WAT E R G L O B A L P R A C T I C E Troubled Tariffs Revisiting Water Pricing for Affordable and Sustainable Water Services Luis A. Andrés, Gustavo Saltiel, Smita Misra, George Joseph, Camilo Lombana Cordoba, Michael Thibert, and Crystal Fenwick About the Water Global Practice Launched in 2014, the World Bank Group’s Water Global Practice brings together financing, knowledge, and implementation in one platform. By combining the Bank’s global knowledge with country investments, this model generates more firepower for transformational solutions to help countries grow sustainably. Please visit us at http://www.worldbank.org/water or follow us on Twitter at @WorldBankWater. About GWSP This publication received the support of the Global Water Security & Sanitation Partnership (GWSP). GWSP is a multidonor trust fund administered by the World Bank’s Water Global Practice and supported by the Australian Department of Foreign Affairs and Trade, Austria’s Federal Ministry of Finance, the Bill & Melinda Gates Foundation, Denmark’s Ministry of Foreign Affairs, the Netherlands’ Ministry of Foreign Affairs, the Swedish International Development Cooperation Agency, Switzerland’s State Secretariat for Economic Affairs, the Swiss Agency for Development and Cooperation, and the U.S. Agency for International Development. Please visit us at www.worldbank.org/gwsp or follow us on Twitter at @TheGwsp. Troubled Tariffs Revisiting Water Pricing for Affordable and Sustainable Water Services Luis A. Andrés, Gustavo Saltiel, Smita Misra, George Joseph, Camilo Lombana Cordoba, Michael Thibert, and Crystal Fenwick © 2021 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW, Washington, DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Rights and Permissions The material in this work is subject to copyright. Because The World Bank encourages dissemination of its knowledge, this work may be reproduced, in whole or in part, for noncommercial purposes as long as full attribution to this work is given. Please cite the work as follows: Andrés, Luis A., Gustavo Saltiel, Smita Misra, George Joseph, Camilo Lombana Cordoba, Michael Thibert, and Crystal Fenwick. 2021. “Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services.” World Bank, Washington, DC. Any queries on rights and licenses, including subsidiary rights, should be addressed to World Bank Publications, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2625; e-mail: pubrights​ @­worldbank.org. Cover design: Bill Pragluski, Critical Stages, LLC. Cover photo: TerryJ/Getty Images. Executive summary photos: Left page (left to right): Gorodenkoff/Shutterstock, Getty Images, KirkD2009/Flickr, ESB Professional/Shutterstock. Right page (left to right): Getty Images, zhu difeng/Shutterstock, Phovoir/Shutterstock, Getty Images. ii Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services Contents Acknowledgments viii Executive Summary xi Abbreviations xxi Chapter 1  Setting the Context 1 1.1 The Case for Financial Equilibrium 2 1.2 The Pressing Need to Conserve Water 3 1.3 The Challenge of Affordability 4 1.4 Emerging Questions 4 1.5 Report Structure 8 Note 8 Chapter 2  Designing an Effective Tariff Structure 11 2.1 What Is an Effective Tariff Structure? 11 2.2 Customer Classification 12 2.3 Primary Tariff Objectives 13 2.4 Identifying and Calculating Costs 14 2.5 Core Water Tariff Structures 16 2.6 Global Prevalence of Water Tariff Structures 21 2.7 Calculating Consumption Tariffs and Connection Charges 22 2.8 Pursuing Efficient Cost Recovery 24 2.9 Financial Analysis 30 2.10 Economic Efficiency 31 2.11 Affordability 37 2.12 Raising Revenue through the Three Ts: Tariffs, Taxes, and Transfers 40 2.13 Conclusions 44 Notes 46 Chapter 3  Secondary Tariff Objectives and Tariff Complements 49 3.1 Strategies to Increase Economic Efficiency 49 3.2 Strategies for Conserving Water 52 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services iii 3.3 Alternative Strategies for Ensuring Affordability and Increasing Access 60 3.4 Simulating the Effects of Different Tariff Structures on Efficiency and Affordability 74 3.5 Conclusions 75 Note 77 Chapter 4  Regulatory Levers to Control Pricing and Increase Efficiency 79 4.1 Rationale for Regulation 80 4.2 Controlling Price and Revenue 81 4.3 Incentivizing Cost Efficiency 82 4.4 Mechanisms for Regulating Service and Environmental Costs 83 4.5 Rationale for Transparency 87 4.6 Conclusions 92 Chapter 5  Key Elements of an Effective and Efficient Tariff Reform Strategy 95 5.1 Strong Political Leadership 95 5.2 Timing of the Reform 99 5.3 Utility Performance and Quality of Services 100 5.4 Using Technology to Improve Tariff Design and Utility Performance 101 5.5 Stakeholder Engagement 106 5.6 Protecting Vulnerable Groups 111 5.7 Conclusions 112 Notes 113 Chapter 6  Final Remarks 115 6.1 Core Concepts of Effective Tariff Reform 115 References 119 Appendix A  List of Background Papers 125 Appendix B  Data Sources 127 Appendix C Simulating the Effects of Different Tariff Structures on Affordability and Efficiency 131 Appendix D Simulation of Potential Reductions in Tariff Levels Resulting from Reducing Inefficiencies 137 Appendix E  Estimating Revenues to Meet Financial Objectives 141 iv Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services Boxes 2.1. Financial Cost Recovery in Lusaka, Zambia 27 2.2. Internalization of Resource Costs in Peru 30 2.3. Reducing Nonrevenue Water in Souk-Ahras, Algeria 32 2.4. Simulation of Nontariff Options for Cutting Costs in Zimbabwe 32 2.5. Simulating Potential Cost Savings from Reducing Inefficiencies across Four Dimensions 35 2.6. Social Water Pricing in Indonesia 39 2.7. The Case for Revisiting IBTs 40 2.8. Mechanisms for Ensuring the Poor Access Water at Cost-Recovery Prices 41 2.9. Social Assistance through Utility Tariffs during the COVID-19 Pandemic 43 3.1. Automatic Meter Readers for TOU Tariffs in Australia 51 3.2. Seasonal Tariffs and Overconsumption Penalties in Chile 58 3.3. Behavioral Nudges Implemented in Chennai (India) 61 3.4. Piped Water Access and Connections in Selected Countries 62 3.5. Interest-Free Loans in Tangier, Morocco 66 3.6. Subsidies Based on Plot Size in Hyderabad, India 67 3.7. Differentiated Regulation of Informal Water Providers in Colombia and Peru 72 4.1. Key Performance Indicators in Albania 86 4.2. Successful Regulatory Practices in Portugal 89 4.3. Water ATMs in Nairobi Slum, Kenya 91 5.1. Zambia’s Water Sector Reforms 96 5.2. Mozambique’s Water Sector Reforms 97 5.3. Countering Inflation in Brazil and Uganda 98 5.4. Colombia’s Water Sector Reforms 99 5.5. Prepayment Meters Are Not a Panacea for Utilities or Customers 103 5.6. Water Tariff Reform in Saudi Arabia 107 5.7. Classifying the Political Economy of Subsidies: A Basic Framework 109 Figures ES.1. Leveraging Leadership to Increase Efficiencies and Effect Lasting Change in the WSS Sector xii 1.1. Low-level Equilibrium Trap 2 1.2. Vicious and Virtuous Tariff Cycles 3 2.1. Elements of an Effective Tariff Structure 12 2.2. Key Tariff Objectives 13 2.3. Cost Categories of Networked Water Supply Services 15 2.4. Decision-Making Tree for Designing an Effective Water Tariff Structure 18 2.5. Global Prevalence of Water Tariff Structures 22 2.6. Cost Recovery by Region 25 2.7. Feedback Loop of Poor Cost Recovery 26 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services v B2.1.1. Cost-Recovery Rates and Quality and Coverage of Service, 2000–16 27 2.8. Connection Charges for Water and Sanitation in Select Countries 28 B2.3.1. Shares of Nonrevenue Water and Cost-Recovery Levels, 2010–18 32 B2.4.1. Various Cost-Recovery Scenarios 33 2.9. Direct and Indirect Effects of Inefficiency on Cost Recovery 34 2.10. Efficient Tariff Design 36 B2.5.1 Total Potential Reduction by Region (left) and by Income Group (right) 36 B2.9.1. Effects of Cross-Subsidy in Indonesia 39 2.11. Subsidies as a Proportion of Tariff and Tax Revenues in Select Countries, by Region (2010–19) 44 2.12. Tax Transfers as a Proportion of Tariff and Tax Revenues, by Region (2010–19) 45 3.1. Trade-Offs in Water Tariff Design 50 B3.1.1. A Comparison of Usage Scenarios 51 3.2. Price and Nonprice Approaches to Water Conservation 52 B3.2.1. Usage Patterns and Tariffs 58 B3.3.1. Example Graphics 61 B3.4.1. Actual vs. Potential Connection Rates in Select Countries, by Poverty Status 63 B3.6.1. Connection Charges Across Various Water Connection and Plot Characteristics 67 3.3. Average Water Pricing across Vendors in Nairobi, Kenya 71 3.4. Efficiency Ranking of Core Tariff Structures and Complements 74 4.1. Rationale for Regulation 80 4.2. Controlling Price and Revenue 82 B4.1.1. Determining Utility Revenue 86 4.3. Information Pipeline between Regulated Entities and Customers 89 5.1. Formal and Informal Stakeholder Engagement Mechanisms 111 5.2. Major Tariff Revisions in Sub-Saharan Africa in 2019 112 Tables 2.1. Backward-Looking Approaches for Determining Average Costs 15 2.2. Forward-Looking Approaches for Determining Average Total Costs 17 2.3. Strengths and Weaknesses of Core Tariff Structures 19 2.4. Methods for Calculating the Cost of Action for Environmental Costs 23 2.5. Cost Recovery of WSS Services in Select European Countries 24 2.6. Depth of Connection Charges 29 B2.4.1. Zimbabwe’s Utility-Level Data, 2013–14 33 2.7. Advantages and Disadvantages of the Three Ts 42 3.1. Strengths and Weaknesses of Tariff Complements 54 3.2. Price Elasticity of Demand Estimates 56 3.3. Seasonality of Water Demand 57 3.4. Reducing Connection Costs 64 vi Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 3.5. Spreading Connection Charges Over Time 64 3.6. Subsidies for Connection Charges 65 3.7. Subsidies for On-Premise Adaptation Costs 68 B3.7.1. Tariff Differentiation by Provider Size in Colombia 73 4.1. Advantages and Disadvantages of Tariff and Nontariff Mechanisms to Regulate Services and Costs 84 B4.3.1. Tariffs for Different Water Sources in Mathare Slum 92 B5.6.1. Tariff Rates before and after the Reform 107 B5.7.1. Characterizing Subsidy Policy Benefits: Basic Framework 109 B.1. Countries and Utilities Surveyed by Region 128 C.1. Flat Rate Efficiency Ranking 132 C.2. One-Block Efficiency Ranking 132 C.3. IBT Efficiency Ranking 132 C.4. Jump Tariff Efficiency Ranking 133 C.5. Decreasing Block Tariff Efficiency Ranking 135 C.6. Two-Part Tariff Efficiency Ranking 135 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services vii Acknowledgments This report was prepared by a World Bank team led and Sanitation Specialist), Joel Kolker (Lead Water by Luis Andrés (Lead Economist) and comprising Supply and Sanitation Specialist), Yogita Mumssen Gustavo Saltiel (Lead Water Supply and Sanitation (Practice Manager), Aude-Sophie Rodella (Senior Specialist), Smita Misra (Lead Water Supply and Economist), Alexander Danilenko (Senior Water Sanitation Specialist), George Joseph (Senior Supply and Sanitation Specialist), and Stephane Economist), Camilo Lombana Cordoba (Senior Water Dahan (Senior Water Supply and Sanitation Supply and Sanitation Specialist), Michael Thibert Specialist). The team also received constructive (Consultant), and Crystal Fenwick (Consultant) of advice from the following external reviewers: Rui the Water Global Practice (GP). Cunha Marques (Universidade de Lisboa), David The report draws on background papers, case Fuente (University of South Carolina), Samuel studies, and additional contributions prepared by Huston (USAID), and Rolfe Eberhard. Finally, the Economic Consulting Associates (Peter Robinson, report has benefited greatly from strategic guidance Nick Haralambopoulos, Richard Bramley, Tatiana and general direction provided by the management Tumenggung, Richard Holcroft, David Storey, Alex of the Water GP including Jennifer Sara (Global Schmid, Andrew Tipping, and Ester Vespasiani), Director), Richard Damania (Chief Economist, German Sember, Laura Abramovsky, Ignacio Sustainable Development Practice Group), Soma Hanesman, and Gonzalo Espiñeira. Ghosh Moulik (Practice Manager), and Maria Angelica Peer review was conducted by Charles Delfieux Sotomayor (Practice Manager). Alona Daniuk and (Senior Water Supply and Sanitation Specialist), Fan Isabel Junior provided administrative support. Zhang (Senior Economist), Bill Kingdom (Consultant), Editorial services were provided by Fayre Makeig. Diego Polania (Executive Director, Comisión de This work was made possible by the financial Regulación de Agua Potable y Saneamiento Básico, contribution of the Global Water Security & Sanitation Colombia), and Alain Locussol (Consultant). Partnership (GWSP), http://www.worldbank.org​ Insightful and helpful advice and comments were /e n / programs/global-water-security-sanitation​ received from Martin Gambrill (Lead Water Supply -partnership. viii Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services Tariffs are essential—but not the only pathway—to recovering costs, addressing affordability, and managing water conservation. To maximize their potential, they must be well designed, complemented by appropriate instruments, adequately regulated, and understood by customers. Designing effective tariffs is a function of economic efficiency and requires a detailed understanding of costs Tariff design demands a holistic approach that carefully considers competing policy objectives Tariff complements can be used to effectively address affordability and improve services Regulation is an effective tool for increasing efficiency and ensuring good governance Resistance to tariff reform is reduced by strong political leadership, improved service quality, and increased stakeholder engagement Executive Summary Few resources on Earth are as important and as capital assets. There is little consensus on optimal poorly managed as water. Its price rarely reflects its tariff design, particularly given that water is classi- economic value or the costs of treatment and distri- fied as both an economic good (which favors recover- bution. Low water prices have resulted in inefficient ing all costs through tariffs) and a human right (which use and reduced provision and expansion of ser- favors subsidization by the government). vices, particularly for the poor, making the sector A 2019 flagship report of the World Bank’s Water less attractive to investors and inflicting high costs Global Practice, “Doing More with Less: Smarter upon the economy, society, and environment. Subsides for Water Supply and Sanitation” In 2010, the United Nations recognized safe and (World Bank 2019), explored the question of how clean drinking water and sanitation as a human right scarce public resources can be used most effectively (UN 2010). At the time, the Millennium Development to achieve universal service delivery. That report Goals (MDGs) were focused on halving the number provided guidance to policy makers on how to design of people living without access to improved water smarter subsidies to attain policy goals. supply and sanitation (WSS) services by 2015. The This report builds upon that one, and provides pol- United Nations then adopted the Sustainable icy makers with the information needed to design Development Goals (SDGs) in the fall of 2015, raising better tariffs to further the economic efficiency, global ambitions further with the new targets of affordability, and environmental sustainability of achieving “universal and equitable access to safe and water supply services. Through a layered and com- affordable drinking water” and “adequate and equi- prehensive analysis of the most prevalent tariff table sanitation and hygiene for all” by 2030. These structures, it provides policy makers with specific declarations and targets have directed much-needed guidance on pricing water supply services in attention to the plight of billions of people who still response to the sector’s often-competing goals. lack access to safely managed water supply and sani- WSS services are intrinsically linked. In member tation (WHO 2017) and bolstered arguments in favor countries of the Organisation for Economic of subsidization, as efforts to charge the full eco- Co-operation and Development, and large cities in nomic costs needed to sustain services have been middle-income countries (such as Brazil, Chile, and seen as exclusionary. South Africa), services are often provided by a single Water and sanitation services are funded through a provider. However, in urban areas in low-income mixture of revenues from the so-called three Ts: countries, most households rely on on-site sanita- ­ tariffs, taxes, and transfers (OECD 2009). The full tion services, which have different financing, man- economic cost of water may be defined as the total agement, and regulatory challenges than do costs of producing, treating, and distributing water, networked services. Similarly, rural WSS services including the depreciation and rate of return of present distinct challenges. Given these differences, Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services xi this report focuses specifically on residential water revenues collected through taxes or transfers. This is consumption tariffs in urban areas. especially important during times of crisis, such as This document comprises a synthesis of 15 unique the COVID-19 pandemic and post-pandemic recov- research papers (listed in appendix A) that, com- ery period, when subsidies are likely to be directed bined, articulate a step-by-step thought process for elsewhere, inadvertently affecting initiatives designing effective tariffs with a view to achieving designed to achieve the SDGs. Total economic costs SDG 6 (figure ES.1). can be defined as capital costs (including financing), The results of this global study on tariffs can be the costs of operating and maintaining water supply summarized in the following five key messages. systems, and externalities (such as environmental costs). The failure to recover any one of these costs Key Message 1. Designing Effective Tariffs is has distinct, adverse consequences. Accordingly, a Function of Economic Efficiency and correctly identifying and quantifying costs are Requires a Detailed Understanding of Costs fundamental to the tariff design process. Using a Improving economic efficiency is critical to design- backward-looking approach to calculate average ing effective tariffs and can reduce reliance on costs focuses heavily on expenses incurred and, FIGURE ES.1. Leveraging Leadership to Increase Efficiencies and Effect Lasting Change in the WSS Sector Efficiency to achieve cost recovery and Political leadership and faith in service quality: regulatory regime: Low-level equilibrium • Efficiency gains can increase service • Crises can be exploited by farsighted quality, WTP, and cost recovery: scope leaders to bring change—e.g., building for increasing access and further back better from COVID service quality improvements creates Farsighted leader sees opportunity for • Transparency needed for tariffs to be positive feedback loop change and wins political support raised and for payment compliance. • Reconsidering the level of service can Past opacity or corruption creates lead to further cost cuts and enhanced resistance. Need right leader to break Improvement in utility performance, access the cycle and entrench transparency collection rates, and cash flows Success motivates staff and development Trade-offs of tariff design vs objectives: partners to provide support Expanding access: • Tariff structures should not be burdened • Pro-poor tariff structures only with too many policy objectives benefit ~200M already connected; Further investments to improve utility challenge is to reach ~700M urban • Complements can be applied to achieve performance and service quality are achieved poor without access specific objectives IBTs are not so effective for: • Service expansion essential in Tariff increases/reforms become possible, off-grid areas. Urban areas and • Affordability – IBTs with a “lifeline” first slums require light-handed block are supposed to be pro-poor but politically and publicly acceptable regulation and the channeling of are not necessarily fit for purpose subsidies (links to • Efficiency – IBTs do not send efficient off-utility business models) Strong financials, management, and large-scale pricing signals and are not effective in investments in service expansion • Connection charges/subsidies to targeting subsidies at poor households address pro-poor dimension • Water conservation – Mixed evidence • Mobile payments are the most on PED in follow-up work in SA Real progress on SDG 6 beneficial technological innovation • Ease of understanding and (including during COVID pandemic) implementation Source: Original compilation. Note: IBT = increasing block tariff; M = million; PED = price elasticity of demand; SA = South Africa; SDG = Sustainable Development Goal; WSS = water supply and sanitation; WTP = willingness to pay. xii Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services because of its simplicity, is by far the most common marginal reduction in full cost-recovery tariffs across approach. There are, however, sound arguments for water utilities. a more forward-looking approach that explicitly Finally, major externalities, such as environmental recognizes invested asset value and the decline in costs, can affect the efficiency of water supply the useful life of capital assets. services. A key challenge is estimating and internal- Total economic costs can be further divided into izing these costs. This can be achieved by incorporat- efficient and inefficient costs. Inefficient costs ing these costs into tariffs or through imposing include costs associated with high system losses and regulatory measures on utilities—for example, limits an overstaffed workforce and are a key determinant on water extraction, water use conditions, or of a utility’s overall efficiency. Inefficiency affects market-based mechanisms such as tradeable water cost recovery directly through low bill collection and rights. Given their complex nature relative to the high costs, and also indirectly through reduced will- calculation and compensation of total economic ingness to pay (WTP) resulting from poor-quality costs, environmental costs are rarely recovered. Yet services, which can hamstring a utility’s ability to as service providers come under increasing pressure raise tariffs in the future. Thus, inefficiency can to meet the growing demands of populations with eventually lead to lower cost recovery as tariffs fewer hydrological resources, environmental costs remain stagnant and costs rise over time. This creates must be taken seriously. a negative feedback loop, as the lower cost-recovery rate induces greater inefficiencies (e.g., stemming Key Message 2. Tariff Design Demands a from low capital investments) and also directly Holistic Approach that Carefully Considers reduces the quality of services (e.g., discouraging Competing Policy Objectives new connections, and thus slowing expansion of The price of water almost never equals its value and service coverage). rarely covers its economic costs. Price does not pro- Evidence put forward in this report suggests that a vide a clear value signal. For example, surveys show 75 percent reduction in each of four dimensions of that most residential water customers are unaware inefficiency (bill collection, nonrevenue water, over- of their consumption. Moreover, as water is consid- staffing, and capital expenditure) would reduce the ered a fundamental human right, attempts to price global average full cost-recovery tariff by an esti- this scarce resource strike many people as unethical mated US$0.13 per cubic meter (m3) (or about and are usually politically challenging. Hence, tariffs 6  percent), equivalent to 14 percent of the global are tasked with harmonizing a set of wide-ranging, average water tariff. The effects of these efficiency conflicting, and often highly political objectives. improvements on the full cost-recovery tariff would Most obvious perhaps is the need to ensure the differ widely across regions; Sub-Saharan Africa financial viability of service providers while making would experience the greatest impact (about water affordable for customers. At the same time, 11 percent). On average, reducing inefficiencies in policy objectives reflect other important goals, such capital expenditure would result in the single-largest as water conservation. