By Janice A. Beecher, Ph.D.
Director, Institute of Public Utilities, Michigan State University
In the wake of flat or falling sales revenues, many a water (and energy) utility have turned to the idea of raising fixed charges. This might seem logical, given that water services require substantial fixed infrastructure costs; that is, they are particularly capital intensive. Monopolies are drawn to the idea of loading more costs on less price elastic usage, and welfare economics lends some support to this strategy (the inverse elasticity rule or Ramsey pricing). From a utility’s viewpoint, fixed charges look like a great deal. They primarily reduce revenue risk, shielding finances from the effects of weather, technology, preferences, and behavior. What’s not to like? In terms of core ratemaking principles related to both resource efficiency and ratepayer equity, there’s plenty.[1] Rate design actually offers the chance to align policy goals, this case those of environmental and consumer advocates.
On the efficiency side, price signals guide consumer decisions about usage and utility decisions about production and investment. While in the short run, many costs are fixed, in the long run, all costs are variable, and variable charges (where rates are applied to usage) reflect this dynamic world view. Price signals for infrastructure are more effective when the user bills reflect the full impact of their usage, not just the short-run marginal cost of commodities. So a good portion of the fixed costs for production and delivery capacity is typically collected through variable consumption charges to maintain their “meaning” even in the context of falling usage.[2] A high fixed charge presents a price signal that is even weaker than a declining block rate, since the latter still correlates total bills with usage.
On the equity side, the case for progressive water rates is easy to make. All utility rates are regressive, perhaps water in particular; that is, utilities take a higher share of the low-income household’s budget. A high fixed charge piles on and takes away control. Some like to point out that not all low-income households are low-use households and vice versa; however, on the whole, just as price is negatively related to usage, income is positively related and higher-income households tend to drive peaks and capacity needs. With higher incomes come bigger properties, more amenities (such as pools), and increased water use. The focus on fixed charges deflects from other potentially useful pricing reforms that could be responsive to both efficiency and equity pricing goals. These include refining customer classes based on usage peaking patterns, charging seasonal-only customers a stand-by rate, and calibrating some of the fixed costs of fire protection to property values (an insurance model).
Of course, various rate design methods and subsidy models can be used to ensure affordability. For energy, minimum bills with a usage allotment are discouraged for economic reasons. Water might offer an exception, however, as a minimal amount of household usage may be needed for both public and system health (optimal operations). Thus, if fixed charges for water are imposed on low-income households, a health-based usage allowance may be in order. In general, however, we need to radically modify our efficiency-centric pricing paradigm to ensure universal and affordable access to drinking water and sanitation (a blog post for another day).
Does reliance on variable charges wreak revenue havoc? Not necessarily.
For essential services, the first blocks of consumption (indoor water usage) and the revenues they generate are likely quite stable and predictable, regardless of the pricing method. This especially holds true for water-efficient households who let nature take care of the lawn. Their usage and bills run steady, reflecting an organic form of decoupling water sales from revenues while maintaining meaningful price signals. System capacity costs are driven by the uses that are more discretionary and price responsive. If utilities account for the repressive impact of prices, standards, and other factors on changing usage (elasticities), and if they work to drive down system peaks, revenue stability and predictability will follow.
The real and long-term problem for water utilities stems from a static world view, including a tacit dependence on dry weather and irrigation for revenues to cover invested capital and operating costs (including a return on equity if applicable). A high fixed charge provides the best of both worlds: revenue stability all year long and a periodic bonus when nature withholds supply. Given cost and price trends, the water industry should be preparing now for substantial price-induced reductions in outdoor usage, which will yield long-term economic and environmental benefits (water and energy). As we approach this inflection point, prudence calls for right-sizing infrastructure now to reap the rewards of efficiency and avoiding imprudent in-kind replacement and excess capacity on behalf of their ratepayers.
In the context of rising costs and falling subsidies, water rates will climb – but not as fast as water bills (because of declining usage) and not as high as they would with uneconomic investment. Of course, these factors will vary from place to place. Over time, improved efficiency will yield benefits to consumers in terms of “lower highs” and to utilities in terms of the revenue stability they long for.
But only if they can resist the fix.
[1] For definitive insight by a real economist, see Severin Borenstein, https://energyathaas.wordpress.com/2014/11/03/whats-so-great-about-fixed-charges/ and https://ei.haas.berkeley.edu/research/papers/WP272.pdf.
[2] See David LaFrance, “What to do with less,” Open Channel, Journal of the American Water Works Association (November 2011).
Janice A. Beecher has served as Director of the Institute of Public Utilities at Michigan State University since 2002. She has more than twenty-five years of experience in public utility regulation and is responsible for Institute development, program management, and interdisciplinary research in support of the IPU’s mission of service to the regulatory policy community. Dr. Beecher’s appointment is in the College of Social Science at MSU, where she has taught graduate courses in public policy and regulation. Her areas of interest include regulatory theory, institutions, and policy; comparative industry analysis; and utility pricing and rate design. She has particular expertise in the structure, economics, and regulation of the water industry. Dr. Beecher is a frequent lecturer and the author of several research reports and other publications; she has also testified before regulatory and legislative bodies. Her work has been recognized through a number of research grants and special appointments. Prior to joining the IPU, Dr. Beecher was an independent policy consultant and held senior research and adjunct faculty positions at The Ohio State University and Indiana University. She also worked as a staff policy advisor to the chairman of the Illinois Commerce Commission. She has a B.A. in Economics, Political Science, and History from Elmhurst College and a M.A. and Ph.D. in Political Science from Northwestern University, where she completed a dissertation on public utility regulation.
and H.R. 448 
There is another strategy that can help utilities recover significant revenue as well as cost-effective supply: fixing their leaks. The benefits of analyzing apparent and real losses in a utility system are so clear as to be irrefutable. So why are utilities not flocking to examine