Urban water pricing structures

I have posted before on the daft water restrictions employed in Melbourne. The current and projected future pricing structure does not make much sense either.

Charging different prices for the same good is counterproductive from the viewpoint of social efficiency. By definition it implies inefficiency since if the good is sold at a low price pl and at a high price ph the low price recipient can resell their water at a price between pl and ph leaving both vendor and recipient of the water better-off. This means that, to use economics jargon, multiple prices do not realize Pareto efficiency.

But multi-part pricing is not intended to drive efficiency – it is used to drive what are claimed to be society’s income distribution objectives. The idea is that something like water is provided up to some minimum amount at zero or low cost and then priced at higher levels if larger amounts are consumed – these are so-called inclining tariffs.

Sometimes too the argument is put that water is an essential ‘need’ that should be met at low cost with discretionary usage provided at higher cost. This is a slippery idea since households with many children, or with large gardens, have different needs than, for example, single person households. In my view ‘needs-based’ pricing arguments should not be used as the basis for pricing of anything.

Currently Yarra Valley Water in Melbourne proposes to introduce an even more strongly progressive set of water charges than they do at present. Currently Yarra Valley Water customers pay 81 cents a kilolitre up to 440 litres a day, 96 cents between 441 and 880 litres, and $1.41 over 880 litres. One proposal is to charge residents who use more than 880 litres a day to pay $4 a kilolitre for every litre over that and to charge mid-range consumers $2-50.

With this arrangement many low usage consumers will pay less than the social cost of their usage – they will still have incentives still to overuse – while high usage households will not be able to enjoy the services a water supply delivers even though they are willing to pay all the social costs of water that they use.

For industrial users Yarra Valley Water may propose a premium for top industrial consumers that use more than 10 million litres of water a year. At present, they pay a flat rate of 95 cents a kilolitre that is less than the current rate paid by residential customers. Under the proposal, they would be set an annual target and would pay a premium of $4 a kilolitre if that target were exceeded.

The proposal is to be evaluated by the Essential Services Commission in their 2008 review. The ESC is ambivalent on the issue of ‘inclining block’ tariffs neither insisting on them nor prohibiting them. The best stance would be to price water at its long-run marginal cost of supply and then recovering fixed costs by means of connection charges and so on. Pricing water below this cost causes wasteful use since benefits at the margin will be greater than costs while pricing water above this cost - $4 per kilolitre would be way above marginal cost - will mean benefits are underdelivered.

Overpricing will also mean that citizens turn to socially wasteful ways of gaining extra water supplies such as backyard tanks and recycling grey water. There is nothing sinful about citizens maintaining large gardens with lawns and swimming in their home pools if they pay the social costs of their consumption.

If policymakers are concerned with income redistribution then it would be best to tie fixed connection charges more progressively to householder income via local government rates paid or by rental than by varying the cost of use. Levying different connection charges is not the same thing as charging a minimum base rate for a fixed amount of water delivered since altering fixed charges can be explicitly tied to income.