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Pricing the Urban Water Supply Service to Please (almost) Everybody


June 1, 2022

Pricing the urban water supply service is a complex exercise that aims at achieving competing objectives.

Cost recovery.  Piped water has some characteristics of a private good to be preferably supplied by publicly or privately-owned commercial entities. “Orthodox” accountants expect sales revenues of a water service provider to cover its “financial” costs, i.e., operating costs, depreciation of fixed assets, and return on assets to service the debt and remunerate the equity invested.  More “pragmatic” accountants are happy with revenues that cover “cash” costs, i.e., operating costs, repayment of loan principals and interests, and a cash contribution to the capital expenditure program.  Dividing revenues estimated by applying these two formulae by volumes of water billed result in different rates in $/m3.  Note that if wastewater is under the responsibility of the water service provider, corresponding costs are included in above estimates; if it is provided by a separate entity, wastewater charges are usually added to the water bill and collected on its behalf.

Regulation of monopolies. Advocacy groups concerned with abuse by natural monopolies, such as piped water, argue that the cost of inefficiencies, common for public service providers, or oversized profit, tempting for private ones, must not be passed onto consumers.  It is thus the role of “Regulators” to set rates based on industry standards.  A common operating indicator is non-revenue water (NRW), which can exceed 50% of production in developing countries because of physical leaks and poor commercial procedures.  Staffing and energy costs are other operating indicators to monitor.  Also, efficiency gains can often be achieved in extension programs and in their financing, that must be compatible with long depreciation periods of buried fixed assets.  Finally, returns on equity must be capped.  Estimates based on “efficient” costs lead to rates in $/m3 lower than that calculated as indicated above.

Poverty reduction. Advocacy groups concerned with poverty reduction argue that water, an essential public good, should be provided free of charge, at least to the poor.  Unfortunately, if water is a gift from God, the infrastructure needed to bring it to consumers is not.  The poor often spend significantly, in cash or time, to collect small quantities of water of poor quality. Estimating their willingness-to-pay for piped water is essential for designing rate structures and subsidy schemes.  If many service providers target subsidies to low-income households for building new residential connections, few do so for encouraging lifeline consumption and prefer increasing block tariffs (IBT) structures whereby large customers are charged higher rates to subsidize small residential customers.  Poorly designed IBTs could however distort consumption and reduce sales revenues.

Demand management. Finally, advocacy groups concerned with environmental protection recommend that pricing should be used to manage demand for water, a public good at high risk of depletion and pollution.  For capturing consumer surpluses, economists recommend that water should be priced at its long-run marginal cost (LRMC), i.e., the cost of supplying an incremental quantity of water once the existing capacity is fully used.  Estimates should include the costs of externalities such as that associated with incremental quantities of wastewater generated.  When it comes to pricing, economists focus on future costs unlike accountants who are mostly concerned with past and present costs.  LRMC estimates usually result in a rate in $/m3 higher than that estimated to meet financial objectives.

Setting urban water rate levels and structures must thus, at the same time, aim at meeting cost recovery, efficiency, and poverty reduction objectives while making economic sense.

A meeting organized by the Urban and Water Thematic Group of the 1818 Society recently presented how Chile applies above principles.  An independent Regulator sets uniform rates based on LRMC estimates for each “efficient” operations while ensuring that returns on assets allow service providers, all privately owned, easy access to commercial financing.  Also, the Government distributes vouchers to low-income households to reduce the burden of water bills on their budgets.

Another presentation on Cape Town, South Africa confirmed that water demand management through pricing works: per capita water production was recently reduced by one third, while the water service remained “24/7” permanent, by applying a “punitive” rate structure fully justified by a highly stressed water situation.

In developing countries, many water service providers however still struggle to simply recover their operating costs from sales revenues.  World Bank loan agreements used to include “rate of return” or “cash generation” covenants to guide rate setting by borrowers.  Nowadays, the Bank does not systematically conduct financial analysis of service providers it eventually lends to and is more concerned with the economic justification of the project it lends for.  But few appraisal documents estimate the LRMC of water.

Note: Alain Locussol is Co-Chair of the Coordinating Committee of the Urban and Water Thematic Group.

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