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services xiii The process of classifying customers—from the To better achieve more specific policy goals, tariff first step of determining how to differentiate various complements can be applied to core tariff structures groups of customers to allocating costs across cus- or customer classifications in a way that balances tomer categories and creating appropriate signals for competing policy objectives. Such complements consumption—is central to the design process and a may include social rebates and vouchers to tackle direct function of policy. The same applies to the affordability. Additionally, tariff structures can incor- process of determining the share of costs to be recov- porate some form of seasonal pricing or overcon- ered by tariffs. Tariff design is thus a demanding yet sumption penalty to promote environmental delicate balancing act that is highly context specific. sustainability and the principles of a circular The aspect of tariff design that typically garners economy. the most attention is the core tariff structure. This Compared to consumption tariffs, connection report reviews five tariff structures in detail: flat rate, charges have received comparatively little attention constant (or one block) volumetric, increasing block and without significant subsidies remain unafford- tariffs (IBTs), decreasing block tariffs (DBTs), and able for many unconnected, poor households. jump tariffs. Along with volumetric tariffs, IBTs are Various options exist for subsidizing connection the most prevalent model globally: more than half of charges, though in reality these are often complex. all utilities analyzed use IBTs to price water services. Some utilities allow charges to be reduced or waived This stands true across countries of all income levels. in exchange for labor or materials. Nonfinancial Conversely, one-block tariffs are more common for interventions designed to encourage connections wastewater services and are especially prevalent in should also be considered more broadly. For exam- countries with low average incomes. DBTs and jump ple, informational campaigns publicizing the bene- tariffs are very rarely applied to water supply ser- fits—and, if appropriate, the prevalence—of existing vices, independent of customer income. water connections are effective in encouraging new Tariff structures should not be overburdened with connectivity. policy objectives. For example, two-part tariffs are the most effective at achieving economic efficiency Key Message 3. Tariff Complements Can and cost recovery, but on their own do not address Be Used to Effectively Address Affordability affordability effectively. When affordability is a and Improve Services major concern, volume-differentiated tariffs (VDTs)— Whether or not water tariffs should be set so as to although uncommon—may be preferable because support access to services by poor households has they cross-subsidize customers in a more targeted been extensively debated in the literature. The short manner and better minimize distortions to effi- answer is they are at best a blunt instrument and at ciency. However, because they may inadvertently worst produce perverse outcomes, and for one cru- penalize large, low-income families that are likely to cial reason: the need to have a policy tool for each consume more water, as with all tariffs, their efficacy policy objective precludes water tariffs efficiently is context specific. meeting both financial viability and affordability xiv Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services targets simultaneously.1 While core tariff structures premium applied by informal water service provid- need to ensure sustainable funding for the provision ers. Although most government water supply strate- of quality services, other targets like affordability gies include nonnetworked services, subsidies are may be best met through tariff complements and tar- primarily targeted to networked services, benefitting geted social measures. For example, if tariffs are set the wealthiest customers (i.e., those who already at economic cost-recovery levels, then access by have access to services or live within the utility’s ser- poor households relies on establishing a parallel, vice area). The current distorted subsidy regime well-targeted subsidy mechanism such as tariff should therefore be rebalanced to equitably allocate rebates or vouchers. subsidies to these off-grid, mostly poor customers. However, the determination of affordability is These could be channeled directly to poor customers marred by scale: aggregate-level analyses commonly or indirectly through performance-based payments overestimate the extent of affordability, and alterna- to informal service providers. tive methods are sorely needed. Furthermore, tariff structures for networked services that aim to address Key Message 4. Regulation Is an Effective poverty benefit only connected customers. This Tool for Increasing Efficiency and Ensuring means the needs of the approximately 700 million Good Governance unconnected, urban poor globally remain unmet.2 In Regulation3 is critical in the water sector, where reality, large swathes of people rely on nonnet- economies of scale and high start-up costs are fertile worked services as piped connections are not always ground for natural monopolies. A primary role of economically feasible in the short term. regulators is to therefore prevent the abuse of power The needs of the unconnected must be carefully by monopolistic utilities. Theoretically, regulation considered, and off-grid service provision is vital to can help prevent inflated prices and costs, maintain bridging this gap. In urban areas, tariffs applied by standards and quality of services provided, and informal service providers tend to reflect collusion avoid persistent failures to address environmental rather than competition, making a strong case for services. In practice, effective regulation is context regulating off-grid services through some form of specific. light-handed regulation. Regulatory frameworks There is no “one-size-fits-all” solution for the eco- should be extended to these providers to grant them nomic regulation of WSS services. Regulatory some form of legal recognition and incentivize their arrangements should be tailored to meet the specific professionalization. Regulation should be adapted to needs of the country. To do this effectively, the coun- mobile vendors through an acceptable relaxation of try should first define its objectives, analyze the standards, whether in terms of tariffs, service qual- potential contribution of economic regulation to the ity, or coverage targets. overall sector accountability framework, specify reg- Customers of nonnetworked services are mostly ulatory functions, and select the legal instruments poor households, which are thus disproportionally and organizations within which to embed these affected by unregulated pricing and the poverty functions. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services xv Regulatory frameworks can take various forms in supplier and consumer, grievance redress mecha- line with a country’s legal context. The most com- nisms, and customer engagement espouse transpar- mon include regulation by an agency or municipal ency and accountability and lead to better outcomes regulator, or a contract between the government and and increased WTP. While technologies can provide provider. Regulatory tools can be cost or incentive the verification of financial flows needed by end based and the appropriate model is often a function customers, closer scrutiny by regulators is nonethe- of the utility’s ownership. For example, a private less critical. utility may respond well to a cost-based approach, The wide variety of potential arrangements calls whereas a public utility may respond better to an for governance practices to be carefully systematized incentive-based approach. and successful experiences identified. Since state- Cost-based regimes attempt to equate revenue owned enterprises are part of the public sector, with costs and minimize a utility’s financial risk by factors of good and bad performance are directly and preventing costs from exceeding revenues. This sce- indirectly related to the overall governance of a nario works well for new utilities motivated by finan- country, province, or municipality. Hence, there is a cial risk but may limit a utility’s incentive to operate need for a corporate structure that prevents political cost-efficiently and consider affordability and acces- intervention, rewards performance, and is subject to sibility. Incentive-based regimes use budget public scrutiny. In this context, corporate gover- constraints to encourage utilities to cut costs while nance appears essential. improving performance, and work well for estab- lished utilities. Utilities that exceed their budget Key Message 5. Resistance to Tariff Reform targets can keep all or part of the difference as a Is Reduced by Strong Political Leadership, reward. This can lead to greater efficiencies and can Improved Service Quality, and Increased Stakeholder Engagement also be used to motivate utilities to expand access, benefitting customers and society. The successful implementation of tariff reform In both cases, information asymmetry between the requires more than a sound design: without an utility and regulator makes the determination of a appropriate strategy that fosters support from cus- fair or competitive tariff difficult. Regulatory agen- tomers and other stakeholders, there is a strong like- cies that are transparent, accountable, and free of lihood of failure. Such a strategy should generally political interference contribute positively to sector entail: (1) strong political leadership; (2) enhanced performance by supporting economic cost recovery performance that results in a service quality that is and reducing operational expenses. Different ele- acceptable to customers; (3) increased stakeholder ments of regulatory governance affect performance engagement; and (4) widely socializing the tariff differently. Take, for instance, the important role design process and underlying costs of provision. that regulation can play in reducing corruption, Successful reforms need strong political leadership. which is often deeply entrenched in the sector. The political attractiveness of “free water” makes it Consistent and reliable flows of information between an alluring way to dispense policy favors. However, xvi Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services tariff reforms are possible and farsighted leaders can reform process. A wide range of mechanisms can be exploit catalytic events such as a health epidemic or adopted to strengthen interactions between a change in the political landscape to create momen- decision-makers, customers, and other stakehold- ­ tum and build alliances that can alter the balance of ers during the tariff reform process, including, for political payoffs. This relationship is dynamic and example, interministerial bodies, citizen commit- mutually reinforcing. That is, as reforms produce tees, public hearings, media-based tools, and com- tangible benefits and WTP improves, politicians are munication strategies. Ideally, these mechanisms more likely to support the reform process. gauge customer priorities in relation to various As a general rule, customers are unwilling to spend aspects of service quality, and in particular how more on low-quality services. Public water supply is they view the trade-off between quality of service inadequate in many countries and suffers from large and tariff level. water losses and intermittent service. This obliges Finally, without transparent pricing, customers households to look for alternative solutions that often tend to overestimate the degree to which tariffs are result in huge coping costs. Inefficiencies and recovering actual costs. This can lead them to resist low-quality services lead to negative perceptions and even affordable tariff increases. To the extent possi- low satisfaction rates among customers, who in turn ble, policy makers should strive to design tariffs that become less willing to pay their bills. To break this are simple and easy to understand. To improve vicious cycle, utilities should first embark upon a understanding of the level of cost recovery achieved series of “quick wins” that improve their performance by existing and proposed tariffs, utilities should and efficiency, thereby improving the level of service develop a multipronged communications strategy. experienced by customers and, in turn, their WTP. Publishing regulatory information online, for Inclusive and participatory approaches can build example, including total costs and how costs are trust between stakeholders and may even result in a recovered through the three Ts (i.e., tariffs, taxes, more effective or sustainable tariff design. The and transfers), enables direct access by media, civil absence of dialogue with end customers is one of society, and customers. Documentation can also the most frequently cited problems affecting water explain the process used to arrive at existing tariffs. service delivery. When customers perceive that Benchmarking against utilities in different regions or their concerns and perspectives are not considered countries is important for contextualizing costs and in decision-making, they lose trust in public author- performance and demonstrating an element of ities and become reluctant to pay, much less accept accountability. Regulators and utilities should ensure tariff increases. A well-planned stakeholder engage- information is disseminated broadly through chan- ment strategy can be used to promote a better nels accessible to customers, which may include understanding of the need for reform and enable newspaper ads, flyers, radio or television spots, com- two-way dialogue and more participatory planning. munity meetings, and so on. It must be flexible to accommodate shifting politi- The results of this global study on tariffs can be cal, social, and cultural factors relevant to the summarized in the following overarching message: Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services xvii Tariffs are essential—but not the only • The expansion of access to services. Related topics include how best to meet the needs of customers pathway—to cost recovery, affordability, in off-grid water areas, connection charges and and water conservation. to maximize their pro-poor tariff complements, the role of adapta- tion costs in expanding access to WSS services, potential, tariffs must be well designed, and rationales for investing in emerging complemented by appropriate technologies. • Regulatory regimes and transparency. Considering instruments, adequately regulated, and these is important in efforts to address corruption, understood by customers. and support water regulators’ efficacy in incentiv- izing best practices among water utilities. Among Historically, the water sector has operated under the other things, it is important to consider how the assumption that tariffs should be designed to achieve weighted average costs of capital differ across full economic cost recovery. Against this backdrop, contexts. water utilities in low-income economies that face the Another key subject of further analysis is the best difficult challenge of balancing tariffs against afford- use of technology. Although advances in technology ability and accessibility also lack the funds needed to offer cost-effective solutions, the water sector has maintain and expand services or address external been notoriously slow to capitalize on these innova- challenges, such as climate change. Moving from a tions. Various technologies are intended to support narrative that equates tariffs with full economic cost tariff design, and subsidy design and targeting, as recovery to one that recognizes the roles of taxes and well as improve provider-customer interactions. For transfers in achieving financial equilibrium demands example, automated water kiosks and smart pay- a paradigm shift and is critical to an effective tariff ment systems facilitate the delivery of subsidies to reform process. the intended recipients, and smart meters enable the This effort also reveals critical knowledge gaps and use of more sophisticated tariff structures. identifies important questions and themes that merit Technologies that engage customers and inform further research moving forward, including: them of their use (e.g., through digital customer • Tariff design and trade-offs. Key subjects in this cat- engagement) can change the way customers interact egory include the price elasticity of demand as a with tariffs. Finally, evidence suggests customers basis for IBTs, direct subsidies to the poor in coun- who use mobile payments as one of their payment tries that lack an established social security classifi- methods pay bills more regularly and contribute cation system, and improved analytical methods to more revenue. In addition, mobile payments reduce capture and analyze the effect of different tariff opportunities for corruption and enhance the quality structures on affordability and subsidy allocation. of billing and payment data. xviii Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services Winds of Change: Is COVID-19 the Crisis service, and (3) a relatively stable political leader the Water Sector Needs to Finally Spur who is supportive and protective of the reform. Lasting Change? Tariff reform similarly hinges on effective leader- If history has taught us one thing, it’s that the water ship and political support for tariff design and effi- sector is notoriously reactive. Population growth fre- cient, sustainable water services. COVID-19 thus quently outpaces the expansion of infrastructure, provides an important catalytic opportunity for and real change often occurs only on the heels of a change. crisis, and, even then, only when there has been a significant loss of life or major economic impact. Notes Water systems are generally considered critical infra- 1. As described in a recent study by OECD (2020, 7). structure; what does it take to spur lasting change? 2. According to the Joint Monitoring Programme, 72 percent of these people live in lower- and middle-income countries. A recent detailed analysis of successful utility 3. Regulation is a policy intervention that aims to promote sector goals reforms in Africa (World Bank 2016b) finds that sus- in the public interest, balancing the competing interests of the vari- tained reform requires three mutually reinforcing ous stakeholders. Economic regulation refers to the “setting, moni- conditions: (1) a catalytic event or space for reform, toring, enforcement and change in the allowed tariffs and service standards for utilities” (Groom et al. 2006). (2) a skilled technical leader motivated to improve Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services xix Abbreviations C&C command and control COD chemical oxygen demand CPI consumer price index DBT decreasing block tariff EIs economic instruments EU European Union GDP gross domestic product IBNET International Benchmarking Network IBT increasing block tariff KPIs key performance indicators NRW nonrevenue water O&M operation and maintenance RAB regulatory asset base ROR rate of return RPI retail price index SRMC short-run marginal cost TOU time of use US United States VDT volume-differentiated tariff WACC weighted average cost of capital WSS water supply and sanitation WTP willingness to pay Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services xxi © Getty Images CHAPTER 1 Setting the Context Tariffs are the foundation of good financial governance and, ideally, enable water utilities to cover their operation and maintenance costs and make provi- sions for capital expenditures. By achieving this, service providers can attract investment to expand their infrastructure network, enhance service quality, or scale up other elements of service provision. However, without strong finan- cial management and a proven track record achieving key service delivery indi- cators, utilities will struggle to secure the investments needed to maintain sustainable service levels, which in turn makes customers less willing to pay and further deteriorates quality of service. The water sector in many developing economies is stuck in this situation, described as a low-level equilibrium trap (figure 1.1) (Savedoff and Spiller 1999). Historically, governments have kept tariffs artificially low or opposed tariff reforms to increase their popularity. A common tactic used to achieve short- term political gains, it ignores society’s long-term interests in the financial via- bility of water utilities. In circumstances where political opportunism prevails, customers are typically insufficiently organized to demand accountability from politicians and utilities, but also unwilling to spend more to increase access and improve the quality of services. Low tariffs and inadequate revenues lead to the deterioration of assets and inefficient operation of utilities. The guiding question is therefore how to move from a vicious cycle, by which the poor quality of service generates resistance to reforms and tariff increases, to a virtuous cycle whereby good performance enhances willingness to pay (WTP), increasing revenues and leading to contin- uous improvements (figure 1.2). The key factors preventing the move to a virtuous cycle can be grouped into the following categories: • Poor overall performance. Public water services in many countries are poorly managed, with low billing and collection rates, large losses, and intermittent service, which often obliges households to look for alternative solutions for water supply, typically at higher costs. