Inclining Tier Rates
Inclining tiered rates are a key tool in managing water resources.
Water agencies can protect themselves from
Proposition 218 lawsuits with a build-up cost approach.
ONE KEY TOOL TO MANAGE WATER RESOURCES is through pricing with inclining tiered rates based on water
consumption. Inclining tiered rates provide incentive for customers to reduce their water consumption because changes
in their water usage have a direct effect on their utility bill. Approximately two out of three water utilities in California
now use some type of tiered rate structure.
20 SOURCE winter 2016
By Habib Isaac
Although pricing water to signal its scarcity and promote conservation is
a very effective economic approach to combat current drought conditions,
the verdict in the recent City of San Juan Capistrano case requires that
utilities proceed with caution. The city’s 2012 rate structure was challenged
as not being compliant with the Proposition 218 requirement that “the
amount of the charge imposed upon any parcel shall not exceed the proportional
cost of service attributable to the parcel.” The takeaway from this case is that
1) inclining tiered rates are not illegal but must be carefully constructed,
and 2) there needs to be a clear nexus between the cost of providing water
service and the tiered rates being charged. Water agencies need to show
their work and document their findings in an administrative record that
clearly demonstrates the cost-rate relationship. The most effective way to
accomplish this is through a build-up cost approach.
Three fundamental steps are necessary when setting water rates:
• Determine revenue requirements.
• Conduct a cost of service analysis.
• Use this analysis to design rates.
Revenue requirements are commonly recovered through a combination
of fixed meter charges and variable rates based on usage (commodity
rates). Grouping like expenses together based on each group’s function
(functionalized expenses) is an essential starting point, not only to
understand the agency’s overall budget, but also to determine how certain
costs are incurred. This provides a clear understanding of how much of an
agency’s total revenue requirement is fixed (cost doesn’t change with water
usage) versus variable (costs vary as water use changes). However, the
amount of cost recovery between fixed charges and commodity rates is not
driven exclusively by how a cost is incurred. If it were, most water agencies
would recover up to 80 percent of their overall costs through fixed charges.
Policy considerations relative to affordability, revenue sufficiency, water
efficiency, and rate stability and other such goals must also be accounted for
in water rate pricing.
Determining the appropriate amount of revenue to recover from
fixed versus variable charges is a balancing act. Policy decisions, such as
affordability, aimed at keeping an agency’s base fee as low as possible,
cause more costs to be shifted away from recovery through the fixed
charge. As a result, functionalizing costs is knowing how much of a
utility’s fixed costs are being recovered through commodity rates.
Revenue Composition Comparison
n Variable n Fixed n Tier 2 n Tier 1
Percent of Annual Bills
Once revenue recovery through fixed charges and commodity rates is
determined, the next step is to determine the unit price for each of the cost
components. This is critical to both a rate study and the administrative report
the agency develops to support its rates and is particularly significant when
inclining tiered rates are introduced. In an inclining tier structure, the rates
for each tier must be substantiated to show how delivering water for usage
in a higher tier incurs additional costs compared to delivering for usage in
a lower tier. Determining the unit prices derived for each cost component
enables an agency to clearly identify how costs are reflected in each tier.
This type of build-up cost approach for establishing each tiered rate
conforms to the court ruling of “Show Your Work.” Figure 2 on the next
page demonstrates how each functionalized expense (filled buckets) is
allocated to a specific cost component (description of each bucket) and
used to derive a unit price for each cost component (unit prices).