The potential and promise of water pricing.

AuthorAyoo, Collins A.
PositionTHE GLOBAL CONTEXT - Report

The claim is often made that more effective use of pricing and various water charges can remedy or completely solve problems of water scarcity, shortage or overuse. A common view is that users pay too little for water and, as a result, they use too much. The public or private agencies that supply water to users could levy higher prices willingly, or the regulatory agencies that manage and oversee water resources could enforce higher rates. Implementing these approaches in developing countries may present special challenges due to the high costs involved or due to inadequate resources to assign, monitor and enforce diverse rights to water use. However, are there reasons that other countries, not so constrained, have not implemented effective water pricing strategies? Is this pricing prescription really so straightforward?

Economists, engineers and others have played a lead role in these policy debates, and economists continue to write volumes about many aspects of the issue. The purpose of this article is to review current approaches to effective water pricing and to examine the gap between these academic prescriptions and the current state of water allocation policy and practice. To what extent are more complex or comprehensive systems of water charges likely to fulfill the growing challenges of water scarcity? What steps are needed to bring theory into practice?

The main conclusions reached here are that in many jurisdictions, schemes of administered prices may represent an attractive policy approach to promoting the overall efficiency of water use. The attainment of appropriate or efficient usage levels is synonymous with encouraging conservation and reuse, with investment and innovation in new technologies and practices and with achieving expected levels of water quality and security of supply. It is also consistent with capturing as fully as possible the many beneficial consumptive uses of water in situations where water is relatively abundant or inexpensive. Unlike the allocations that might be reached in some private market transactions for water use, an advantage of administered pricing is that it offers the ability to include, as part of the prices charged, society's best estimates of social costs related to downstream or future users, instream flow uses, and so on. Unlike private market outcomes, administered pricing also offers the ability to make the water pricing program revenue-neutral. A carefully designed rebate program can leave the average water user's annual household or business income unchanged, even while providing strong financial incentives to conserve.

These issues and arguments are explored in the following sections. The discussion starts by examining the concept of water pricing and its rationale, focusing attention on those pricing approaches that promote the efficient use of water resources. The concluding sections highlight pricing issues that require further attention. Some brief illustrations of the state of water pricing in Canada and elsewhere show that despite initial steps toward policy reforms, considerable action is still required to harness the potential gains of effective water pricing.

THE MEANING OF WATER PRICING

Various systems of water rates, water fees and user charges are employed around the world as a means of influencing the processes by which water is provided and used, and as a means of cost recovery or revenue generation. In some places, these water prices are the principal form of water allocation. In other places, these prices are combined with various forms of licenses, permits, quotas, restrictions and other practices and customs that dictate how much water is used, where and at what cost. Where pricing is used, there may be a range of apparent price levels since, in practice, water systems have a number of stages in the supply chain. There might be prices assigned for bulk water withdrawals from a surface water or groundwater source that differ from other prices further along the supply chain. Specific prices might be assigned once the water has been successively transported, stored, treated and distributed for final use by residents, industries, irrigators, public works and so on, and these prices may vary by time, place or purpose of use.

Economists have occupied themselves for centuries exploring the role and behavior of prices in influencing decisions about the production and use of all manner of goods and services. Long before economists became involved, people had experience with barter and trade in town and village markets everywhere. It was readily apparent that markets could function with varying degrees of effectiveness for a wide range of transactions. At their best, markets--and the price signals they generate--are capable of coordinating the independent decisions of vast numbers of producers and traders and of allocating scarce supplies of goods and services across diverse consumer groups. It is also the case that markets work more effectively at allocating some types of goods and services than others. Historically, markets have not been the principal means of allocating the use of fresh water in most parts of the world.

Since, in most countries, an individual's ability to use groundwater or surface water is not decided by the interaction of numerous independent buyers and sellers, there is a potentially important distinction to be made between market prices and administered prices. Market prices are those that arise from the changing balance of supply and demand among competing traders, whereas administered prices are those that are set or imposed by some public agency in the absence of an interactive market process. The two types of price determination occupy opposing ends of a continuum, where the determining difference is the degree to which information about buyers' and sellers' valuations drive the price-setting process.

To illustrate this distinction, consider a regional water authority that acts as a single supplier and that sets prices based only on notions of its own cost of service. This pricing behavior would place it at the administered pricing end of the spectrum, since users' valuations are not reflected in the prices charged. If the water authority's policies and strategies were to change, and the water authority chose to set prices reflective of buyers' willingness to pay, then the resulting market prices might be indistinguishable from those a profit-oriented monopolist also would have charged. (1) Indeed, a central notion for the improvement of water pricing practices around the world is to shift or reorient price-setting objectives and/or processes at the local level. Especially where notions of market efficiency and the best use of scarce resources are paramount, the challenge is to make administered prices more closely resemble the market prices that a well-functioning market might set.

When prices are determined by auction or due to the competitive supply to the market by numerous sellers, an anticipated shortage is usually resolved spontaneously through a price increase. Alternatively, under the administered price approach, a conscious effort would have to be made to adjust prices in times of scarcity. If that effort were insufficient, then other measures such as quotas and water restrictions would be needed if all customers were to be assured some supply. In the face of an anticipated shortage, both pricing approaches do better if there is timely and accurate market information and forecasting. In the case of markets, any adjustment of prices in response to new forecasts is the implicit responsibility of all buyers and sellers collectively. Under the administered approach, the selling agency is the only one that can raise or lower prices. Under both pricing approaches, there remains a risk of shortage. Some of the cost of this risk and of any resulting shortage will be borne by both buyers and sellers.

Discussion about the design and reform of water pricing policy, then, is almost always about the purpose and relative effectiveness of various schemes of administered pricing as a means of allocating usage of water or raising revenue. There may or may not also be a policy option to establish some form of water market. With active water markets, there would be no specific role for pricing policies, since then the specific price levels are not a policy choice but the result of market interactions. Where there is a choice between new or reformed water markets and reformed water pricing, a clear understanding of reformed water pricing would help inform such a decision.

THE RATIONALE FOR WATER PRICING

Setting a price for water use can potentially achieve a number of diverse purposes, but an acknowledged limitation is that each price can generally only achieve one of these purposes and so priorities need to be established. (2) Typically, the three primary and competing purposes to be prioritized are promoting economic efficiency, generating revenue and advancing economic equity or fairness. Where a water pricing method includes two price elements--such as a flat monthly...

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