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 1 FIGURE 1.1. Low-Level Equilibrium Trap Politicization • Lack of public support • Political instability • Public ownership Low prices Bad service and corruption • Cover only salaries • Low coverage • Limited investment • Rationing • Dependency on • Cash hiding government transfers • Overemployment Source: Adapted from Savedoff and Spiller (1999). • Lack of trust and low WTP. Inefficiencies and streams to back proposed reforms and compen- low-quality services lead to negative perceptions sate groups that are adversely affected. and low satisfaction among customers, who in turn become less willing to pay their bills, rein- Though tariff reform is invariably central to efforts forcing the negative spiral of low revenues from to move beyond the vicious cycle, policy makers low tariffs and collection rates. When water utili- would do well to implement comprehensive reforms ties and policy makers aren’t held accountable for that embrace the policy, institutional, regulatory, poor performance, customers lose trust in public and financial aspects needed to achieve sustainable authorities and become even more reluctant to improvements. Resistance to tariff reforms can be pay for unsatisfactory and inadequate services, overcome through increasing investments, improv- much less accept tariff increases. Building mutual ing utility performance, and increasing the quality of trust between different actors is therefore a pre- services while engaging the public throughout the requisite for any intervention that aims to improve entire process. quality of service and cost recovery. • Lack of funding. Insufficient revenues undermine 1.1  The Case for Financial Equilibrium the ability of utilities to make investment Tariff structures are commonly based on the prevail- decisions and hamper the success of sector ing belief that tariffs should recover all costs associ- reforms. Revenues collected through tariffs should ated with the production, supply, and delivery of complement other forms of financing to support water (i.e., full economic cost recovery). Against this utilities’ capital expenditures for maintenance and backdrop, water utilities in low-income economies expansion, while keeping services affordable. In that face the difficult challenge of balancing tariffs countries with unstable macroeconomic condi- against affordability and accessibility also lack the tions, this means having the real value of tariffs funds needed to maintain and expand services or protected through indexation formulae and ensur- address external challenges, such as climate change. ing significant funding through different revenue This perpetual cycle of funding inefficiency renders 2 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services FIGURE 1.2. Vicious and Virtuous Tariff Cycles Lack of Badly financing/ performing investment utility Improved/ Well- increased performing financing/ Financial Improve utility investment support Vicious utility Cycle performance Virtuous Cycle Resistance to Customers not tariff reform/ willing to pay / increase low willingness Customers to pay Successful willing to reform/ pay more Remove tariff Educate / increase barriers to raise tariff reforms awareness Source: Original compilation. them unattractive to savvy private investors. Shifting There is a pressing need to revisit the fundamen- the current paradigm that equates tariffs with full tals underpinning concepts of cost-recovery and to economic cost recovery to one that recognizes the better understand the wider implications of different roles of taxes and transfers in achieving financial tariff structures and pricing mechanisms for invest- equilibrium, while improving economic efficiency, ments and services. Developing a better understand- will be critical to effective tariff reform, a process ing of the mix of revenue streams used to fund the that has historically lacked consensus. provision of water—the so-called three Ts of tariffs, There are three principal reasons for the prevailing taxes, and transfers (OECD 2009)—is equally import- discord (World Bank 2018b). First—and conceivably ant. This knowledge can then be used to improve the most difficult challenge—is that because water is policy making while addressing the very real con- simultaneously an economic good, human right, and cerns of consumers. environmental resource, opinions on how best to price, protect, and allocate it vary considerably. 1.2  The Pressing Need to Conserve Water Decision-making surrounding the corresponding Population growth and urbanization, together with policy objectives of cost recovery, economic effi- the effects of climate change, have put significant ciency, water conservation, and affordability is pressure on water resources worldwide. These chal- equally variable. Second, the potential impacts of lenges are commonly addressed through water pric- overhauling tariff structures and pricing are poorly ing but also depend on tariff design. Water reuse can understood. In the face of such uncertainty, many also support environmental sustainability by reduc- policy makers prefer complacency over spending ing raw water demand. Promoting water reuse will political capital. Lastly, the monopolistic nature of require a coordinated approach to water and waste- water utilities means they are often indifferent to water pricing in addition to behavioral strategies. market-driven incentives to improve service quality In theory, progressively higher water prices should and efficiency. reduce consumption, but the evidence on the price Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 3 elasticity of demand and the role of tariffs in incen- Traditional affordability analyses fail to account tivizing water conservation is mixed. Price-based for differences in the quality of services provided, for approaches to managing water demand offer multi- example, in cases of frequent interruptions (World ple benefits in terms of ease of implementation, Bank 2020). Although particularly relevant to non- monitoring, and enforcement. However, household networked services, networked customers are also demand is not highly responsive to changes in water affected. Where the quality of services is low, house- tariffs in many countries. At the same time, the level holds may need to complement their water service of tariff increases that would be needed to induce with alternative sources, adding to their financial sufficient reduction in water consumption might be burden. Finally, in many developing economies too high to be politically feasible. Therefore, pricing water theft and inadequate metering pose difficul- approaches to water demand management should ties in measuring consumption levels and subse- be complemented by nonprice interventions to pro- quently the affordability of prevalent water tariffs. mote water savings among households. Specifically, To fully analyze the equity and affordability tariff structures that incorporate some form of sea- impacts of different tariff structures, billing records sonal pricing or overconsumption penalties to (that show actual consumption) would ideally be reduce water consumption during periods of peak matched to household income levels; however, such demand and/or lower resource availability are better information is rarely, if ever, available. In some cases, at achieving environmental sustainability. property values, for example, from municipal tax databases, are used as a proxy for household income. 1.3  The Challenge of Affordability A long-standing challenge of tariff design and reform 1.4  Emerging Questions is ensuring tariffs are affordable. A key challenge of This report is the product of an extensive series of tech- ensuring affordable tariffs is defining affordability. nical papers (listed in appendix A) covering some of the While there is no consensus, a typical approach most relevant topics related to pricing performance in involves limiting costs to a share of total household the water and sanitation sector. In the majority of cities expenditure. Thresholds used by international orga- in member countries of the Organisation for Economic nizations range from 3 to 5 percent (Hutton 2012). Co-operation and Development, a single service pro- However, these limits are arbitrary and not sup- vider is responsible for delivering both water and sani- ported by robust theory. tation services. This is also the case for some Traditionally, the analysis of affordability has been middle-income countries with extensive sewage net- conducted at an aggregate level and involves taking works such as Brazil, Chile, Colombia, South Africa, the average consumption and income levels for a and Uruguay. In most low-income countries, mean- specific group (e.g., an income decile or quintile) and while, sanitation services are more commonly man- calculating the average share of income spent on aged separately, if at all. For example, the majority of water tariffs. This approach fails to capture heteroge- urban households in Sub-Saharan Africa and Asia rely neity within groups and may fail to reveal the true on different forms of on-site sanitation such as septic extent of affordability constraints. This problem is tank and pit latrines. Given these unique differences, particularly prevalent for poor, large households that and recognizing that sanitation remains critical to may require significant quantities of water. achieving Sustainable Development Goal 6 (SDG 6), 4 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services a complementary analytical report on the implications the resulting revenue shortfall prevents the service of this study’s findings on urban sanitation service pro- provider from properly maintaining its infrastruc- vision is anticipated. Meanwhile, the present docu- ture. This reduces the life of its assets and will even- ment focuses exclusively on residential water tually lead to reduced service quality. Therefore, full consumption tariffs in urban areas. economic cost recovery depends not only on tariffs, Grounded in economic theory, this report combines but on achieving financial equilibrium from reve- a detailed literature review with real-world examples nues collected through each of the “three Ts.” The constructed from data collected by the International size and contribution of each is context specific and Benchmarking Network for Water and Sanitation generally determined by policy. Utilities (IBNET) to arrive at a comprehensive assess- Lower levels of revenue collected through tariffs ment of water tariffs. This provides the backdrop for a generally reduce the accountability of the service discussion of the methodological approaches and provider to its customers. The presence of subsidies tools needed to design and implement effective and can act as a soft-budget constraint but if not well efficient water tariffs. It explores the strengths and designed, often distorts incentives for service pro- weaknesses of different tariff structures and provides viders. For example, while under free market condi- guidance to policy makers on which contexts are most tions the potential increase in revenue gained from appropriate for their application. As such, it serves as undertaking service improvements and extensions a richly detailed, companion report to “Doing More may outweigh the costs of any investment, under with Less: Smarter Subsidies for Water Supply and subsidized conditions this potential revenue may be Sanitation” (World Bank 2019). offset by the corresponding loss of the subsidy. A loss The assessment seeks to address a series of emerg- of subsidies could inadvertently have an impact on ing questions pertaining to tariff design and reform poor households. Weak institutions and imperfect organized around three central themes of economic regulation exacerbate this problem. Thus, it’s import- efficiency, water conservation, and affordability and ant to consider the trade-offs entailed in pricing accessibility. water more efficiently in economic terms (with a focus on revenues collected through tariffs) versus How Should Costs Be (re)Covered? more equitably (leaving revenues to be collected There is little agreement on which specific costs through taxes and transfers). This is especially evi- should be covered by tariffs, and in which contexts. dent in the case of overdesigned systems where Even the term “cost-recovery tariff” is fraught with newly constructed facilities, intended to serve an confusion and uncertainty. In some cases, govern- increase in demand that has not yet been achieved, ment plans explicitly prescribe a method for deter- potentially push costs beyond the affordability of mining customer fees. Whatever the case, the current customers. difference between revenues collected through tar- iffs and full economic cost recovery constitutes an What Is an “Affordable” Tariff? economic shortfall that must be offset by a subsidy if Affordability is an important cross-cutting concern the service is to be sustained. This subsidy can be that evokes the human rights dimension of water, funded through a combination of taxes or transfers. yet there is no consensus on how affordability should When governments fail to provide the full subsidy, be defined or measured, and estimates are frequently Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 5 inaccurate. Households often face significant costs affordability without too much distortion to efficient beyond customer fees paid to the service provider, price signals. such as investments in associated household fix- tures (e.g., bathrooms, drains, plumbing, etc.). Should Costs Related to Externalities Be Recovered Through Tariffs? Affordability analyses must reflect all costs incurred Given the public good dimension of water, prices by the household. As affordability is mainly deter- should accurately reflect the true costs of service mined by customer income and preferences,1 mea- provision including externalities such as environ- suring it requires a different definition of costs than mental costs. Routinely neglected, environmental that used by the service provider to determine costs are vital to environmental sustainability and tariffs. reflect the conditions of water supply resources and Which Tariff Structures Are Most Appropriate in the potential contamination resulting from the a Particular Context? improper treatment of wastewater. However, mone- Most utilities in developing economies use increas- tizing environmental pressures and impacts is a ing block tariffs (IBTs), where volumetric tariff rates complex and imperfect exercise, since many hydro- increase with total consumption. Based on the logical services are nonpecuniary, unmeasured, and assumption that poor customers consume less uncertain in the context of climate change. water, reducing prices for the lower consumption brackets is believed to render services more afford- Are Prices Effective in Regulating Water able. However, there is little empirical evidence to Consumption? support this assumption. To the contrary, poor Demand for water is not highly responsive to changes households are often large or share their water sup- in water tariffs in countries where prices are low; yet ply with neighbors and therefore consume more reducing consumption is critical in water-scarce water. As a result, many non-poor households bene- regions. Utilities seeking to reduce demand in peri- fit from IBTs while the poor and unconnected remain ods of drought have experimented with seasonal unserved. tariff increases. However, there is insufficient evi- ­ IBTs are also used to promote environmental sus- dence to determine the magnitude of price tainability by influencing water consumption yet increases needed to induce changes in patterns similarly there is limited empirical evidence to sup- of consumption. port their effectiveness in this capacity. Conceivably, Insights gathered using behavioral economics greater efficiency could be achieved through a two- suggest customers can be “nudged” into using less part tariff that contains a fixed charge and a volumet- water. These techniques include creating social ric component. The fixed charge could be adjusted to norms by comparing household consumption to assure (full or partial) economic cost recovery, while neighborhood consumption and presenting the the volumetric rate could be used to send a signal benefits of reduced consumption—for example, about the scarcity value of water and the marginal cost savings or societal gains—in simple graphics on cost of the service. customer water bills. In addition, presenting the Ultimately, tariff structures are country and utility actual cost of services alongside the subsidized specific, and trade-offs are inherent to different tariff cost can reduce opposition to subsequent tariff structures—some are better than others at improving increases. 6 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services How Should Utilities, as Natural Monopolies, Be How Can Policy Makers Promote Transparent Regulated? Tariff Structures? Water utilities are natural monopolies that face Subsidies delivered through opaque pricing struc- limited competition, so there are few market-driven tures contribute to a host of problems within the incentives to induce improvements. When assets water sector. When incentives are misaligned, even are publicly owned, the incentives to reduce costs, large subsidies—whether in the form of improved improve quality, or innovate are relatively weak service quality or reduced costs—can fail to benefit given that management is unlikely to accrue any customers. When service providers are provided financial benefits. This creates the risk that utilities with a guaranteed revenue regardless of perfor- will exploit their market power by inflating costs or mance, customers may even observe a deterioration raising prices. Simple pricing rules that aim to in service quality as maintenance becomes “recover costs” without considering the scope for neglected. cost inflation might condone waste and aggravate Furthermore, subsidized tariff structures that inefficiencies. A utility knows more about its own obscure the true economic cost of service may cause cost structure and level of efficiency than does its customers to falsely assume they are being charged regulator. This information asymmetry translates full economic cost-recovery rates. These structures into a bargaining advantage that can lead to inade- may generate resistance to tariff reform since, in the quate services, inflated costs, or the ad hoc renego- customer’s view, any price increase is unwarranted. tiation of contracts (a pervasive problem in the Moreover, taxpayers may also oppose tariff reform if sector). Ensuring the independence of regulators they fail to perceive they are responsible for any when service provision is public is yet another costs, as well as any resulting inefficiencies not recu- challenge. perated through tariffs or transfers. Depending on a The task of policy and regulation is to recognize country’s tax policies and service coverage, this these asymmetries and ensure that affordable, qual- may result in either regressive or progressive ity services go hand in hand with a fair and “nor- redistribution. mal” rate of return to the service provider. How to Can Tariff Reform Be Successful? achieve this remains unanswered and has received Tariff reform remains elusive in many countries, sug- almost no attention in the literature. In this context, gesting that the political economy constraints corporate governance appears essential. The wide confronted by decision-makers are poorly under- variety of arrangements calls for governance prac- stood. The political attraction of “free water” makes tices to be carefully systematized and successful it an alluring way to dispense policy favors—it can be experiences to be identified. Since state-owned marketed as a commitment to poverty reduction or enterprises are part of the public sector, factors of as support for rural development. Even where good and bad performance are directly and indi- subsidies are recognized as imprudent and rectly related to the overall governance of a country, counterproductive, their removal proves challeng- province, or municipality. Hence, there is a need for ing. Governments are often reluctant to reform a corporate structure that prevents political inter- tariffs, particularly given the many recent examples vention, rewards performance, and is subject to of public backlash in the face of price increases. public scrutiny. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 7 Still, numerous case studies in the water sector global prevalence. The chapter then discusses the suggest reform is possible. Catalytic events such as a complexities of pursuing cost recovery, including cholera outbreak, or a change in the political land- identifying costs, outlining the hierarchy of total scape, can create momentum for change. Farsighted costs (including connection costs), and different cal- leaders can use these crises to create informed alli- culation techniques. Tariff objectives are then intro- ances that can alter the balance of political payoffs. duced with a focus on economic efficiency and But crises are rare and cannot be relied upon to facil- affordability before the chapter summarizes the itate reform. Lessons from trade protection and effects of different tariff structures on each. Finally, environmental legislation where radical and suc- the different sources of revenue needed to achieve cessful reforms have been sustained are informative. financial equilibrium are described and discussed. These often begin with recognizing that reform will Chapter 3 presents a detailed summary of common be resisted in proportion to the economic losses it tariff complements alongside strategies to improve brings. In theory, compensating losers may be the economic efficiency, conserve water and ensure necessary price of change. In practice, the end result affordability, and increase access—and their associated is often a patchwork of the original objectives, which trade-offs. The chapter then moves on to consider bar- may endure, with the promise of further change. riers to connection before presenting the rationale for Given the huge variation in the political economy nonnetworked services and tariffs in urban areas. of countries globally, the task of delivering a compre- Chapter 4 outlines the regulatory levers available hensive toolkit to overcome resistance in all settings for tariff setting in networked systems with a strong would be difficult. Instead, this report builds upon emphasis on the intricacies and barriers that regula- the framework developed in “Doing More with Less” tory tariff setting must address in practice, such as (World Bank 2019) (which sought to classify a coun- information asymmetry and transparency. try’s political equilibrium into one of four cases, con- Chapter 5 explores the key components needed to sidering interest groups and generalized benefits), by design an effective and efficient tariff reform strat- identifying crucial considerations specific to tariff egy before discussing how recent advances in tech- reform through the presentation of case studies of nologies are slowly revolutionizing the water sector, both successful and failed attempts. and how they can be used to improve the utility per- formance and the tariff design process. 