices are increased, the information furnished to consumers would contain examples of ways in which water could be conserved, such as planting sustainable gardens and shrubs. Such water efficiency measures would be similar to the energy efficiency measures mandated in various jurisdictions.

The utility could also make available water audits on a free or subsidized basis like the energy audits provided by electric and gas utilities. Rebates and financing for the purchase of water efficient dishwashers and washing machines could be considered like the rebates for the purchase of energy efficient refrigerators and furnaces used by electric and gas companies.

Ratepayer Savings

Ratepayers benefit from market responsive pricing in several ways. Price increases during times of shortage reduce the demand for water resulting in less capital spending for new capacity. Less capital spending results in lower rates going forward, as well as less environmental impact associated with construction.

The additional water sold because of price decreases in times of water surplus also provides benefits to ratepayers particularly to low-income ratepayers. The reason for this counter-intuitive result is because water rates in many jurisdictions recover most fixed costs in volumetric charges.

The effect of such pricing is that high-volume water users who have relatively higher incomes subsidize low-volume users who have relatively lower incomes. To the extent that water consumption is price elastic for high-volume users, price cuts increase the subsidies from high- to low-income users. Public advocates tend to support this type of ratemaking.

Some would argue that water rates should include demand charges and other methods to recover fixed costs, but such pricing has not been implemented in most jurisdictions.

The environment benefits because the price system is utilized to encourage the use of water in times of surplus and discourage its use in times of scarcity. Market responsive pricing represents efficient demand-side management because it employs the price mechanism to shift the demand for water depending on supply and demand conditions.

This proposal benefits consumers, water utilities and regulators by using the price mechanism to increase economic efficiency while benefiting the environment.

Compensation for the Utility

Utilities would be compensated for their efforts to make pricing more effective and efficient. Expenses including development of communication materials, administrative and systems changes, call-center education and prudent incremental operation expenses would be deferred for future collection.

The deferred expenses would be recovered through a customer recovery rate. The company would be authorized to recover the deferred expenses over a four-year period on a straight-line basis with the return on the unamortized investments based on the utility’s weighted average cost of capital. The amortization period could be extended if necessary, to reduce the rate impact but the low cost of market responsive pricing likely would make extension unnecessary.

To encourage utilities to actively monitor the market and implement price changes, the program also would allow the utilities to keep a small percentage of revenue increases or decreases (the absolute value of the revenue changes) relative to the standard tariffed rates. The percentage would be set by regulators to assure managements’ focus on results and as a reward for the reduction in capital spending.

The costs and incentives would be re-evaluated in the context of a base rate case. To assure that cost-of-service revenues are held constant relative to the status quo, revenues that would have been realized without the program would be compared with actual revenues during the period and the excess or shortfall would be collected or refunded on a forward-looking basis.

The goal is to make water pricing responsive to market conditions. Not to increase or decrease cost-of-service revenues, which are determined as a standard part of ratemaking overseen by regulators.

Going Forward

Market responsive pricing is an incentive based shared-savings approach to utility regulation. Adjusting water prices based on supply and demand conditions will create more effective and efficient utilities, lower customer rates and protect the environment.

Lower water prices will enhance consumers’ standard of living while utility investors will receive the benefit of some of those savings. Ratepayers, utility investors and regulators will gain from enhanced community relations.