As the saying goes, a utility’s variable pricing structure and its largely fixed costs are soon parted. And the sweet spot can be a moving target, which has water managers grappling with the boundaries of conventional municipal financing and exploring creative rate structures to make ends meet.

On this blog, we’ve already talked about the cash-flow conundrum and closing the rate-cost gap, delved into the “water as a service” mindset, and learned from utilities that have a history of investing in reliability. We also posted a guest blog about finding the right tool for the job, from the Alliance for Water Efficiency. This week we get more about real-world solutions from Jeff Hughes, director of the Environmental Finance Center at the University of North Carolina School of Government, who talks about traditional revenue models and innovative water pricing for the modern world. This blog is adapted from a longer article on pricing in the October edition of the Government Finance Officers Association’s Government Finance Review.

Revenue is on the forefront of many water managers’ minds. When polled during a session on utility revenue at the Government Finance Officers Association’s 2015 annual conference, 75 percent of participants identified revenue variability as a major financial issue for their utility. The Environmental Finance Center (EFC) recently completed a national study for the Water Research Foundation (WRF) to examine revenue trends and business models across the country. This research documents the many challenges associated with current utility business models, and identifies existing and emerging strategies for addressing them. This blog discusses the “Peak Set Base” model, an emerging pricing strategy that holds promise as a solution for some water utilities seeking to increase revenue stability.

Balancing fixed vs. variable revenue
One of the most important decisions a water utility has to make is how to price its service so it has the revenue it needs to protect the community’s public health and to fairly allocate the responsibility for paying for the service among community members.

The traditional water utility business model charges customers each month based on two factors – the size of the customer’s meter and the amount of water the customer used during the previous billing period.  For most utilities, the volumetric/variable portion of their customers’ bills generates most of the utility’s revenue, particularly for larger or commercial users.

The chart at right shows the percentage of a customer’s bill at different consumption points based on billing data from 84 utilities in California.  When water use patterns were more predictable and generally increasing, the disconnect between the underlying pricing structure (largely variable) and costs (largely fixed) was disguised. However, now many utilities have seen their customers’ usage become far less predictable and in many cases drop significantly. This disconnect is causing revenue challenges, especially in California as agencies strive to meet the state’s overall 25 percent reduction target.

Utilities have several options for adjusting how revenue requirements are allocated across their customer base. A common starting point is to tweak how much of a customer’s bill is fixed, how much is linked to volume, and how incremental volumetric prices are set. As the figure above shows, differences in these decisions have a huge impact in the variability of revenue stability: the lower the percentage of the charge that is fixed, the more variable the revenue is likely to be.

Balancing revenue stability with conservation
Innovations in water pricing during the past 20 years have often revolved around the implementation of tiered pricing, in which the price of water is based on how much a customer uses in a billing period. These tiered structures allow utilities that have relatively inexpensive water to price water at the highest consumption points much higher, which in turn sends pricing signals to customers to reduce their usage.

In some cases, tiered pricing has been justified more as a conservation strategy than a legitimate method of allocating costs. This debate played out in California this year, where the City of San Juan Capistrano had implemented a pricing system that charged customers more per-gallon for heavier water use. In July, the California Supreme Court ruled that San Juan Capistrano’s approach in setting rates could not be cost justified and was therefore determined to be an illegal method of overcharging some customers for water.

Because of this tension, utilities seeking a stable and predictable revenue stream are often concerned they will have to sacrifice all customer conservation pricing signals to gain stability. One approach that has been discussed by researchers for many years involves more tailored, individualized pricing structures.  Now that many utilities have invested in meter and software technology to collect and analyze customer usage and to communicate with customers, pricing options previously believed to be too difficult to implement are now within reach.

The PeakSet base model
As part of the WRF research project, the EFC team identified several potential pricing structures that follow cost of service pricing, lead to more stable revenue, and maintain conservation oriented pricing signals. One of the approaches, PeakSet Base Charge, has the potential to drastically increase revenue stability without completely sacrificing conservation pricing.

The approach is relatively simple — shift the majority of revenue requirements to a base charge that is annually reset for each customer based on historic usage linked to cost of service. The rationale for this approach is that residential customers’ historic use, particularly peak usage, has a closer relationship to the capacity demands a customer puts on a system than the maximum flow-through capacity of a residential meter. There is ample evidence that meter size alone is a very poor predictor of peak usage for single-family customers.

Using historic usage rather than the preceding billing period’s usage to determine monthly billing is not new to utility pricing. Many utilities across the country, particularly in the Southwest, set their summer bills as a function of a customer’s average water consumption during the previous winter season. Utilities anecdotally report that this model encourages customers to be very conscientious about their winter usage.

While the PeakSet Base Charge has not yet been implemented, it has been modeled in half a dozen utilities since 2010. Still, there is reason to believe that this strategy could lead customers to pay closer attention to their usage, since usage would have significant future financial impacts. At least one community, Davis, California, independently developed an almost identical approach that they refer to as “Consumption-Based Fixed Charges.” Though this innovative approach was nearly implemented in Davis, a ballot vote overturned the rates after opposition from a vocal group of ratepayers who were slated to pay more under the new system.

PeakSet Base Charge is certainly not for all utilities, and many will continue to be best served by traditional pricing. For those utilities that have made the decision to invest in smart technology and are seeing increased weaknesses with traditional pricing, this approach may be appropriate.  Utility customers in other sectors such as electricity and telecommunications have seen tremendous change in how they pay for service and how they communicate with their utility about those payments. Text messages sent directly to customers providing feedback on usage and pricing thresholds have become commonplace. As water utilities expand their communication with their customers and embrace technology, new pricing approaches may follow.

For more information on the challenges of the current utility business model and emerging approaches, visit the EFC’s website to access a comprehensive report, series of blog posts, and tools. For those seeking a short visual introduction to PeakSet Base Charge and other innovative rate structures, watch this short video.

About the experts

Jeff Hughes is director of the Environmental Finance Center at the University of North Carolina School of Government.

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