1.5  Report Structure And, finally, chapter 6 offers concluding remarks. Chapter 2 of the report introduces the tariff design process, starting with a discussion of key inputs such Note as the customer classification process before pre- 1. See World Bank (2019) for a more detailed methodological discussion senting a typology of major water tariffs and their of affordability. 8 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services © Have a nice day Photo/ Shutterstock CHAPTER 2 Designing an Effective Tariff Structure Designing an effective tariff requires a better understanding of the key inputs needed to support the tariff design process and the costs associated with the provision of water supply services. This chapter starts by defining efficient tar- iffs before identifying key inputs and presenting the main tariff typologies. It then classifies each of the costs across the water supply cost chain before grouping them into distinct categories, which combined give rise to the eco- nomic costs of providing water. Connection costs and external costs, such as environmental costs, are discussed separately. Thereafter the chapter quickly delves into the two most common methods used to calculate costs and dis- cusses the distinct advantages and disadvantages of each. It then describes the primary objectives of tariffs, and the effects of different tariff structures on effi- ciency and affordability. It discusses the advantages and disadvantages of each of three revenue streams and their relevance to achieving financial equilibrium before considering cost-cutting efforts and the importance of efficiency. The chapter concludes with a brief summary of key findings. 2.1  What Is an Effective Tariff Structure? First and foremost, a water tariff is a price assigned to water supplied by a util- ity through a piped network to its customers. The system of procedures and elements used to extract, treat, store, and distribute water determines a cus- tomer’s total water bill. Any part of that bill can be called a charge, measured in money/time units (e.g., US$50 per month) or money units alone, and any unit price can be called a rate, usually measured in money/volume units (e.g., US$1 per m3) (OECD 1999). To define the appropriate tariff structure, regulators and service providers must first determine the cost of providing services and the appropriate initial service access charge to cover the cost of connecting customers to the network. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 11 Several steps are then involved in defining the tariff 2.2  Customer Classification structure (figure 2.1) and summarized as follows: Customers are grouped by cost of supply and also as 1. Classify customers. Central determinants of tariff a means of addressing other tariff objectives, such as design include differentiating customer groups, ensuring tariffs are affordable. The most common allocating costs among different customer catego- methods of customer classification applied interna- ries, and creating appropriate signals for water tionally center on: consumption. • Consumption profiles. Residential, industrial, and 2. Select core tariff structure. The main types of core commercial customers are differentiated to reflect tariff structures involve flat charges, volumetric differences in the water usage of households, tariffs, or a combination of fixed and variable com- institutions, and businesses. ponents, that is, two-part tariffs. • Pipe diameter. When customer water consump- 3. Apply tariff complements.1 These can be applied to tion data cannot be used, the size of the connec- both core tariff structures or customer classifica- tion pipes is used to capture the volume of water tions to achieve competing policy objectives. flowing into the premises. FIGURE 2.1. Elements of an Effective Tariff Structure CUSTOMER CLASSIFICATION TARIFF DESIGN Customer categories Core structure Tariff complements Consumption Residential Flat rates Volumetric Location-based profiles Dynamic pricing pricing Industrial Two-part: House value Fixed fee One- Seasonal tariffs Affordability Commercial block IBT measures Variable Over-consumption Integrated Pipe size Location DBT VDT penalties water reuse TARIFF OBJECTIVES Economic Affordability Cost recovery efficiency & equity Environmental Simplicity & ease Financial Promoting Acceptability Transparency sustainability of implementation stability access Source: Original compilation. Note: IBT = increasing block tariff; DBT = decreasing block tariff; VDT = volume-differentiated tariff. 12 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services • House values. This classification uses the rated efficiency, and affordability, tariffs also address many value of a customer’s property, under the assump- important secondary objectives: tion that higher-value houses and larger properties • Environmental sustainability. Tariff structures can are associated with larger consumption volumes. be an effective water demand management strat- • Geographic location. Where poor households are egy to promote water conservation through pric- typically clustered in the same area, grouping by ing incentives. geographic location can mitigate the impact of • Promoting access. Tariff structures should be con- water tariffs on lower-income customers. sistent with guaranteeing the provision of water Geographic targeting is also used to charge custom- and wastewater services to all consumers regard- ers according to their underlying cost of supply. less of their socioeconomic situation or geographi- cal location. Ensuring access to safe and sustainable 2.3  Primary Tariff Objectives WSS services is often challenging in rural and peri-urban areas where a large proportion of the Some tariff objectives are interrelated and the suc- population is covered by nonnetworked services. cessful implementation of one may positively or neg- atively influence another. Thus tariffs must strike a • Quality of service. Tariff structures should ensure a delicate balance between different policy objectives, quality of service commensurate with a custom- which are often conflicting (figure 2.2). er’s needs and wants. This can increase willing- While this chapter focuses primarily on the three ness to pay (WTP), and address transparency and primary tariff objectives of cost recovery, economic inequities. FIGURE 2.2. Key Tariff Objectives Attributes Primary objectives Cost Economic Affordability recovery efficiency and equity Simple Easy Consistent to implement Secondary objectives Transparent Acceptable Financially Environmental Promoting Quality of stable sustainability access service Source: Original compilation. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 13 Additionally, an effective tariff has several key the relevant aspects and impacts of limited cost characteristics. It is: recovery. The specific costs associated with the provision of • Simple and easy to implement. Tariff structures water supply services can be organized by cost should be simple, understandable, and economic groups and then categorized (figure 2.3).2 Total eco- to implement and maintain. Simpler tariff struc- nomic costs relate to a utility’s infrastructure, ser- tures are also likely to be more easily accepted by vice delivery, and additional external costs related to the public and less challenging from a political water resources and the environment. Total eco- perspective. nomic costs do not necessarily refer to expenditure. • Consistent. Tariffs should generally remain stable Operation and maintenance (O&M) costs and capital over time as customers prefer stable bills, which in costs are distinct from operational expenditure turn facilitates long-term decision-making. This (OPEX) and capital expenditure (CAPEX), as the for- implies that any change in the tariff structure or mer include costs that are not captured by the latter. level should be phased over a transition period to For example, a utility may avoid paying its electricity allow customers to adjust to the tariff revision. bills to keep OPEX lower, despite O&M costs being • Transparent. This is a desirable aspect of water incurred in reality. Similarly, while CAPEX includes tariffs to avoid informational asymmetries about expenditure on an investment project, there are cost structures and efficiency levels that can be costs incurred in financing this spending through exploited by water utilities to inflate costs or pro- debt and equity that are included in capital costs. vide low-quality services. There are two broad approaches to calculating • Acceptable. An important aspect of water and costs: (1) a backward-looking approach that focuses wastewater pricing is obtaining the required social on the utility’s historical average costs; and (2) a and political support and acceptance to imple- forward-looking approach that treats historical aver- ment a given tariff structure. This is often a very age costs as sunk and instead looks to future mar- difficult task. ginal costs. • Financially stable. The risk of unexpected revenue Backward-Looking Methods fluctuations can be minimized by tariff structures Backward-looking approaches are the most common that provide revenue stability and mitigate water and typically used by regulators in price determina- utilities’ vulnerability to demand variations. tions, in part because they are simple and objective given their basis in recorded costs. Backward-looking approaches for determining average costs can be 2.4  Identifying and Calculating Costs broadly categorized into cash-based or building The failure to recover each element of the economic block methods (table 2.1). costs of water supply results in unique impacts on The cash-based approach is closely related to the sustainability of the utility and the wider water expenditure in financial documentation, while the supply system in the short and long term. These latter models the costs of the utility instead. This has impacts provide the underlying justification for cost major implications for calculating capital costs. First, recovery and the basis for the ensuing discussion on the building blocks approach distributes asset cost 14 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services FIGURE 2.3. Cost Categories of Networked Water Supply Services Efficient costs Effective costs Common costs: Dams, aqueducts, networks, plants, etc. Specific costs: Meters, connections, etc. Capital costs Common costs: Management, information technology, etc. Inputs: Energy, chemicals, labor, etc. Operation and Specific costs: Meter reading, variable costs maintenance costs Environmental costs: Resource costs and externalities Environmental costs Cost of inefficiencies Source: Adapted from Andres et al. (2019). TABLE 2.1. Backward-Looking Approaches for Determining Average Costs Method Description Advantages Disadvantages Cash based Sum of cash outlays Good for a utility’s cash flow. Unfair for current customers to pay for that appear in financial Simple to implement, requires low capacity. assets that will be enjoyed by future statements. customers. Typically includes Fails to recover some hidden costs that do operation and maintenance not appear in financial statements, such as (O&M) expenditure, loan equity and subsidization. repayments, and debt Focus on financial documentation readily interest. validates previous costs, paving the way for costs to be approved in future even if erroneous or inefficient. Building Sum of imputed costs. Recovers hidden costs, such as cost of Requires regulatory capacity, including for blocks Typically includes O&M equity. the often-controversial WACC term. costs, return on capital, and A weighted average cost of capital (WACC) depreciation. term can incentivize an efficient capital structure (if notional gearing is used). Expenditure is amortized over the economic life of asset. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 15 recovery over the asset’s life through a depreciation Since it is not practical to equate steep variations in term, while the cash-based approach allows recov- the short-run marginal cost (SRMC) with revenue ery of debt repayments in real time, regardless of the levels each time the infrastructure is extended, it lifetime of the asset. From a financial management would be more appropriate to set the latter according perspective, the cash-based approach is best for the to the long-run marginal cost (LRMC) instead utility’s cash flow, but results in current customers (McPhail, Locussol, and Perry 2012). paying the debt repayments on assets that benefit The SRMC is the cost of supplying an additional future customers. Conversely, because the building unit of water demand with capacity held constant. blocks model recognizes the opportunity cost of Since most costs are fixed, this approach is simple equity via the WACC term, which is omitted from the and broadly equates the SRMC with variable costs cash-based model, the building blocks model more or average O&M costs. This approach might be adequately recovers all financing costs and can appropriate where there are no capacity constraints. incentivize an optimal capital structure if notional It can also serve as a price floor; for example, gener- gearing is used (see appendix A, paper 4 on tariffs ally, volumetric tariffs should not be set below and regulation). the SRMC. The LRMC3 is also the cost of supplying an addi- Forward-Looking Methods tional unit of water demand. However, unlike the There are several arguments for a forward-looking SRMC, the capacity is allowed to vary. In simple approach based on future marginal costs. Kahn’s terms, it is the system expansion cost associated marginal cost pricing doctrine stipulates that a utili- with a sustained incremental increase in demand, or ty’s tariffs should be based on marginal costs in order equivalently the avoided cost for a sustained to create the correct price signals for economic effi- decrease in demand. Since capacity costs may vary, ciency. Furthermore, as water utilities adopt new the approach is more sophisticated than the SRMC and expensive technologies to meet modern chal- and requires a water system cost analysis. There are lenges, they may find they have a marginal cost that two key methods for estimating the LRMC cost: the significantly exceeds their historical average costs, Turvey and average incremental cost methods which can create a challenge for cost recovery. A for- (table 2.2). ward-looking approach treats these historical costs as sunk and looks to future marginal O&M and 2.5  Core Water Tariff Structures capacity costs. There is considerable variability in the design of Economic theory indicates that resources are water tariffs, as different combinations of core struc- efficiently used when prices are set according to mar- tures and tariff complements aim to achieve various ginal costs. An efficient use of resources implies that policy objectives. Water tariffs typically comprise supply and demand are balanced at a level of con- fixed changes, volumetric charges, or a combination, sumption that maximizes total producer and con- and are context specific. The advantages and sumer surpluses. Marginal costs will rise sharply as disadvantages of each are presented below and sum- the infrastructure’s capacity is increasingly used up marized in table 2.1. A simple, step-by-step process and decline rapidly after extension of the latter. intended to help identify the most appropriate core 16 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services TABLE 2.2. Forward-Looking Approaches for Determining Average Total Costs Method Description Advantages Disadvantages Turvey Change in present value of system Close estimate of long-run Requires substantial effort, such as expansion costs in response to marginal cost. production of optimal expansion plans. incremental increase in demand each Sensitive to demand forecasts, which are in year over a fixed time period. turn difficult to produce due to uncertainty. Average Change in present value of system Closer representation of Pragmatic increment but can cause significant Incremental expansion costs in response to forecast marginal cost than short- deviation from marginal cost. cost increases in demand over fixed time run marginal cost. period. tariff structure for urban water services is then fully dependent on the volume of water con- included in figure 2.4. sumed. Constant volumetric pricing is adopted in various developed and developing economies • Flat rate tariffs. Flat structures consist of a fixed given its simplicity and is common for nonresi- nonvolumetric fee paid periodically regardless of dential consumers throughout the world. the volume of water consumed. Flat rate tariffs Volumetric pricing requires a functional metering provide a 100 percent fixed revenue that poten- system to monitor consumption and provide regu- tially allows water utilities to cover their operating lators and water utilities with the necessary infor- and capital costs. The tariff level depends on the mation for effective price revisions. proportion of costs that service providers can • Increasing block tariffs (IBTs). This tariff structure is recover through tariffs as part of the regulatory based on a progressive unit price of water that varies regime. Flat rate tariffs are often applied in regions between consumption blocks, with the unit price where the water sector is in the first stage of devel- increasing with higher consumption. IBTs are typi- opment and metering cannot be installed. In the cally adopted to provide water to poor households at absence of a metering system, a flat rate charge is an affordable rate for a volume equivalent to the basic the only possible tariff structure. This model minimum requirement and at a price lower than the requires a stable agreement between regulators cost of supply known as a “lifeline” tariff. Subsequent and water utilities with respect to the fraction of blocks are usually charged at higher rates above the costs recovered by water operators through the cost of supply to generate cross-subsidies and encour- fixed fee. Fixed charges are typically weighted age efficient consumption. IBTs are also used to using specific variables, such as the size of the address environmental sustainability by encouraging property or diameter of the distribution pipe. This water conservation. This is particularly relevant in implies a slight variation in fees collected. countries or regions that suffer from drought. IBTs • One block or constant volumetric tariffs. This tariff require a functional metering system to monitor con- structure consists of a variable charge with a con- sumption. The different blocks of the IBT should be stant unit price for each category or group of cus- established under rational criteria and are typically tomers. Both fixed and variable costs are expected based on reliable demand forecasting tools to esti- to be covered by variable revenues as the model is mate how total water demand will be separated Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 17 FIGURE 2.4. Decision-Making Tree for Designing an Effective Water Tariff Structure Designing an Effective Water Tariff Structure Tariffs are essential—but not the only pathway—to cost recovery, addressing affordability, and managing water conservation. To maximize their potential, tariffs must be well-designed, complemented by appropriate instruments, adequately regulated, and understood by users. Estimate the full costs of service provision Covered by the combination of three revenue categories: Revenue targets across categories are politically determined 1 2 3 Connection charges Predictable subsidies with (subsidize when the unconnected Consumption performance incentives are mostly poor or when high bulk tariffs water costs limit affordability) (through taxes and/or transfers) Are connections metered? NO YES Is a social Two-part tariff with: + registry available? Fixed component Variable covering component administrative determined NO YES costs, etc. as follows: Variable flat-rate tariff per Is a social customer category or proxy Flat-rate tariff with cash registry available? for poverty (house value, transfers for affordability pipe size, location, etc.) NO YES Policy Objectives of Tariff Reform Cost Recovery, Efficiency, Affordability, Equity, Environmental Sustainability, Are poor households Cost-reflective VDT with cash Universal Coverage, Climate Change clustered together? transfers for affordability Mitigation and Adaptation YES NO FOUNDATIONAL ELEMENTS: Stakeholder Engagement Enhanced Performance and Service Quality VDT with Are poor households Regulation and Transparency location-based pricing significantly larger on average? Timing of Reform Tariff Complements NO YES Regular and Gradual Tariff Adjustments Strong Political Leadership Innovative Technology IBT Subsidized VDT Protect Vulnerable Groups Source: Original compilation. Note: IBT = increasing block tariff; VDT = volume-differentiated tariff. 