In this video we will discuss the different objectives that are important when we select a water tariff structure and set water prices. Tariff designs and water prices affect both water users and water service providers. The interest of both water users and providers matter to society and the state. There are four primary objectives in tariff design and water pricing, and then some secondary objectives. First, from a water service provider's perspective, the primary objective of the tariff is to raise revenue. Revenues are needed to pay for the financial cost of providing water and sanitation services. The water utility is most concerned with the total revenue collected. There are many different tariff structures that can be used to raise the same total amount of revenue. The water utility may not be as concerned about the specific details of the structure of the tariff, but will be concerned about the average price customers pay, the amount of water they buy, and the total revenue billed and collected. Of course, customers may respond to different prices in the tariff structure. This response by customers to water prices may affect the amount of water used and the total revenues received by the utility. But in general, water service providers can live with many different tariff structures, provided the total revenues are sufficient. Water service providers needs sufficient revenues to attract and retain high-quality employees, to purchase and obtain supplies on time, and generally to run an efficient, effective organization. Economist John Maynard Keynes said, an institution must aim at financial independence in the long run. People always get tired of supporting what seems a sink for resources. You never get the right spirit in the management of a concern that runs habitually at a loss. A financially sound water utility is also important to water users. If revenues are sufficient to pay for the service provider's cost, it's more likely that customers will receive better services. For example, bills are more likely to be rendered and collected efficiently. Also, if most or all of a water utility's funds come from customers, and not from higher levels of government or donors, utility would be more responsive to customer demand. At the same time, cost recovery is no guarantee of high-quality services. But if a water utility is heavily subsidized, and receives little of its funding from its customer base, then the focus of its management will naturally be on courting its founders, and not its customers. A second objective of the water tariff is economic efficiency, to send a signal to water users to use water wisely. We want the tariff to promote efficient consumption by water users, and efficient production by water service providers. The water tariff structure should send information to water users about the cost of providing water and sanitation services, including the opportunity cost of the utility's raw water supply. Efficient water use does not mean that water users should conserve water at all cost. In some places where all water supplies are plentiful, an increased water use by municipal users imposes limited, or zero opportunity cost in others. In other locations raw water supplies are scarce. In this case the use of water by municipal customers has an opportunity cost in terms of water use foregone by others. There are also differences in capital costs and operating costs in different locations. These cost differences should be reflected in the water tariff structure in prices, so that customers understand the costs that their use imposes on water service providers. For example, in some urban areas water must be pumped to higher elevations to reach some customers, or must be pumped long distances. In these cases the tariff should send a signal to customers about these additional pumping costs. It is harder, though, for a tariff to send a signal to water service providers to produce water efficiently. But if water prices are too low, the service provider will have little incentive to reduce water that is lost in the distribution system before it even reaches customers. Nor will the service provider have an incentive to prevent illegal connections. In the extreme case, if water prices are too low, the utility may not even bother collecting water bills. Because there's often limited competition in the provision of piped water and sewer services, there's also a risk that water service providers will not use revenues efficiently, whatever the level of water prices. The role of regulation is to try to ensure that water service providers have sufficient revenues to provide high-quality services, but at the same time to ensure that their revenues and water prices are not higher than necessary. One of the functions of the regulator is thus to provide water service providers with incentives for efficient production. We will return to this topic in a future video. Proponents of the economic efficiency objective often make two theoretical arguments that water prices should be kept low. The first is that there are positive health externalities associated with piped water services. This draws on the classic Pigouvian argument that we should tax negative externalities, and subsidize positive externalities. And the positive health externalities justify subsidized water prices. The second argument is that piped water services are a natural monopoly, where marginal costs are below average costs. In this case economic efficiency requires that prices be set at marginal cost. If prices are set at marginal cost, the utility will run at deficit and need to be subsidized. Both of these arguments for subsidized water prices deserve close scrutiny. It is true that if piped water services provide positive health externalities, this is a sound justification for subsidized water services, if other sources of funding are available and are not overly distortionary. But in fact few low-income countries have good alternative sources of tax revenues that can be used to efficiently subsidize piped water and sanitation services. Moreover, there's little empirical evidence that increasing the quantity of water used by one household with piped services results in positive health externalities for other households. There is stronger epidemiological evidence for positive externalities from moving from non-piped services to piped sources. But not from increased water use from a piped source. There is also a stronger epidemiological case for the existence of positive externalities from proof sanitation, than for increased water used from a piped connection. The second theoretical argument is that marginal costs are below average costs, and thus piped water services should be subsidized. But are marginal costs below average cost? This is certainly not true for the costs of our water supplies in water-scarce locations. Usually some components of the cost of water and sanitation service are experiencing falling marginal cost, but other components are experiencing rising marginal cost. Where the balance lies is an empirical question, not a theoretical question. I'm thus not convinced by either the positive externalities argument or the marginal cost pricing argument that water prices should always be kept low on economic efficiency grounds. We need empirical evidence from local conditions to support either argument, theory alone is not sufficient. Let us move on to the third objective of water tariff design. I like to describe this third objective as social, and then break this social objective down into four related, but distinct parts. The first of the four parts of the social objective is equity. Water users should perceive the water tariff structure as equitable in two senses. Water users who are in the same situation should face the same water prices. Also, water users who are different should be treated differently by the water tariff. It is inequitable to charge water users who are in the same situation different water prices, based on arbitrary and capricious considerations. Equity is thus measurable. Are equals beings treated equally, and are unequals treated differently? The second part of the social objective is fairness. We want a water tariff that society judges to be fair. Fairness is more subjective than equity. It is typically in the eye of the