On April 1, 2015, California Gov. Jerry Brown issued a landmark executive order mandating water cutbacks for urban residents to address the state's historic drought.[1] Gov. Brown directed the State Water Resources Control Board to impose restrictions to achieve a statewide 25 percent reduction in potable urban water usage as compared to the amount used in 2013, and to work with state agencies and water suppliers to facilitate the adoption of rate structures and pricing mechanisms to promote water conservation. On May 5, 2015, the state water board adopted an emergency regulation for statewide urban water conservation.[2] The emergency regulation includes the promotion of tiered pricing structures to encourage conservation.[3]

As much as 80 percent of California water providers already use some type of tiered rates (i.e., charging higher per unit rates for higher levels of consumption or different categories of water users) to encourage conservation.[4] On April 20, 2015, a California appellate court held the tiered water rate structure used by one of those water providers is unconstitutional.[5]

In Capistrano Taxpayers Association Inc. v. City of San Juan Capistrano, the court held San Juan Capistrano's tiered rate structure violates a requirement added to the California Constitution by Proposition 218, a tax-cutting voter initiative passed in 1996, that fees "not exceed the proportional cost of the service attributable to the parcel."[6] Specifically, the court held that the city's above-cost-of-service pricing for tiers of water service is not allowed by Proposition 218 because the city did not carry its burden of proving its higher tier rates reflected its costs to provide service to the high-end consumers.

Gov. Brown's response to the court's ruling was unequivocal: "The practical effect of the court's decision is to put a straitjacket on local government at a time when maximum flexibility is needed. My policy is and will continue to be employ every method possible to ensure water is conserved across California."[7]

While some see a straightjacket, others see a life preserver in the Capistrano court's decision. Although the court held the city's water pricing policy is unconstitutional, the court declined to find the city's pricing policy per se unconstitutional, explaining that:

[W]e see nothing in Article XIII, Section 6, Subdivision (b)(3) of the California Constitution that is incompatible with water agencies passing on the true, marginal cost of water to those consumers whose extra use of water forces water agencies to incur higher costs to supply that extra water. Precedent and common sense both support such an approach.

The court reiterated that tiered rates can be lawful when additional water costs more to supply, including costs for capital investments for the development of future water supplies such as a water recycling plant, notwithstanding Proposition 218's requirement that no fee or charge may be imposed for a service unless that service is actually immediately available:

[A] water agency might develop a capital-intensive means of production of what is effectively new water ... and pass on the costs of developing that new water to those customers whose marginal or incremental extra usage requires such new water to be produced.[8]

The court remanded the case to allow the city to prepare the calculations necessary to support its tiered pricing structure consistent with Proposition 218's fundamental mandate that rates and other government fees be pegged to the costs of providing the service, and not to other factors such as government's desire to encourage conservation or subsidize the cost of service for one category of users by charging another category of users a higher rate.[9]

How Can Public Water Agencies Develop Proposition 218-Compliant Tiered Water Rates in a Post-Capistrano Environment?

If Capistrano teaches us anything, it is to show your work. Under Proposition 218, the burden of proof is on the agency to demonstrate that revenues derived from a service fee or charge not exceed the funds required to provide the service and that the fee or charge imposed on a parcel not exceed the proportional cost of the service attributable to the parcel.[10] Absent such a showing, the city's rate structure could not pass constitutional muster.

Public water agencies can shore up their inclining block rate structures against Proposition 218 challenges by preparing a new rate study or updating existing rate studies and supplementing the administrative record with new information. New or updated rate studies should include the following:

  • Water management studies, economic analyses and cost accounting to support the cost of service rate design.
  • Identification of the marginal costs of water to justify an inclining block rate structure, including consideration of the varying costs of existing sources of supply, the costs of developing alternative supplies and water conservation programs and the costs of increasing storage and delivery capacity. Because Proposition 218 requires more than balancing the total costs of providing water service with its total revenues, water agencies must correlate tiered prices with the actual cost of providing water at tiered levels. Remember to test your water rate structure: Does it distinguish between or among customers for reasons other than differences in cost of service? If so, return to step one.
  • A thorough explanation of the rate-making process in a way that is accessible to lay readers, particularly judges. Water rate structuring requires technical experts in water finance, engineering and policy to weigh complex technical, environmental, economic, social justice and policy considerations to develop a fair and balanced water budget and pricing structure. The validity of property-related fees, including water service pricing, is a constitutional matter placing judges as the ultimate arbiters of rate structuring. Although an interactive spreadsheet model may be a necessity in rate-making studies, it must be accompanied by a narrative explanation that simplifies the underlying data and studies so that interested members of the public and judges — not just technical experts — can understand the rate-making process and an agency's final decision to adopt a particular fee, charge or rate structure.

The court's holding in Capistrano applies to public water agencies only. Thus, the court's holding has no immediate or direct effect on the pricing structures of privately owned water utilities, many of which also have adopted tiered rates to promote water conservation, pursuant to policies adopted by the California Public Utilities Commission. However, private water company operators must be sensitive to public concerns about their rate structures and so are well-advised to consider their marginal water supply costs when designing end-user rates.