18 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services TABLE 2.3. Strengths and Weaknesses of Core Tariff Structures Tariff structure Strengths Weaknesses Requirements Context for implementation Flat rates • Financial stability and predictability • Does not promote efficient use of • Property/connection • Appropriate for regions in their • Simple and easy to implement (no water (at all) registration first stage of development of water need for metering) • Makes affordability difficult, unless • Ideally also accurate data provision, or where metering cannot be tariffs are well below cost-recovery on property features (i.e., installed • Not vulnerable to demand fluctuations levels pipe size, property value) or customers One-block tariffs • Easy to understand and implement • Less revenue stability for the utility • Metering at level of • Applied in countries where water • Flexibility in determining the because the rate is completely variable household, or industrial or supply service is in its developing volumetric charge • Challenging for affordability if all commercial establishment stages and total water demand is Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services residential customers pay the same gradually increasing and can generate • Customers can be incentivized to rate higher revenues over time use water efficiently • Usually does not reflect marginal cost of supplying different customers, unless varying by time of day Increasing block • Encourage customers to reduce • Definition of blocks often arbitrary • Metering at household level • Where affordability is challenging for tariffs (IBTs) consumption • Difficult to target vulnerable • Accurate data on household a significant share of the customer • Make basic water needs affordable households (i.e., large, poor water use, income, and base and there is no way of subsidizing households end up in higher tariff composition to design blocks those customers directly • Flexible to adapt to different contexts blocks) and tariffs • Regions with water scarcity issues and • Vulnerable to demand fluctuations a mature water supply service where demand has reached a stable volume • Complex to monitor and administer • Appropriate where water demand does • May discourage large customers not fluctuate excessively, and basic service investment is already funded table continues next page 19 20 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services TABLE 2.3. continued Tariff structure Strengths Weaknesses Requirements Context for implementation Decreasing block • Secure utility revenues and achieve • Discourage water conservation • Metering at household level • Cities where large industrial customers tariffs (DBTs) cost-recovery objective • Value judgement in setting the blocks • Data on water use, household enable the utility to capture economies • Can be used to reflect the income, and composition of scale and do not require expansion • Place a higher burden on low-income underlying cost of service in cases of the distribution network for their customers, while high-end customers where a fixed charge is not viable supplies pay lower-than-average tariffs • Promote economic development and greater production levels by applying lower tariffs to large customers Jump tariffs • Encourage customers to reduce • Perceived as inequitable • Metering at household level • Regions where IBTs present consumption • Definition of blocks often arbitrary • Accurate data on household disadvantages (errors of inclusion) • Make basic water needs affordable water use, income, and and with a stronger focus on water • Difficult to target vulnerable composition to design blocks conservation • Flexible to adapt to different households (i.e., large, poor contexts households end up in higher tariff and tariffs • Recommended in developing blocks) economies to improve targeting • Address affordability in a more targeted manner than IBTs, by • Vulnerable to demand fluctuations reducing the error of inclusion • Semi-complex to monitor and administer • May discourage large customers • Not effective when billing period is not frequent, as consumers are not aware of excessive consumption • Distorted/arbitrary value judgement in setting the blocks Two-part tariffs • Fixed charge can achieve social aims • Fixed charge not linked to • Metering at household level • Regions willing to balance between and affordability objectives consumption implies lower water- efficient and social aims (application • Ensure efficiency pricing and saving effects of a fixed charge and a volumetric rate cost recovery when fixed charge • Fixed charges can threaten to maintain the “user pays” principle) recovers fixed costs and volumetric affordability without significant water scarcity issues part covers variable costs • Flexibility to meet other objectives into  tiers. Information on individual consumption unattractive because it allows high-volume cus- patterns and cost profiles is therefore necessary to tomers to pay less than average water tariffs. design an effective IBT structure. • Two-part tariffs. The two-part tariff model con- • Jump tariffs. This tariff structure is commonly sists of a fixed payment per month that is not classified as a special case of IBT as it follows a linked to the amount of water consumed and a similar pattern with one important difference. variable part that is consumption related and Once customers reach an upper block, they pay hence called the volumetric rate. The fixed com- the last block price for all previous units of water ponent of the tariff is typically considered as a ser- consumed in that block. In other words, the high- vice access fee and should at least cover services est block reached determines the unit price of all such as meter reading and maintenance, billing, previous units of water used. This tariff model and collection. The fixed component of the tariff is  uncommon in the water sector and more can also be used to spread the connection cost ­ widespread in the electricity sector. Jump over time. It can be set to different levels between ­ tariffs  are also commonly referred to as customer types, that is, higher fixed charges for volume-differentiated tariffs (VDTs) and are typi- ­ commercial and industrial customers as compared cally applied to avoid targeting errors in subsidies to households, or according to the size of the intrinsic to standard IBTs, wherein all consumers distribution pipe. As for volumetric tariffs and benefit from the subsidized lower block(s). IBTs, metering systems are required for effective • Decreasing block tariffs (DBTs). This tariff struc- implementation of two-part tariffs and knowledge ture applies a progressively lower volumetric rate of the cost structure is essential to provide regula- to consecutive consumption blocks. The reason- tors and utilities with the necessary information to ing behind this tariff model was to recognize adequately price water and wastewater services. declining average costs of supply due to econo- For this reason, two-part tariffs are more common mies of scale and promote economic develop- in developed than developing economies. ment and greater production levels by applying lower tariffs to large consumers. Similar to IBTs, Global Prevalence of Water Tariff 2.6  the design of DBTs relies on decisions regarding Structures the number of blocks, volume of water There is a significant degree of flexibility in how tariffs consumption, and unit price associated with each are designed through various combinations of cus- block. DBTs have largely fallen out of tomer classifications, core tariff structures, and com- favor  because they penalize consumers in plements. A closer analysis of the geographical low-consumption tiers, providing a disincentive prevalence of core tariff structures suggests there is for water savings. As water conservation has also considerable variability in the types of pricing moved up the political agenda in many countries structures adopted across different countries (appen- and the marginal cost of supplying water contin- dix C). However, overall, IBTs and one-block tariffs ues to rise, DBTs have become less profitable for are the most prevalent with approximately 60 percent utilities. This tariff structure is also politically of countries surveyed applying IBTs (figure 2.5). Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 21 FIGURE 2.5. Global Prevalence of Water Tariff the marginal cost of providing water to an additional Structures, By Type, (%) household is very low. Moreover, given low marginal costs, they enjoy economies of scale and scope and 1 1 2 1 can meet the demand for a larger pool of customers. A two-part tariff structure, often recommended as the second-best solution to this natural monopoly problem, thus justifies the prevalence of connection charges (to cover the fixed costs) and consumption charges (to cover the variable costs) to facilitate full cost recovery. 44 51 However, the significant share of unconnected households and continued urban growth underscore the need to ensure that connection charges receive greater attention. Utilities and policy makers can pursue different avenues to recover connection costs while ensuring connections are affordable. In cases IBT One block Flat rate where new customers struggle with the liquidity DBT Jump tariffs Other needed to pay a large up-front fee, costs can be Source: Original compilation based on data from IBNET (2020). recovered over time through consumption charges. Note: DBT = decreasing block tariff; IBT = increasing block tariff. In instances where connections charges are prohibi- tively high, subsidies can help households gain a Calculating Consumption Tariffs and 2.7  connection. Another option is to pursue alternative, Connection Charges lower-cost solutions for connecting households. Once the economic costs have been calculated, the Beyond the connection costs, adaptation costs service provider must determine how best to allo- incurred by households to make use of water and cate these costs across consumers in the form of tar- sewerage connections must also be considered. So iffs to support cost recovery. Typically, service far, these costs have received little attention but are providers levy two types of tariffs on water users: crucial in connecting households to piped water consumption tariffs and connection tariffs. (or sewerage) networks. From a household perspec- Consumption tariffs are charged based on some tive, adaptation costs can also be included in the notion of the quantity of water used. However, con- overall connection costs. Thus connection costs can nection tariffs are charged—at one time or in be split into four categories: installments—to cover the fixed cost of connection. With policy often focused on consumption tariffs, • Adaptation costs. These are costs behind the meter connection charges have received comparatively to accommodate a connection, for example, little attention. Typically, water service providers are installing taps or toilets. If water supply is natural monopolies with large fixed capital invest- intermittent, households may also face “coping ments in infrastructure (establishing reticulated costs” to ensure a secure supply. For example, piped networks, treatment facilities, etc.), However, they may need to invest in tanks or jerry cans to 22 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services ensure access to water is maintained during that additional demand can be met. Furthermore, interruptions. the utility may require additional administrative • Local costs. The process of installing pipes from capacity to provide billing, customer service, and the boundary of a customer’s premises to the main maintenance to a larger number of households. pipeline, in addition to meters, involves material, However, it is difficult to identify and isolate the labor, and administrative costs. These costs can be remote costs arising from additional connections attributed to specific households. from increased demand across the existing network. • Network expansion costs. Utilities need to expand the main shared network to provide access to Calculating Environmental Costs unserved areas or new settlements. The process involves material, labor, and planning costs that While O&M and capital costs can be calculated using cannot be attributed to specific households. These the utility’s expenditure, this is not an option for cal- costs can vary depending on the terrain and on culating environmental costs. Ensuring the utility whether extensive roadworks are needed to internalizes these costs is equally challenging. This lay pipes. can be achieved through incorporating the costs into tariffs or through regulatory measures including lim- • Remote costs. These are upstream costs in the net- its on water extraction, conditions on water use, or work (such as reinforcement or storage) or at the market-based mechanisms such as tradable water production/treatment level (to meet increased rights. These challenges, relative to the calculation capacity). As the number of connected households and compensation of costs, are why environmental increases, extra water extraction, production, and costs are very rarely recovered. treatment capacity needs to be provided to ensure TABLE 2.4. Methods for Calculating the Cost of Action for Environmental Costs Method Description Advantages Disadvantages Cost Damage Cost of preventing a water source Direct and pragmatic measure Closely linked to expenditure based avoidance cost from dropping below its rate of of costs needed to maintain and may overlook hidden natural replenishment. resources. costs. Especially relevant to Simple to administer, requiring damage repair cost, since Damage repair Cost of replenishing a water source only cost data and low repair expenditures may not cost after it has dropped below its rate of regulatory capacity. incorporate unrecovered natural replenishment. harm resulting from depleted Represents the cost of the resources. action actually taken rather than the cheapest action. Market based Market value of a unit of the Reflects the market price and Overallocation of permits can resource when rate of extraction is incentivizes use of the cheapest distort the market price and capped to prevent dropping below alternative resource. lead to overextraction of the the rate of natural replenishment. resource. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 23 Environmental costs can be conceptualized as the receive. If one customer group pays less than cost of action or inaction. The former refers to the the  cost-recovery target, other group(s) must pay costs associated with preventing the depletion of more than the cost-recovery target so the aggregate water resources, while the latter refers to the costs of revenue covers the costs of serving all customer depletion, such as forgone opportunities. There are groups. Most water utilities in developing economies two broad ways to measure the cost of action: cost- fall on the low end of the cost-recovery spectrum, based approaches, including the total cost of actions with very few recovering more than 50 percent of taken either to avoid the damage or to repair the total costs. Several utilities operate at 10–25 percent damage, and market-based approaches. Their rela- of full cost recovery with government and/or donors tive pros and cons are outlined in table 2.4. often covering all their capital costs and some of their operating expenditures. Even in higher-income 2.8  Pursuing Efficient Cost Recovery countries, relatively few water utilities achieve Services must be financially viable for the operators, full cost recovery (table 2.5). meaning that tariff revenues plus any funding from Cost-recovery targets and the extent to which they public sources (local or central government, donors) are fulfilled depend in part on the country’s should guarantee a stable revenue stream to deliver regulatory framework. If the regulatory regime is high-quality services over the long term. such that the utility has significant exposure to Cost recovery exists on a continuum from zero to volume risk, that is, a price cap rather than revenue 100—that is, from fully subsidized to no financial cap, then it will be important that customer-specific support from either the government or development tariffs reflect the underlying costs of supply. This will partners. Full cost recovery does not imply that each ensure that changes in demand relative to forecasts customer group pays the full cost of services they do not jeopardize cost-recovery targets. TABLE 2.5. Cost Recovery of WSS Services in Select European Countries Total cost recovery (%) Country Period Water Wastewater Austria 84.0 84.0 2002–05 Bulgaria 48.0 55.6 2014 Czech Republic 77.9 77.9 2011 Estonia 69.0 69.0 2010 France 75.6 75.6 2009 Greece 83.4 83.4 2010 Italy 43.9 43.9 2004 Portugal 80.0 46.0 2009 Spain 74.4 74.4 2010 Source: Reynaud 2016. Note: WSS = water supply and sanitation. 24 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services Given these competing objectives, what level of FIGURE 2.6. Cost Recovery by Region cost recovery is observed in practice? For simplicity, anything above 120 percent of O&M costs is inter- preted as the minimum required for the recovery of financial costs, although in practice a much higher level of recovery will be needed if the capital costs of network expansion are to be recovered. Large varia- tions in the average level of O&M costs recovered across countries in each region are observed. In North America, utilities recover over 120 percent of O&M costs (figure 2.6). Utilities in the Middle East and North Africa recover the least, which is primarily a result of the high degree of subsidization through taxes and transfers. Recovering Operational Costs The recovery of O&M costs is generally understood to be essential for the short-term financial sustain- ability of a utility. When a utility’s income fails to cover these costs, each additional unit of sale pro- duces a loss. This can lead to immediate financial stress and rapid deterioration in the quality of ser- vices. In lower- or middle-income countries, the con- sequences can be especially severe, leading to a reduction in service provision and/or a reduction in water quality. However, approximately 60–80 percent of total costs in networked water systems are for long-lived assets that take multiple decades to degrade (Komives et al. 2005). Thus, the impacts of underre- covery of these costs tend to materialize in the longer term. By failing to recover long-term capital costs, the utility postpones capital replacement in existing assets, resulting in a period of lost productive capac- ity at the end of the assets’ useful lives. Future gener- ations would need to address this gap in funding through higher taxes or tariffs, resulting in an inter- Source: Original compilation. Note: Analysis is of 3,026 utilities across 84 countries using IBNET data. generational subsidy (World Bank 2019). In the long Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 25 FIGURE 2.7. Feedback Loop of Poor Cost Recovery More difficult to Low(er) rate of attract private recovery investment Government unable to Lack of investment commit more in existing funding infrastructure Greater O&M More failure in costs infrastructure Source: Adapted from figure 1 in WHO (2019). Note: O&M = operation and maintenance. term, this can result in poorer reliability of services, a governments are unable to plug this growing gap greater rate of nonrevenue water (NRW) or even a figure 2.7). This is especially pernicious in a private (­ reduction in access to services, all of which have setting, as investors can be dissuaded from investing deleterious effects on human health. in response to a drop in the rate of cost recovery, The deterioration of water infrastructure can also which signals lower profitability, leading to further result in higher maintenance costs, and thus an even deterioration in infrastructure through lack of invest- lower rate of cost recovery as total costs increase and ment (Zambia, box 2.1). 26 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services BOX 2.1. Financial Cost Recovery in Lusaka, Zambia In recent decades, the Lusaka Water and Sewerage Company (LWSC) has managed to recover operation and maintenance costs, but failed to recover financial costs (figure B2.1.1, left panel).a This is primarily due to poor revenue collection, especially from government facilities, the intention to subsidize poorer customers, and an unclear regulatory and institutional framework, including the lack of a national policy. As a result, capital investments have suffered: in 2013, more than half of LWSC’s infrastructure was past its useful lifetime. Consequently, sectoral outcomes have, over time, failed to improve. Water supply (and sanitation) coverage in the LWSC’s region has barely improved since 2000, and quality of service (proxied by continuity of service) has shown a similar lack of progress (figure B2.1.1, right panel). FIGURE B2.1.1. Cost-Recovery Rates and Quality and Coverage of Service, 2000–16 300 100 30 250 Service (hours/day) Coverage (%) 200 20 150 50 100 10 50 0 0 0 10 00 08 12 02 14 04 16 10 12 14 16 00 02 04 06 08 06 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 Operating cost coverage Continuity of service (hours/day) Water coverage (%) Sewage coverage (%) To overcome these challenges, various institutional and financial improvement programs have been implemented, including implementing a revised National Water Policy in 2010 that aimed toward recov- ery of operation and maintenance costs in the short term and the recovery of financial costs in the long term. To ensure investments in infrastructure, the US$332 million Zambia Compact of the Millennium Challenge Corporation, 2013–18, was conditional on LWSC devoting at least 50 percent of its annual retained earnings to asset renewal and capital expansion and an “appropriate amount” toward repair and maintenance of water supply (and sanitation) infrastructure. Among other projects, these efforts appear to have produced an uptick in cost coverage and sectoral outcomes in recent years. Source: WHO 2019; MCC 2019, 2020; Banerjee et al. 2010; IBNET 2020; NWASCO 2014. a The Africa Infrastructure Country Diagnostic (AICD 2007) WSS Survey Database, reported in Banerjee et al. (2010), confirms that O&M costs were recovered while financial costs were not. In the left panel, we see similar levels of cost recovery from 2007, implying the situation has not yet resolved. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 27 Recovering Connection Costs differences in the depth and definition of charges and To maintain financial sustainability, utilities must level of subsidy provided (figure 2.8). In Mongolia, the recover connection costs, typically through connec- average water connection charge is around US$260, tion charges. However, connection charges can act as while in the Dominican Republic the average is US$37. a barrier to accessibility for poor households, creat- Even within countries significant heterogeneity is ing an additional obstacle to achieving SDG 6. In such observed. In Bangladesh, the charge in Chittagong is circumstances, they maintain the inequity of almost US$210 compared to US$90 in Dhaka and as low as all subsidies being siphoned by wealthier, already US$3 in some divisions. The differences highlight that connected households. connection charges do not clearly reflect costs. Connection charges levied by utilities are not There is a lack of recent data illustrating the com- always defined clearly nor designed with a common position of connection charges globally. The most underlying theory or method (Franceys and Gerlach recent comparative study that provides a detailed 2006). Some utilities charge application, surveying, overview of the full range of costs experienced in and approval fees, and others restrict charges to connecting to the piped water network in four material and labor costs only. The charge itself is countries dates from 2006 (Franceys and Gerlach frequently related to the size of the connection, the 2006). This study highlights that in addition to location of the property, and/or its distance to the explicit connection charges, which are the focus of nearest main (ADB 2008). The lack of a clear defini- this section, households can also experience infor- tion poses a challenge as it’s not always clear what mal costs, for example, “encouragement payments” households are paying. to ensure an application is approved. Connection charges vary significantly globally, in Connection charges can be categorized by different part due to differences in costs, but also due to “depths.” Charges can fall into one of two extremes, FIGURE 2.8. Connection Charges for Water and Sanitation in Select Countries 300 Average connection charge (US$) 250 200 150 100 50 0 o e lia a e an sh as tu ic i ji ric aw qu in gr Fi bl ur de ua go st ra ne Af bi pu al kh nd n la on Uk am M te Va Re th ng za Ho M on u oz Ka Ba an So M M ic in m Do Water Sewerage Source: Original compilation based on data from IBNET (2020). 