The Los Angeles Times published an article yesterday on the water rate challenge ongoing in San Juan Capistrano, California. Not just any water rate challenge, a challenge to a rate design that includes rates that increase the price of water the more water that a customer uses, known as inclining block rates or tiered rates. In an age where water conservation is promoted as being good public policy, one of the best and most effective ways to promote conservation is using price as a signal, right? So rate designs such as these seem entirely consistent with good economics and public policy.

The problem in California arises with what’s known as Proposition 218. Adopted in 1996, Prop 218 protects taxpayers from revenue hungry local governments charging more than a service costs.

The lawsuit is presently on appeal after the trial court ruled in favor of the complaining customers. As the article reports, an appellate ruling is expected soon.

I have not studied the rates at issue in the lawsuit, so I am analyzing the situation from afar. (I’m also not providing legal advice). My baseline assumption is that the utility is not over-collecting its overall revenue requirement. Essentially, if the utility needed $100 Million in revenue to cover its costs, then that’s what it is earning through the collection of its rates. On the macro level, again under my assumptions, the utility is not collecting more than the service costs.

Here’s what I believe the lawsuit argues: the customers whose consumption places them in the higher tiers argue they are being charged too much for water and that they are in fact subsidizing the rates of customers whose consumption places them in the lower tiers. It’s unclear from the information I’ve reviewed whether there could also be an argument that the higher tier customers’ position is that commercial or industrial rate classes are enjoying the alleged subsidy provided by those higher tier customers. Either way, this appears to be a classic issue that takes place in utility rate cases every day throughout the country. One customer class is attempting to push costs onto another customer class. It’s a zero sum game, and some class of customer needs to pay for the utility’s reasonably incurred costs.

In the trial court ruling, the judge found that the rates were not cost-based. The judge did not, however, “declare all tiered systems illegal[.]” That’s the specter being raised by some. The Orange County Register article quoted and linked earlier cited to Richard Little, a now-retired director of the Keston Institute for Public Finance and Infrastructure Policy at USC. On the idea of tiered rates, Mr. Little is quoted as stating, “Of course it’s social engineering,” and “It’s trying to achieve a social outcome – which is water conservation – and the best way to do that is send pricing signals.”

I disagree that inclining block rates cannot be cost-based. There may be policy reasons for implementing inclining block rates, but I strongly disagree with the notion that a cost basis for inclining block rates is out of reach. The challenge is coming up with a strong cost-of-service study to support the inclining block rate design.

The cost-of-service study could factor in a number of variables to support inclining block rates. The variations of the demand imposed by customer classes could support cost-based inclining block rates – akin to a demand charge in the energy sector. Customer classes whose use varies widely throughout the day and causes peak usage should be charged more for water, as they are the ones putting a greater strain on the system. These are the customers that wash clothes and dishes, take showers, and irrigate their lawns when system-wide consumption is at its highest point. This causes the need for increased pipe sizes, bigger pumps, and increased energy use, among other factors. These factors all cause the price of furnished water to increase and could support, with appropriate data of course, inclining block rates. The American Water Works Association’s M1 Manual – Principles of Water Rates, Fees and Charges (available for purchase) explains how these “capacity factors” can be calculated. (Hat tip to a friend who’s also a utility rate consultant and CPA who suggested capacity factors and the AWWA’s M1 Manual to support this argument; my friend also suggested having separate rate structures for each class of customer: residential, commercial, and industrial).

Another factor that could support an inclining block rate design is the avoided cost of additional capital construction, like new water treatment plants, water tanks, pumps and the like. By avoiding that capital cost, it helps keep rates low and customers who are using less are contributing less towards the need for new capital facilities. Recall from the earlier point that the customers whose use spikes and causes peaks will be the customers who initially cause the need for expanded system capacity. In the long run, all customers will take advantage of the expanded capacity, but in the short-run, the economic value of delaying construction of new system capacity, I would argue, can be attributed to those high volume, variable users that contribute to the peak usage of the water system. As with the prior factor, appropriate data demonstrating this will be needed to support inclining block rates.

Some cautionary notes: I have not seen a utility undertake to use these elements when supporting an inclining block rate structure with a cost-of-service study. Support of this nature requires a substantial commitment to data capture, scrubbing and analysis. That kind of support won’t come cheaply. My suspicion is that until now, there has not been a need to expend the funds for that analysis because in jurisdictions where inclining block rates had been implemented, they had not been challenged. That obviously has changed, and the LA Times article notes that other lawsuits have been filed based on the tiered rate structure in other California communities.

Another cautionary note concerns rate-making for utilities regulated by state public utility commissions. In my experience, the burden of proof is much higher for the regulated utility than it is for an unregulated utility, like many municipal utilities. While I’ve heard an interest in cost-based conservation rates from regulators, I have not seen an inclining block rate successfully proposed in a regulated utility setting. Part of the problem is using the delayed or avoided cost of future capital expenditures component because it would depart from traditional utility rate-making. Accordingly, without statutory support, I doubt such delayed or avoided costs for water utilities (in contrast to the electric sector) will be proposed in the regulated water utility sector. We’ll need to see unregulated water utilities succeed in utilizing such a delayed or avoided cost framework before commissions (or legislatures looking to provide statutory support) begin to look at water rates supported by a delayed or avoided cost framework, at least in my view.

This blog post is not meant to be a treatise on rate design, and the factors identified are my initial thoughts on evidence that might support an inclining block rate design. I’m certain other arguments may be developed to support it, and probably have been advanced in the San Juan Capistrano case. My hope is that if the San Juan Capistrano rates are ultimately defeated, that any bad facts in that case do not translate into bad law and the death of inclining block rates. I believe that with the proper evidentiary support, an inclining block rate structure can survive a challenge such as that currently ongoing in San Juan Capistrano.

What do you think about these tiered rate structures and the future of inclining block rates?