beholder. For example, some groups of water users may be given lower water tariffs in order to rectify a historical injustice. For example, in the United States the federal government has often provided the capital needed for the construction of piped water and sewer systems on the reservations of Native American tribes. As a result water bills are very low, far below the actual cost of service. But a few taxpayers complain about this large subsidy to Native Americans because of the historical injustices they had to suffer. The majority of water users may consider this fair, or it may be perceived just fair to offer low water tariffs to churches, mosques, temples and synagogues. Thus fairness can be difficult to measure. The social norms of fairness maybe important considerations in the design of a water tariff. These social norms about fairness may also be derived from the ancient instincts we've already talked about in earlier videos. The third part of the social objective is affordability. The state typically has a strong desire for piped water and sanitation services to be available to all households in a service area. Thus, they need to be affordable to poor households. There is a large literature in the water sector discussing what is affordable to poor households. A widely cited, but ad hoc rule of thumb says that 5% of a household's gross income is an affordable amount for water and sanitation services. Globally, most households pay much less than 5% for piped water and sanitation services, because they are heavily subsidized. But in some locations, especially in informal settlements, households may pay much more than 5% of their income to water vendors, even without considering the cost of sanitation. The problem, of course, is that 5% of the income of a poor household may be far less than the cost of providing piped water and sanitation services. So this affordability objective may conflict with the cost recovery objective. The fourth part of the social objective is poverty alleviation. Poverty alleviation is an explicit redistribution objective, the desire to delivery subsidies to poor households through the water tariff to address income inequities. Pursuing a poverty alleviation objective will typically require lower water prices, or perhaps lower connection charges. The consequence of a poverty alleviation objective is thus similar to the affordability objective. Water prices should be kept low, however the rationale is different. Poverty alleviation uses the water tariff for redistribution purposes, not simply to make water affordable. A water bill could be affordable to poor households, and still not provide much of a redistribution benefit. The objective of poverty alleviation might push water prices lower than an affordability objective. A fourth objective of tariff design is simplicity. A water tariff should be both simple and easy to understand. There are two main reasons that water tariff users should not have to struggle to understand how their water bill is calculated. The first is that a tariff cannot fulfill its role of sending the correct signal about the cost of water services and raw water scarcity if customers cannot decipher it. The information the water utility wants to send to its customers through the water tariff should be clear and easy to understand. If not, customers can't act on it. The second reason is that unnecessary complexity is a nuisance, and possible aggravation to households. So to recap, the four primary objectives of water tariff design I just told about are, one, cost recovery. Two, economic efficiency. Three, social, and four, simplicity. Note that I have not included a separate objective for sustainability or resource conservation. From my perspective, these are fully incorporated into the economic efficiency objective. In other words, if water is priced to accurately reflect its opportunity costs, on both the supply side and in terms of the environmental externalities imposed on others, then the amount of water customers use will be sustainable, and the resource will be optimally conserved. There are four additional, and what I call secondary, objectives. These would be nice to achieve, but they are not as important to tariff setting as the first four primary objectives. The first is rate stability. Financial management is easier if revenues are regular and steady. The water service provider would like not to have to deal with widely fluctuating cash flows. The second subsidiary objective is that it should be easy to implement a new water tariff. The third is that a new water tariff should enhance the credit rating of a water service provider, so that it can access finance on better terms. The fourth is that tariff design should ideally avoid rate shocks to costumers. When tariffs are changed, water service providers in the state generally prefer that this change should be gradual, so that customers are not too affected by higher prices. But sometimes the avoidance of rate shock is just not possible, if tariff reform is going to achieve its other objectives. I understand the desire for gradual tariff changes, but sometimes it may be better to marshal the political capital to make big changes in the tariff all at once. The choice between gradual and dramatic change in the tariff is a political judgement that depends on timing and sequencing. There's no general rule as to what's best for a particular situation. It is typically impossible to accomplish all of the primary and secondary objectives with a single water tariff design. The task of deciding on a specific water tariff involves balancing, or weighing, of the relative importance of different objectives. Let's look in a little more detail about how these objectives conflict with one another. This slide shows the relationship between the average price of piped water services and the three indicators related to our primary objectives. The rows show the price of water from 0 to US$1.25 per cubic meter. The columns show percent of households who can afford a private water connection, water use by households with private connections, and economic benefits received by households with private water connections. From the perspective of all three of these indicators, high prices are bad. At high prices fewer households can afford a private connection. At higher prices water use by household with private connection is lower, which is bad from the perspective of the household. And at higher prices the economic benefits received by households with private connections are lower. But this is not the full picture, because we have not yet considered the cost of providing piped water services. In this next slide, the rows are the same, different prices per cubic meter of water supplied by a piped system. But the performance indicators in the columns are different. The columns now show, one, revenues received by the water utility. Two, cost to the water utility to deliver water supply. And three, economic cost paid by others. For example, subsidies needed by the water utility. Now the trade-offs that result from low water prices become clear. At very low and at very high prices, the revenues received by the water utility will be low. But there is some intermediate price that will maximize the utility's revenues. At low prices, the costs to the utility of supplying the water are high, and these decrease as the price increases. And finally, as prices increase the cost of the subsidies paid by others falls. One way to think about the challenge of setting water tariffs is to find the right balance between, on the one hand, the interest of water users, who want low prices, and on the other hand, the interest of the utility and the stakeholders, who provide the subsidies. The utility and the stakeholders want higher prices, but not too high. The inherent conflict between competing objectives is one of the reasons why water tariff design is so controversial. In my experience, managers of water utilities generally consider cost recovery to be their most important objective. But higher levels of government are more concerned about the social objective, and the political controversy that results from higher water tariffs. So higher-level government may require that prices be kept low as a condition of providing the water utility with a subsidy.