28 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services TABLE 2.6. Depth of Connection Charges Depth Description Evaluation Deep The charge covers the full marginal cost of the May discourage connection to the network due to high up-front costs and connection, including remote costs. first-mover disadvantages, undermining network economies of scale. Cost reflective, protecting existing customers from price increases and risk of stranded assets. Locational price signals incentivize efficient use of assets, lowering costs. Difficult to separate assets required only by the connecting party from assets required for general growth. Partially A deep charge with some exemption from Reap some of the benefits of a shallow charge, such as lower up-front deep remote costs of facilitating the connection. costs to incentivize network connections, and the benefits of a deep charge, such as locational pricing and cost efficiency. Partially A shallow charge with some contribution to shallow network remote costs. Shallow The charge is the cost of connecting to the Lower up-front costs reduce barriers to connections. nearest appropriate point in the network, Simple charging methodologies. excluding remote costs. More stable and predictable charges than deep charges. No locational pricing signals. deep and shallow, or intermediate policies, slightly There are two primary approaches to assessing deep or slightly shallow (table 2.6). A shallow connec- environmental costs: focusing on damage avoidance tion charge only covers the local cost of connection, costs and damage repair costs. Damage avoidance whereas a deep connection charge covers both local costs are typically measured by looking at the cost of and remote costs of connection. This means that in extracting from the least-expensive alternative water the case of a shallow charge, remote costs are subsi- resource once the current resource reaches its rate of dized. Another example is for local and extreme costs natural replenishment. For example, this might be the to be fully subsidized through a free connection. cost of extracting from an alternative groundwater source, or in cases of extreme water scarcity it could Recovering Environmental Costs be the cost of extracting and desalinating. It could also In principle, the recovery of environmental costs be the cost of providing services for maintaining should be pursued wherever such cost externali- resources such as watersheds (see, for example, the ties exist and/or there are significant opportunity case of Peru in box 2.2, which mandates a floor on costs, which are generally inevitable in the water spending on maintaining and repairing watersheds). sector. Failing to account for these external costs If the utility provides these services, the costs are can lead to environmental degradation, drought, internalized and can be calculated directly. In cases severe pollution, and other consequences in the where a third party conducts damage repair services, long term. Furthermore, failure to recover costs such as the government, the costs could be internal- can inhibit new investments, such as network ized by the utility through taxation. expansion. In the long term, this slows the increase Damage repair costs are measured by looking at the in access to services and if a utility fails to keep cost of extracting from the least-expensive alterna- pace with population growth, access can even tive water source, which allows the depleted resource diminish. to replete naturally, or through looking at the cost of Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 29 BOX 2.2. Internalization of Resource Costs in Peru Countries across South America are facing water shortages as a result of decreasing rainfall, contami- nation, and overextraction. Changes in rainfall alone could see 70 percent of South America’s popula- tion living in water-scarce areas by 2025. A key solution to issues of water scarcity in the region is to secure upstream water resources through the protection of watersheds from conversion, development, extraction, and diversion. To ensure water utilities internalize the costs required to maintain these watersheds, Peru’s water regulator (Superintendencia Nacional de Servicios de Saneamiento, SUNASS) introduced a new tariff framework in 2015 that requires utilities to recover costs of watershed conser- vation, restoration, and maintenance. In addition, laws were introduced requiring service providers to submit updated master plans every five years, detailing their 30-year investment strategy to protect watersheds. The cost of these investments would represent the damage avoidance cost for watersheds. In line with regulatory requirements, at least 1 percent of revenue must be invested in natural infrastruc- ture, representing a floor on the damage avoidance cost. Source: Nature Conservancy 2018; Forest Trends 2016; Pham 2016. manually replenishing the depleted source using rationing of water, any costs associated with replen- water from the least-expensive alternative water ishing the water resource (above the ordinary costs source. Equivalently, the latter could include the of maintaining the rate of replenishment), and so on. construction of rain gardens to replenish a depleted The present value of these costs can be calculated water source, which is the same principle as extract- across the period over which the resource is depleted. ing water from another sustainable source. Approaches that look at damage repair or damage 2.9  Financial Analysis avoidance costs are conceptually similar and produce The tenets of financial sustainability, and cost recov- broadly equivalent estimates despite representing very ery in general, have been extensively discussed by the different activities. This underlines their key weakness: World Bank and others. The basic principles are eru- being closely linked to expenditure, hidden costs, dite, persuasive, and based on thoroughly elaborated including those related to inaction, may be overlooked. concepts and extensive evidence from academia, eco- The cost of inaction requires the calculation of the nomic models, and field observations. The challenge economic consequences resulting from allowing the therefore is not to find the missing link or identify abstraction to cause the water resource to fall below new approaches, but rather to operationalize what is its rate of natural repletion. There are a number of already well known, through policy guidance that is costs associated with inaction, of which a primary practical, unambiguous, and stable.4 cost is typically the lost opportunity through lower In spite of repeated efforts to advocate for the grad- overall levels of the cheapest water resource, which ual recovery of costs starting with O&M over the last leads market players to utilize a more expensive three decades, very little progress has been made. resource. Other costs could include the economic Nonetheless, some of these historical principles value of lost crops, any lost labor productivity remain the same: through job losses or health costs associated with the 30 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services • For urban WSS projects implemented by WSS • Whether WSS service providers are likely to bene- utilities that use accrual accounting, the finan- fit from other implicit subsidies through, for cial analysis should include, as a minimum, the example, the payment of inflated bills to public last three years of audited financial statements customers; and (e.g., income and cash flow statements and bal- • How WSS service providers are protected against ance sheets). Additionally, the analysis should fluctuations in exchange rates. include ten years of projected statements sup- ported by a description of key assumptions. 2.10  Economic Efficiency Select ratios to monitor the coverage of O&M Arguments for cost-recovery tariffs only hold where costs, liquidity, or capital structure should be total costs are efficient. Without reasonable expecta- estimated and compared with industry stan- tions of efficiency, cost-recovery tariffs reward utili- dards. If ratios are significantly below industry ties for inefficiency and result in a misallocation of standards, the financial analysis should describe resources. A compromise is to set a reasonable, aspi- the agreed action plan for correcting any identi- rational target. Incentive-based regulations can then fied shortcomings. motivate utilities to achieve this goal. For example, • For entities such as government departments or reductions of NRW or increases in bill collection water user associations that use cash accounting, rates can be incentivized, and often improved with- the financial analysis should include past and out significant investment in new capital, resulting future cash revenues, cash expenses, and debt in large increases in revenue as was the case in service as well as a summary of assumptions. Algeria (box 2.3). A combination of cost-cutting mea- In both cases incremental revenues and expenses sures, including nontariff options, has been shown to should be identified to estimate the net present significantly improve the level of cost recovery in value of future cash flows and financial internal Zimbabwe (box 2.4). rate of return of the project. Inefficiency can also reduce cost recovery indi- The financial analysis should also clarify how rectly through decreased WTP (figure 2.9). The first explicit and implicit subsidies are provided to step in this indirect transmission is a reduction in service providers and estimate current and future service quality due to inefficiencies. For example, contributions. In particular, this analysis should poor customer outcomes such as low engagement assess: with customer complaints, slow processing of con- nection applications, and generally poor sectoral • How central, regional, or local government bud- outcomes are often symptomatic of inefficient man- gets complement revenues collected from cus- agement. Poor quality of service can reduce a cus- tomers for covering the cash needs of WSS service tomer’s WTP, making future tariff increases difficult. providers and if any conditions are attached to Tariffs stagnate and costs rise over time, creating a such funding support; negative feedback loop, as lower cost-recovery • Whether WSS service providers are exempt from induces more inefficiencies (e.g., stemming from paying taxes, import duties or fees (e.g., bulk low capital investments) and also directly reduces water fees, discharge fees, etc.) legally applied in the quality of service (e.g., slower connections). the country; Mechanisms for communicating what customers Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 31 BOX 2.3. Reducing Nonrevenue Water in Souk-Ahras, Algeria Water supply services in Algeria are managed by the Algerian Drinking Water Company (Algerienne des Eaux, ADE) and the National Sanitation Office (Office National de l’Assainissement, ONA). ADE and ONA have been facing financial difficulties, primarily due to low tariffs. The government provided grants to both companies while also looking at efficiency. The municipality of Souk-Ahras has faced a particularly large gap between costs and revenues collected through tariffs. In large part, this resulted from high water losses along distribution networks. Over the last decade, it has reduced the level of nonrevenue water by almost 20 percentage points (figure B2.3.1, left panel), narrowing the gap between the volume of water produced and invoiced (figure B2.3.1, right panel). This will narrow the gap between costs and revenues. Despite this improvement, the municipality still faces financial difficulties. Research indicates that while the tariff is unsustainably low, the situation could also be improved by reducing nonrevenue water fur- ther and applying other cost-cutting measures. FIGURE B2.3.1. Shares of Nonrevenue Water and Cost-Recovery Levels, 2010–18 75% 14,000 12,000 70% 10,000 65% 8,000 60% 6,000 4,000 55% 2,000 50% 0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2010 2011 2012 2013 2014 2015 2016 2017 2018 Nonrevenue water Produced volume Invoiced volume Source: Data and insights from Boukhari et al. (2019); further insights from Boukhari et al. (2011, 2018). BOX 2.4. Simulation of Nontariff Options for Cutting Costs in Zimbabwe Utility-level data from Zimbabwe collected in 2013–14 (table B2.4.1) were used to simulate the impact of changes in efficiency on the level of cost recovery at each utility and at a national level. Based on these data, only 16 percent of utilities recover more than 120 percent of their operation and maintenance (O&M) costs through actual cash collection. Thirteen percent of utilities recover less than 120 percent of O&M costs, meaning they are unlikely to recoup their financial costs. All told, 71 percent of utilities were unable to cover their O&M costs. This can be partially explained by the performance indicators, which show a low rate of col- lection, a somewhat high proportion of nonlabor costs, and a high level of nonrevenue water (NRW). The impacts of improving efficiency on cost-recovery rates were simulated. The additive effects of four improvements were investigated: 32 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services BOX 2.4. continued • Increasing rate of collection to 100 percent • Reducing nonlabor costs by 15 percent • Reducing NRW to 20 percent at any utility where this value is exceeded • Increasing revenues by 10 percent By ensuring a collection rate of 100 percent at all utilities, the cost-recovery figure rose to 65 percent (or a 51 percentage point increase) (figure B2.4.1). If, on top of this cost-savings measure, nonlabor costs are reduced by 15 percent, the proportion increases to 74 percent (+9 percentage points). Taking the additional step of reducing NRW to a maximum of 20 percent across all utilities, the proportion increases to 84 percent (+10 percentage points). Finally, a 10 percent increase in revenue, associated with miscellaneous efficiency improvements or small increases in tariffs, would lead to a proportion of 90 percent (+6 percentage points). TABLE B2.4.1. Zimbabwe’s Utility-Level Data, 2013–14 Utility performance indicator National value Water coverage (%) 88 NRW (%) 52 Operating cost-coverage ratio (based on billed revenue) 88 Billed revenue amount (US$) 95,601,859 Collection rate (%) 48 Nonlabor cost (% of total cost) 64 Number of utilities 31 FIGURE B2.4.1 Various Cost-Recovery Scenarios 100% 90% 80% 84% 74% 60% 65% 40% 20% box continues next page 16% 0% 0% e 15 st 20 to 10 ue se 10 rat by co ca by en % % % d ce n d ur se d ev io du ce bo Ba se r ct ea & re du la lle re n- W Co NR no & cr & in Source: See background paper 2, listed in appendix A. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 33 FIGURE 2.9. Direct and Indirect Effects of Inefficiency on Cost Recovery Lower bill collection and high costs Greater Lower cost inefficiency recovery rate Poorer Lower Lower quality willingness tariff service to pay increases Source: Original compilation. are required to pay and why are therefore they have to invest in more production capacity or important. revert to more expensive sources. A strong case can therefore be made that • Network operation costs. Some of a water utility’s inefficiencies should be the primary port of call variable supply costs, in particular energy costs (box 2.5). In general, the timing of tariff increases related to pumping, vary by time of day. and wider reforms can only be justified after service If costs vary by time of day (i.e., pumping costs), improvements have been demonstrated. then ideally so will the volumetric tariff. A good Economically efficient tariffs reflect the​ example of this is in the electricity sector, where ­ underlying cost of providing services. More specifi- prices are set based on a competitive spot market and cally, efficient tariffs will reflect the marginal cost of those prices are directly charged to customers by supply, ensuring pricing reflects the true economic retailers through smart meters. Although rarely cost of supplying a unit of water (figure 2.10). The applied in practice, the ideal tariff complement is cost of supplying water depends on many factors real-time pricing. This tariff structure consists of and may vary over time. Factors that influence this many different pricing periods throughout the day, variance include: increasing the granularity and frequency of price • Climate. Temperature, rainfall patterns, droughts, revisions to reflect real-time costs. These and floods are important factors in determining time-varying tariffs are however much more com- the costs of water supply. plex than current conventional pricing mechanisms • Hydrological aspects. The use of different water and are achieved through smart metering.5 There are sources and the varying quality of raw water is other dynamic pricing options that are not as precise another aspect that typically affects total costs. as real-time pricing but achieve a similar effect. • Water consumption demand. Water utilities incur Given the complexity of dynamic pricing, it has higher costs during peak demand periods because been rarely applied to date. Yet research studies 34 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services BOX 2.5. Simulating Potential Cost Savings from Reducing Inefficiencies across Four Dimensions In this exercise, the full cost-recovery tariff (FCRT) is the cost-reflective tariffa plus any inefficiencies that a water utility incurred. These include inefficiencies resulting from: bill collection, nonrevenue water (NRW), overstaffing, and capital expenditure (CAPEX). The estimated global FCRT is around US$2.13/ cubic meter (m3) and ranges from a low of US$0.69/m3 among water utilities in South Asia to as high as US$3.16/m3 in Latin America and the Caribbean. Across income groupings, the FCRT is estimated to be around US$0.97/m3 among water utilities in high-income countries and US$4.37/m3 among those in low-income countries (see appendix E for full results). Ideally, the full tariff can be reduced by reduc- ing inefficiencies. This exercise assumed an overall reduction of 75 percent across all four inefficiencies. Nontechnical inefficiencies resulting from bill collection and NRW were then combined 50-50. SCENARIO 1: A 75 PERCENT REDUCTION IN NONTECHNICAL INEFFICIENCIES The effect of a 75 percent reduction in nontechnical inefficiencies from bill collection and NRW is marginal: the estimated reduction in FCRT was around 0.63 percent globally (from US$2.13/m3 to roughly US$2.11/m3). This reduction varied by region with the highest reduction observed among water utilities in Sub-Saharan Africa (up to 1.27 percent), followed by those in South Asia (up to 0.82 percent). Across income groups, the simulated reduction in inefficiencies resulted in a 0.86 percent reduction in FCRT among water utilities in low-income countries followed by a 0.69 percent reduction among those in upper-middle-income countries. SCENARIO 2: AN ADDITIONAL 75 PERCENT REDUCTION IN OVERSTAFFING INEFFICIENCIES The reduction in FCRT from reducing inefficiencies in bill collection, NRW, and overstaffing was also marginal and estimated to be around 0.73 percent globally, which does not affect the overall result. Regionally, the cumulative reduction in the FCRT was much more concentrated among water utilities in the Middle East and North Africa region (5.60 percent) and those in South Asia (4.07 percent). Across income groupings, the cumulative reduction in the FCRT was estimated to be highest among utilities in lower-middle-income (1.75 percent) and low-income (1.55 percent) countries. SCENARIO 3: AN ADDITIONAL 75 PERCENT REDUCTION IN CAPEX INEFFICIENCIES The cumulative reduction in FCRT from all four dimensions of inefficiency was estimated to be around 6.06 percent globally (figure B2.6.1, left-hand panel), corresponding to a decrease from US$2.13/m3 to US$2.00/m3 and corresponds to the single-largest marginal reduction in the full tariff. Regionally, the additional reduction in CAPEX inefficiencies resulted in significant cumulative full tariff reductions among water utilities in Sub-Saharan Africa (11.28 percent), Europe and Central Asia (10.19 percent), and South Asia (8.03 percent) (left-hand panel). Across income groups, the cumulative reduction in the FCRT is observed to be highest among utilities in low-in- come (8.95 percent) and lower-middle-income countries (7.23 percent) (figure B2.6.1, right-hand panel). a.  