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
2012 © American Water Works Association
61
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
FEBRUARY 2012 | JOURNAL AWWA • 104:2 | MEHAN & KLINE
2012 © American Water Works Association
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-
MEHAN & KLINE | 104:2 • JOURNAL AWWA | FEBRUARY 2012
2012 © American Water Works Association
63
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-
FEBRUARY 2012 | JOURNAL AWWA • 104:2 | MEHAN & KLINE
2012 © American Water Works Association
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.
MEHAN & KLINE | 104:2 • JOURNAL AWWA | FEBRUARY 2012
2012 © American Water Works Association
65
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
66
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.
FEBRUARY 2012 | JOURNAL AWWA • 104:2 | MEHAN & KLINE
2012 © American Water Works Association
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.