Cost-reflective tariffs were calculated for a number of utilities registered in the IBNET database using Chilean utilities as a benchmark. Subsidies were estimated by comparing the resulting tariff to what was actually charged. Cost-reflective tariffs are the average tariffs per m3 of water produced that would cover the cost of providing the service under the assumption of no inefficiencies and are calculated at the utility level for a given year. box continues next page Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 35 BOX 2.5. continued FIGURE B2.5.1. Total Potential Reduction by Region (left) and by Income Group (right) 12% 12% 10% 10% 8% 8% 6% 6% 4% 4% 2% 2% 0% 0% e co le co le e ci ia La Asi & be ica ric t ia ric n Af Eas m m Af ara Pa As As In idd In idd ra pe e e fic a an a a rib er co co m m h nt ro h st Ca m rt le rM M In In Sa ut Ea & in A Ce Eu No idd l er h w b- So pe h ig w Lo & & M Su t Up H Lo Note: Global average is indicated by the orange line. FIGURE 2.10. Efficient Tariff Design • Used to recover network capacity and distribution costs, Demand / capacity based on the maximum volume of water customers are charges likely to consume Volumetric charges • Used to recover the variable costs of additional (varying by time of use) water supply in each time interval • Used to recover the costs of customer-related activities Fixed or standing such as metering, billing, and collection, which do not vary charges with demand Source: Original compilation. provide useful insights. For example, Cole, Efficient tariffs may also vary by location. Location- O’Halloran, and Stewart (2012) assess the impact of based pricing is a tariff complement that applies dif- TOU tariffs on peak water demand in Queensland ferent water prices for different customers according (Australia). Their case study shows how dynamic tar- to the cost associated with servicing those custom- iffs can be adjusted or modified to meet marginal ers. This mechanism allows water operators to pricing requirements while achieving other objec- account for the higher costs of serving customers tives, for example, equity and water conservation. that live in distant or isolated neighborhoods, 36 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services although it raises social concerns with regards to the several limitations as discussed in Andres et  al. socioeconomic condition of households located far (2020). Alternatively, determining affordability from the network. with the method commonly used to draw the mon- When smart metering is not practical, customer etary poverty line offers several advantages.6 classifications that closely reflect consumption pro- 2. Equity, on the other hand, is concerned with the files (and therefore costs) facilitate economically fairness of the allocation of resources across a efficient tariffs, for example, when setting volumet- given population and demands that equals should ric charges to recover capacity-related costs. receive identical treatment. If similar households Tariffs that reflect the marginal cost of providing do not receive a similar bill, it might be considered supply send a precise signal to the consumer to use inequitable even if both bills are affordable. In tar- water and wastewater services efficiently. An effi- iff design, equity can be achieved at different cient tariff reflects both the level of costs that have to levels: be recovered and the structure of costs, and typically involves a two-part structure with a fixed charge per • Equity among income groups. This is the most obvi- month and a volumetric charge per cubic meter. ous social aspect of water pricing and implies that low-income customers should not pay a dispro- 2.11 Affordability portionately larger fraction of their income on water services than higher-income customers. There are misconceptions regarding the human right to safe water and the meaning of affordable versus • Equity among customer types. Measures that aim equitable tariffs. First, while safe drinking water is to provide a preferential treatment to lower-­ considered an essential human right, it does not enti- consumption customers could unintentionally tle every customer to an unlimited free supply of penalize low-income but larger households, given water. Second, affordable water bills are not neces- the imperfect relationships between water con- sarily equitable. While “affordability” and “equity” sumption and income. are often erroneously used as synonyms, it is import- • Equity among regions. While achieving efficiency ant to distinguish the two objectives: and cost-recovery objectives, location-based pric- ing is an example of a tariff complement that leads 1. Affordability implies all potential customers to geographic inequity in terms of water pricing. should be able to afford water. Water priced at full Inequity could also be assessed in terms of access economic cost-recovery levels, for example, may and quality of service. not be affordable for low-income customers. There • Intergenerational equity. This is broadly related to are various ways to define and measure affordabil- another tariff objective, environmental sustainabil- ity. A common method is to calculate an affordabil- ity, reflecting the need to address climate change ity indicator based on each household’s water bill and increasing water stress levels. Section 3.2 dis- as a percentage of their income. If water expendi- cusses how tariff structures and complements can tures exceed a specified threshold, the tariff has promote water conservation through pricing incen- generated unaffordable water bills for at least some tives, with more details provided in background of the households. However, this approach has paper 7 (listed in appendix A). Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 37 Social tariffs seek to address the impacts of pricing Other types of customer classifications based on policies on different income categories and customer proxies (e.g., property size, pipe diameter) can some- categories/groups to mitigate the burden of water times be more effective in supporting targeted subsi- bills on low-income households. While lack of access dies than customer type or usage, depending on the to water is often due to the lack of ability to pay for degree of the population’s socioeconomic homoge- the service, low-income families are not necessarily neity within the given proxy, but are still much less low-consumption households, raising equity con- effective than an up-to-date national register. cerns if they pay a disproportionately large share of Ensuring affordability often conflicts with the their income on water services. Yet in the absence of tenets of cost recovery. And despite efforts to develop a developed welfare system, tariff structures are and implement pro-poor pricing mechanisms, cer- used to address water affordability and equity chal- tain tariff structures unwittingly penalize the poor: lenges. The key challenge in designing social water • Increasing block tariffs (IBTs). These are among the tariffs is effectively targeting households facing most common tariffs used to ensure affordability. affordability constraints and avoiding errors of inclu- The first block can be set low enough to allow all sion and exclusion: households to consume a minimum amount of • Errors of inclusion. These stem from efforts that water. Conversely, higher blocks can be set above (often inadvertently) target households for whom the cost-recovery rate to cross-subsidize the first services are already affordable. Given an overall block. However, as water is typically billed by lack of financial resources, only the poorest house- household, this may inadvertently penalize large, holds should benefit from social pricing poor households that consume larger volumes. measures. • Volume-differentiated tariffs (VDTs). These are also • Errors of exclusion. As many households do not known as “jump” tariffs. Lower blocks can be sub- have access or cannot afford to connect to the sidized to a greater extent. However, this may also water supply network, targeting mechanisms adversely affect affordability among large, poor often fail to reach low-income households or households. exclude those that do need assistance. • Fixed rate. Fixed or flat rate tariffs (whether as a stand-alone or a component of a two-part tariff) The more targeted tariffs are, the less “wasteful” generally have a negative impact on affordability. the affordability mechanisms, in that affordability Regressive in nature, they compromise a larger can be achieved without compromising as much on portion of a low-income household’s total other tariff objectives such as cost recovery and effi- expenditure. ciency. Where a national register of vulnerable/ low-income households is available, this would in • Constant volumetric tariffs. These aim to strike a theory enable the more precise targeting of mecha- balance between two-part tariffs with fixed rates nisms to address affordability. Yet this is not always (which make affordability challenging) and IBTs possible in practice, and customers are typically and VDTs (which are specifically designed to make classified based on their customer type (residential, tariffs affordable for low-income households). small commercial, etc.) or by use (i.e., through IBTs). 38 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services IBTs are often applied to address the redistributive case. Low-income households may be larger than challenges related to water pricing. This tariff struc- assumed by the tariff design and may consume ture is usually adopted to guarantee a basic volume greater levels of basic water, while high-income of water consumption for poor households at an customers with low consumption in second homes affordable rate. The intention is that richer custom- would also benefit from the subsidy.7 ers, assumed to have higher consumption rates, are • “Lifeline” block. In order to successfully target charged higher tariffs to cross-subsidize the water low-income households, the lifeline block of IBTs usage of poorer households, assumed to have low should correspond to the minimum volume of consumption (box 2.7). water needed to meet basic needs. Determining However, there are several difficulties with IBTs, this quantity can be rather complicated and while which can even exacerbate negative impacts of the international standards estimate the basic needs tariff on vulnerable customers. These include: of an average-sized household at 4–5 m3 per month, the lifeline block threshold of most IBTs is • Targeting. The advantages of this tariff structure much higher. This might provide a disincentive for are based on the assumptions that low-income wealthier households to conserve water and households consume less water and that low tar- reduce water utilities’ revenues. Policy makers iffs for low-consumption customers will allow therefore face a difficult trade-off, as a restriction poor households to access affordable water ser- designed to discourage wealthier customers’ vices. In practice, however, this is not always the BOX 2.6. Social Water Pricing in Indonesia ­ ustomers The water operator in Indonesia applies a cross-subsidy mechanism between six groups of c (divided between residential and nonresidential categories, the first of which is further divided by income level, or class). The tariff structure is an increasing block tariff but each social group is charged a different rate FIGURE B2.9.1. Effects of Cross-Subsidy in Indonesia with the highest tariff approximately 14 times 100 higher than the lowest rate to subsidize low-­ 90 30 income groups. The effect of the cross-subsidy 80 49 70 is shown in figure B2.9.1. The graph shows that 75 60 20 percent of the customers are classified as 50 % 50 low-­ income customers and account for around 40 28 30 23 percent of total consumption but only 20 23 21 percent of revenue. 4 ­ 10 20 0 4 The bulk of the revenue (75 percent of the Customers Consumption Revenue total) is collected from upper-class groups with Low-income class Medium class Upper class remarkable impacts on economic redistribution. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 39 overconsumption is likely to have negative reper- IBTs, while box 2.8 outlines other methods for ensur- cussions for poorer, larger households. ing poor households’ access to water. VDTs/jump tariffs share many of the same disad- 2.12 Raising Revenue through the Three vantages as IBTs—notably the assumption that con- Ts: Tariffs, Taxes, and Transfers sumption is correlated with income. However, VDTs There are three key sources of revenue for funding cross-subsidize less “wastefully” by targeting water services. These are known as the three Ts: low-consumption households without inadvertently tariffs, taxes, and transfers. The difference between subsidizing the first water consumption blocks for revenue collected through tariffs and total costs higher consumption customers. Conversely, jump must be bridged using a combination of government tariffs tend to attract more customer complaints due subsidies (raised through taxes on current or future to the variability of monthly bills for customers who generations) and transfers (from development orga- consume near the block boundary. Although still in nizations). Each revenue stream involves a series of use in a few countries, these have mostly been trade-offs (table 2.7). replaced by IBTs. Box 2.7 presents arguments against BOX 2.7. The Case for Revisiting IBTs The most common pro-poor tariff mechanism is to include a heavily subsidized first block in an increasing block tariff (IBT) that is sized to represent a minimum amount of water required to meet basic consump- tion levels. To convey the message that the needs of the poor are being met, this is often referred to as a “lifeline block.” There is extensive discussion in the literature on whether water tariffs (and especially IBTs) can and should be used to alleviate poverty. The clear answer that emerges is they are a blunt instrument at best and at worst can produce perverse outcomes. As the Tinbergen principle (OECD 2020, 7) explains, policy makers trying to achieve multiple objectives need a policy tool for each objective. This precludes water tariffs efficiently meeting financial viability and affordability targets simultaneously. Thus tariffs should be designed to secure sustainable financing for service provision while other targets such as affordability are best met through targeted social measures. Nauges and Whittington (2016) reach much the same conclusions throughout their quantitative analysis of IBT tariff structures, advocating instead for a much simpler uniform volumetric tariff structure. The widespread use of IBTs is difficult to rationalize, in particular while knowing that the use of a (simple) uniform volumetric tariff where water provision is charged at its full cost could improve social welfare by removing price distortions and would be easier for households to understand. Despite the obvious conclusion that pro-poor measures should not be delivered though tariffs, the political nature of the tariff-setting process means much time and energy continue to be spent on pro-poor tariff structures. Policy makers may not be aware of existing criticisms and genuinely believe the tariff structure they have selected is effective but political expediency reinforces this claim, often made with donors in mind. 40 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services BOX 2.8. Mechanisms for Ensuring the Poor Access Water at Cost-Recovery Prices When water tariffs are set at cost-recovery levels, parallel mechanisms to ensure basic water require- ments are met include: • Tariff rebates, through which low-income customers receive direct cash transfers to pay part of their water bill, the proportion being related to a family’s social situation. • Vouchers that allow customers to receive a portion of their water consumption at a subsidized rate or even for free. The problem with such schemes is the need for an accreditation scheme to identify eligible recipi- ents. This is best managed not by the water utility but by a social welfare agency or a community-based organization. Due to the need for complete and accurate data at the household level, it is not surprising therefore that the examples given are drawn from high-income countries (e.g., France, Singapore, and Australia) (for a more detailed analysis, see Termes-Rifé and Bernardo [2015]). Where affordability is not a challenge, a compelling characteristics that allow a degree of differential case could be made that tariffs should be used to pay pricing without the distortion of price signals. for all economic costs. First, tariffs can provide price Additionally, directing tariffs toward specific costs signals to customers that incentivize the efficient use may be less effective than directing taxes or transfers. of water. Second, tariffs mostly target the recovery of For example, in some regimes, existing customers costs to those who produce them. This is especially pay for the network’s expansion through tariffs, relevant in the case of environmental costs (where it despite not benefiting from the new infrastructure. is referred to as the “polluter pays” principle). Third, This raises the question of who should pay for these decision-making on tariffs can more easily involve costs and to what extent, known as deep versus shal- stakeholders, ensuring community inclusion. low connection charges. In some cases it might be Conversely, taxes and transfers are more volatile and more justifiable to turn to taxes or transfers. generally beyond the reach of the community. Tariff Another challenge is willingness to pay (WTP). revenues thus have some advantages relative to Even when customers can afford to pay, they are taxes and transfers. often unwilling especially as water is viewed as an Tariffs are not, however, without their disadvan- essential service and human right or when low tariffs tages. For example, though tariffs can partially are in place for a sustained period, as increases may address affordability through cross-subsidization be perceived as an abuse of power or unjustified. In from larger customers to low-income households these cases, the gulf between revenue captured and provide social assistance in times of crises through tariffs and economic cost recovery becomes (box 2.9), cross-subsidies can create an economic difficult to bridge; consequently, taxes may have to distortion of price signals, disincentivizing efficient be levied at least until the underlying problems are consumption. Nonetheless, the WSS sector has resolved. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 41 TABLE 2.7. Advantages and Disadvantages of the Three Ts Tariffs Taxes Transfers Advantages Efficiency: Cost-recovery tariff levels can Affordability: Can ensure the affordability Reliable: Development banks tend to be induce an efficient consumption response. of tariffs. However, unless designed reliable in their commitments. Furthermore, the use of tariffs can be an adequately, subsidies may not target the Inclusion: Transfers may be more within the enabler to design tariff structures with price poorest or those without service. control of the community and stakeholders signals that encourage efficient consumption. Willingness to pay: Customers may not be than taxes. Targeting: The payment of costs can be willing to pay a cost-reflective tariff due Political economy: Funding from external charged to those who induce them. This to quality of service or poor transparency. development banks can give utilities more is especially relevant for external costs. Economies of scope and scale: Can autonomy than assistance through taxes However, in the case of network expansion, encourage new customers to connect, from government. Transfers might also be currently connected customers could pay densifying networks. beneficial in economies where institutions while nonconnected customers ultimately are still being developed. Positive externalities: Subsidies that benefit. encourage greater sectoral outcomes have Fiscal space: The government’s fiscal space further benefits for health, human capital, can be increased through reducing the and the economy. subsidy burden. Progressive: Less regressive than taxation. Inclusion: Stakeholders and the community can be involved in decision-making on tariffs. Reliability: Transfers provide a reliable source of income to providers. Disadvantages Affordability: Some customers may be Inclusion: Taxes are prone to volatility Loss of autonomy: Country cedes unable to pay for tariffs. While cross- beyond community and stakeholder opportunities to design its own policies, subsidies can address this, they create a control. whether directly or indirectly. Particularly distortion in incentives, leading to inefficient Political dependence: Can reduce the problematic in case of increased consumption. political autonomy of the utility. indebtedness. Unreliable: Risk of government sliding on Loss of accountability: Governments feel commitments. Hence, private investors, accountable to donors rather than citizens. especially, are reluctant to invest if Volatility: Transfers from development revenue is reliant on taxes. However, agencies of other countries can be volatile targeted taxes can reduce this risk. or unreliable, undermining sectoral planning and growth. There are positive externalities associated with charging below the economic cost can motivate greater access to water. The most obvious are the greater accumulation of human capital, in turn gen- public health impacts, for example, the reduction in erating economic benefits that result in greater tax disease within local communities as access to water revenues that compensate the initial subsidization increases. These benefits act as pathways to the via taxation. improved accumulation of human capital by, for An additional benefit of subsidies (or taxes) over example, reducing childhood mortality. Thus, tariffs is their ability to target specific costs. Targeted 42 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services BOX 2.9. Social Assistance through Utility Tariffs during the COVID-19 Pandemic During the COVID-19 pandemic, utility tariffs have been used to manage and alleviate social impacts. Privately owned utilities have been required to protect cash flows and to ensure the continuity of service to households. For example, in Germany, small businesses could temporarily delay energy payments, and utilities pledged not to cut off households during the crisis (Clean Energy Wire 2020). In Canada, the winter ban on electricity disconnections was extended to the end of July (Global News 2020). Publicly owned utilities returned customer deposits and slashed tariffs, which is both quicker and sim- pler than increasing welfare payments, bearing a resemblance to “helicopter money.” For example, the government of Thailand reduced public utility bills by 3 percent, and electricity authorities returned cash deposits to customers (The Diplomat 2020). The government-owned electricity utility of Indonesia, PLN, pledged to supply 24 million households in the smallest tariff category with free electricity for three months. The second most vulnerable customers, across 7 million households, would get a 50 percent discount (The Jakarta Post 2020). These measures demonstrate an advantage of using utility bills to deliver income support. By linking discounts to consumption levels, a rough targeting of benefits to the lowest-income households can be created without the need for complex application and verification procedures. It is important to note the implications of these measures on cost recovery: the World Bank found col- lection rates had dropped by 40 percentage points among the utilities monitored. Nonetheless, these examples illustrate the potential for water tariffs to have far-reaching socioeconomic impacts in times of crises. Source: Holcroft 2020. tariffs are less effective for some capital costs. For North Africa region, followed by Sub-Saharan Africa example, existing customers might pay for the (figure 2.11). expansion of the network through tariffs, despite not When subsidies are required to plug the gap benefiting from the new infrastructure. This raises between revenues collected through tariffs and eco- the question of who should pay for these costs and to nomic costs, particularly with respect to CAPEX, a what extent—that is, deep versus shallow connection key benefit of transfers over taxes is the reliability of charges? In these circumstances, taxes may be more development banks over domestic governments, justifiable. which in turn increases the confidence of private The ratio of subsidies to revenue collected through investors. Furthermore, transfers have political tariffs and taxes differs internationally. The average economy benefits. They reduce the dependence of ratio for utilities across 47 countries aggregated to utilities on the domestic government (box 2.13), the national level is highest in the Middle East and which can erode the autonomy of the utility. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 43 FIGURE 2.11. Subsidies as a Proportion of Tariff and Tax Revenues in Select Countries, by Region (2010–19) 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18192021 22232425262728293031 32333435363738394041424344454647 East Asia & Pacific Europe & Central Asia Latin America & Caribbean Middle East & North Africa North America Oceania South Asia Sub-Saharan Africa Source: Original elaboration using IBNET data. Transfers might also be beneficial in economies generally not be set below the short-run marginal where institutions are still being developed. Finally, cost. However, the long-run approach is much more development banks often work closely with commu- common. nities and stakeholders when devising subsidies, The environmental cost can be calculated as the increasing the degree of inclusion. Figure 2.12 pres- cost of action or of inaction. There are two broad ents original analysis of how tax transfers relate to approaches for measuring the cost of action. Cost- tariff and tax revenues across global regions. based approaches look at the cost of preventing or repairing overabstraction of resources, while 2.13 Conclusions market-based approaches simply look to the market ­ price that emerges from volume-based controls. There are two main approaches to determining aver- A weakness of the cost-based approach is that esti- age costs. In the cash-based approach, the calcula- mates are closely linked to expenditure, meaning tion is largely based on figures reported in financial they may overlook hidden costs and may not neces- documentation. In the building blocks approach, sarily represent the least expensive action possible. more work is required to infer the more abstract Despite this, they are simple to understand and costs: O&M costs, depreciation, and return on capi- administer. Market-based approaches naturally tal. The marginal cost can be calculated on a short- or determine the efficient price associated with sys- long-term basis. The long-term calculation can be tems of abstraction charges. However, the licenses based on an incremental increase in demand (Turvey can easily be overallocated with the right pressure method) or an increase in demand forecast in expan- from market players. Despite the merits of such sys- sion plans (AIC approach). Both methods appear to tems of permits, volume-based controls are rarely be common among countries where marginal cost is adopted. The cost of inaction requires the calcula- used. The short-run approach might be appropriate tion of the economic consequences resulting from where there are no capacity constraints. It can also allowing the abstraction to cause the water resource serve as a price floor—volumetric tariffs should 44 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services FIGURE 2.12. Tax Transfers as a Proportion of Tariff and Tax Revenues, by Region (2010–19) 30% 25% 20% 15% 10% 5% - ri c & ri c n lA & be a & ia ia ci & a ic Af ara an As Af t r a pe Pa sia a a si a an fic er h as r i b ri c ce h nt ro h Am A rt E Sa Ca e ut O Ce Eu st Am No dle b- So Ea th id Su tin r No M La Source: Original analysis of 47 countries using IBNET data. to fall below its rate of natural replenishment. The taxes or transfers. Tariffs tend to increase efficiency present value of these costs can be calculated across by inducing efficient consumption while targeting the period over which the resource is depleted. those who incur the costs. Taxes and transfers may For  example, this could be used to calculate the be necessary or desirable, for example, when bal- damage in the aftermath of a drought. ancing affordability. Though taxes can be unreliable As water is a public good and a basic human right, and erode the political independence of a utility, customers need to be able to afford services. Water targeted taxes can be ring-fenced to improve priced at full economic cost-recovery levels may not reliability. be affordable for low-income customers. External Using tariffs to cover costs should not be perceived subsidies, or, more commonly, a cross-subsidy from as the single policy lever for cost recovery. A strong other customer categories, may help address this case could be made that improvements in efficiency need. Alternatively, as discussed in the next chapter, should be the first port of call for addressing cost tariff complements, such as tariff rebates, vouchers, recovery. Efficiency gains can spur improvements in and subsidies, can be leveraged to help address services and WTP, in turn increasing cost recovery, affordability. These mechanisms may be especially resulting in a positive feedback loop. Where neces- important to address barriers to access, such as con- sary, modifying service levels could be a route for nection charges. cutting costs while increasing access. Countries across the world struggle to cover costs Importantly, designing an effective tariff structure through tariffs alone. Given competing policy objec- is only possible where robust, quality data are avail- tives, a more rational goal might be to set an aspira- able. Different data are needed for different tariff tional target. The gap between revenues collected structures and different tariff objectives. For exam- via tariffs and total costs must then be met through ple, the lack of metering largely limits utilities to flat Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 45 rate tariffs and in the absence of a social registry elasticity of demand]. [Further, charging for metered services creates uncertainty about revenue streams… [i]n low water usage house- excludes even variable flat rates. Given the holds, resource savings eventually driven by metering are not likely context-specific nature of tariffs, the availability of ­ to outweigh [the] costs [of installing meters].” The point being, metering is not a panacea in and of itself to reduce consumption. data and access to specific data are likely to influence Instead, “[i]t is primarily a measure to make customers aware of their the choice of tariff structure even further. level of usage, and a tool to identify and situate water leaks. This explains why metering is most effective when it comes with nudging Notes techniques to drive water users’ behaviour [see Section 3.2.3].” However, “[a]n ancillary benefit of metering is the generation of data 1. Tariff complements are instruments that can be leveraged to support that can be used not only to determine the water bill of consumers, utilities in meeting their goal of financial equilibrium. While they are but also to drive improvements in tariff policy, water management generally related to pricing (e.g., dynamic pricing), they may also be and decisions on infrastructure maintenance and extension. If political or regulatory (e.g., overconsumption penalties). See chapter meters are used primarily with the purpose of detecting leakage and 3 for a detailed discussion of these complements. informing water policy, block or district metering is a fully adequate 2. Costs can be untangled and categorized in different ways, for exam- and less costly solution.” ple, operations, depreciation, capital maintenance, and financing 6. First, it defines a “basket” of WASH services that accounts for the (debt and equity) (AWWA 2017). However, figure 2.3 offers the most type and level of WASH services that a household receives (and that appropriate representation for this report. involves a threshold quality of service, deemed necessary for health 3. Additional references for the LRMC include London School of and well-being). Second, it makes use of the actual costs of service, Economics (1997) and Marsden Jacob Associates (2004). therefore moving away from household estimates of WASH expendi- ture that tend to be inadequate and rarely reflect actual costs. Third, 4. For a summary of the history of financial sustainability and guidance it considers both initial fixed costs and recurring consumption costs, on its implementation, see McPhail, Locussol, and Perry (2012). each of which pose their own unique challenges to affordability. Fourth, it makes use of household-level data on access to WASH ser- 5. According to the OECD (2020), “[i]ntroducing metering at household vices, which allows for the grouping of households into categories level in existing built up areas can be disproportionately costly to with distinct policy implications. Finally, this approach facilitates support sophisticated tariff structures. Depending on context and scenario analyses, whereby the impact of different pricing policies history, metering can be used at block level to detect leakage and can be assessed (Andres et al. 2020). raise users’ awareness of water use. Where in place, metering can be used to generate data that increasingly supports decision making 7. Whittington and Nauges (2020) assessed IBTs in the municipal water though sophisticated data management techniques. [However, t]he supply sector and concluded they do not perform well in most situa- installation of universal water metering comes at a cost, and its tions in terms of subsidy targeting. effects on water consumption may be limited [see section 3.2.1 on 46 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services © Getty Images CHAPTER 3 Secondary Tariff Objectives and Tariff Complements Tariff design inevitably entails trade-offs between different, often conflicting, policy objectives (figure 3.1). Such trade-offs can potentially be mitigated through the application of tariff complements. Tariff complements are instru- ments that can be used alongside core tariff structures to target specific tariff objectives while supporting utilities in meeting their goal of financial equilib- rium. In this way, they can help balance the trade-offs between competing objectives, ideally without compromising financial stability. Although they are generally pricing related (e.g., dynamic pricing), they may also be political or regulatory (e.g., overconsumption penalties). They also include affordability measures to target lower-income households and efficiency measures to ensure customers are charged according to the underlying costs that corre- spond to their supply. 3.1  Strategies to Increase Economic Efficiency Tariffs that reflect the real-time cost of supply encourage economic efficiency. Examples include peak pricing, peak rebates, real-time pricing, or time-of-use (TOU) tariffs, although the latter are relatively uncommon. Such tariffs are commonly applied in the electricity and other sectors, but are less common in the water sector, particularly in low-income countries, due to their reliance on smart metering. Location-based pricing reflects variations in a supplier’s costs due to location, for example, the need to provide desalinated water in the absence of freshwater or gravity-fed distribution schemes versus pumping, and aims to pass these costs on to the customer. Although necessary at times, they are generally unpopular given the potential to disproportionately affect poor households who are often located further away from primary distribution networks. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 49 FIGURE 3.1. Trade-Offs in Water Tariff Design two-way communication meters or directly to the customers, in combination with smart tools that Efficient allocation may not automatically adjust water consumption in critical induce water conservation peak days. Environmental Economic i • Critical peak time rebate. The idea underlying this sustainability efficiency tariff mechanism is similar to critical peak pricing, Full cost Give priority with customers paying a given rate structure in Environmental recovery vs to access for requirements marginal high-value normal periods (typically a TOU tariff) and receiv- increase costs cost pricing uses vs merit uses ing rebates for reducing their water usage during critical peak days. Average historical consumption levels are used to determine benchmarks under Cost Move to fuller Affordability which water usage is eligible for rebates. As for recovery cost recovery and equity may negatively critical peak pricing, the choice to notify custom- affect affordability ers might involve more or less advanced metering Source: Original elaboration, adapted from OECD (2020). technologies. • Real-time pricing. Increasing the granularity in Dynamic Pricing TOU pricing and the amount of pricing periods, real-time pricing schemes aim to reflect real-time Dynamic tariffs that reflect the real-time cost of supply costs. The day is divided between several differ- are the ultimate means of encouraging economic effi- ent charging periods and prices are regularly ciency. They are particularly useful when costs vary updated. significantly by time and therefore provide an incen- tive for large consumers to shift water consumption to • Time-of-use (TOU) tariffs. Consumers pay different off-peak periods. However, they are costly and com- prices at different hours of the day, with the price plex to implement as they require smart metering tech- distribution predetermined and known to custom- nologies. They are nonetheless expected to become ers. The simplest design is based on two pricing increasingly used in the water sector with time. periods, peak (commonly daytime) and off-peak A key feature of dynamic pricing is varying the (commonly nighttime) hours, although TOU tariffs price of services with time, building on the idea that could also involve midpeak periods. TOU tariffs the underlying costs of supply depend on the time of require less sophisticated metering options than use. The main types of dynamic pricing schemes of alternative dynamic tariffs and are less common relevance to water services include: than other pricing strategies. • Critical peak pricing. Customers are charged higher These time-varying tariffs are much more complex prices for water consumed during critical peak than current conventional pricing mechanisms and periods. Different events may be used to select there is far less experience applying dynamic tariffs critical periods. In the electricity sectors, these in the water sector. However, research on TOU tariffs mainly relate to reserve capacity constraints. has attempted to provide insights on the potential Notification about critical periods is given through impacts of peak pricing (box 3.1). 50 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services BOX 3.1. Automatic Meter Readers for TOU Tariffs in Australia The Australian government’s Water Fund, Water Smart Australia, and Wide Bay Water Corporation carried out a project in Queensland (Australia) in which automatic meter readers were installed on a number of customer properties. The project allowed the water utility to save on meter reading costs and identify leakages in the water network. It became the topic of several studies. For example, Cole, O’Halloran, and Stewart (2012) collected data on consumption patterns in Wide Bay showing two clear peak demand periods throughout the day (see figure B3.1.1, blue line). The aim of the time-of-use (TOU) tariffs is to shift demand to achieve a softer consumption pattern (figure B3.1.1, red line) to minimize the risk of reaching the network capacity limit. The project highlight- ed that automatic meter readers and hourly metering provide useful insights for the design and imple- mentation of TOU tariffs. The readers allow water utilities to collect and analyze information and figure out which type of consumption (i.e., indoor versus outdoor versus discretional use) customers are likely to reduce when water restrictions take place. FIGURE B3.1.1. A Comparison of Usage Scenarios Current average day diurnal pattern 140000 120000 100000 Volume (L) 80000 60000 40000 20000 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 Hour Double peak pattern (actual) No peak pattern (desired) The application of these innovative pricing demand-side management through the advent of models has been spreading through many sectors smart technologies (e.g., smart metering, real- such as electricity, telecommunications, insur- time monitoring, and improved demand forecast- ance, and transport, to better recover the costs of ing), which have revolutionized the relationship supply and drive consumer behavior. Dynamic between water operators and customers (see pricing has become a reliable option in chapter 4). Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 51 Location-Based Pricing cross-subsidization between services and customer Location-based pricing may be necessary in some categories. cases but is often unpopular. It is particularly rele- Location-based pricing, also known as “zonal pric- vant where there is significant variation in the cost ing,” is rarely applied. Water utilities typically apply of supply by location, perhaps because water a uniform geographic charge similar to postage sources vary (i.e., boreholes versus desalination) stamp pricing. or because network costs vary (i.e., gravity fed ver- sus pumping). Location-specific tariffs, however, 3.2  Strategies for Conserving Water often raise social concerns as households located Population growth and urbanization, along with the farther away from the central distribution network effects of climate change, have put increasing pres- are likely to fall within the poorest segments of the sure on water resources. Encouraging water use effi- population. ciency, water conservation, and water reuse have This pricing scheme charges different prices for therefore become primary objectives of national different customers depending on their location governments and water utilities. The most common inside the operator’s service area and the underlying intervention to address these challenges and achieve cost of supply. This could entail different tariffs for environmental sustainability is through water pric- customers within the same supply network (i.e., ing. There is a vast literature on pricing approaches depending on the water intake point along the net- for WSS services covering a wide range of instru- work infrastructure) or apply to separate supply sys- ments aimed at stimulating efficient water allocation tems, as is more commonly observed. This approach and use (figure 3.2). ensures that costs reflect different infrastructure Overconsumption penalties and seasonal tariffs types and locations, avoiding the potential for can be applied in locations with large seasonal peaks FIGURE 3.2. Price and Nonprice Approaches to Water Conservation Integrated approach to water conservation Price approaches Non-price approaches Tariff structures Tariff complements Water licensing • Abstraction license • Seasonal pricing • Water use restrictions fees / charges • TOU tariffs • Water saving devices • Subsidies for water • Water budgets s • Information and saving / reuse • Water reuse awareness • Taxes / tax breaks pricing Source: Original compilation. Note: TOU = time of use. 52 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services in demand. These approaches are much easier to The economic literature has attempted to shed implement than real-time pricing but still effectively light on the impact of water tariffs on water penalize high-end consumers in periods with high demand by measuring the price elasticity of water demand or low availability to reduce seasonal- demand (PED), the percentage change in the ity and the costs generated when network capacity is amount of water consumption in response to a per- reached. The relative strengths and weaknesses of centage change in the tariff. A summary of the various tariff complements are presented in table 3.1. range of PED estimates from the existing literature is provided in table 3.2. Tariffs for Water Conservation Despite the heterogeneity in specifications, data, Water conservation is often one of the most import- and estimation techniques, the following are key ant objectives in water management given the grow- insights from the available literature on PED (Lu, ing scarcity of water resources. Internationally, many Deller, and Hviid 2017): (1) the price of water is a statis- water tariffs are below the cost of supply and do not tically significant variable in explaining water reflect the full environmental impacts of water con- demand, suggesting that water tariffs are effective sumption and wastewater disposal. instruments to reduce water consumption and When water conservation is the utility’s primary achieve environmental objectives; (2) the range of objective, IBTs can be employed to progressively PED estimates from existing empirical studies is wide increase water tariffs until customers achieve suffi- and highlights that household-specific factors are cient reductions in water consumption. While theo- important drivers of behavioral change in water con- retically attractive, the effectiveness of IBTs in sumption patterns; (3) PED is usually higher for IBTs promoting water conservation critically depends on than uniform pricing and other tariff structures, likely whether they are appropriately designed and reflecting customers’ higher awareness of large non- received by customers. IBTs are more difficult to essential consumption feeding into larger bills under understand than other tariff structures such as uni- IBTs, regardless of whether they understand the block form pricing, and their complex nature requires cus- structure or not; and (4) water is traditionally consid- tomers to have accurate information about the tariff ered a highly price-inelastic good, and significant structure and their level of water consumption in price increases might be required to induce sufficient order to make rational decisions. reductions in water demand. These tariff increases Economic models typically assume that information are unpopular and politically difficult, highlighting has no cost and customers are well informed. However, the role of nonpricing tools in promoting water sav- this assumption is unlikely to hold in utility markets ings (see background paper 15, listed in appendix A). where obtaining data can be difficult and costly. It is When alternative supplies are not available, IBTs common for IBTs to involve more than two blocks, are a potentially useful pricing instrument to reduce increasing information costs for customers. Therefore, overall water consumption, in line with theoretical the impact of IBTs on water conservation is unlikely to predictions. However, the wide range of PED esti- be as straightforward as it appears in theory, since con- mates suggests that households and regional vari- sumers do not accurately perceive pricing signals nor ables should be taken into account in assessing the correctly predict their water consumption. impact of IBTs on water demand. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 53 54 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services TABLE 3.1. Strengths and Weaknesses of Tariff Complements Tariff complement Strengths Weaknesses Requirements Context for implementation Core structures Time-of-use (TOU)/ • Operates as peak-load pricing and • Very costly and complex to • Smart metering technologies • Used as a demand management dynamic pricing sends the most efficient pricing implement (requires sophisticated (automated meter reading) strategy when water consumption signals to customers metering technologies and • Management and monitoring presents peak and off-peak periods • Generates incentives to adjust determination of pricing periods) requirements • Applied by utilities to gain better consumption and water savings • Could create a secondary peak • Communication between water knowledge of demand behavior • Cost reductions from automatic during the off-peak period with utility and customers before introducing specific readings, shift of demand to off- adverse impacts for customers who measures and increase awareness of peak periods, and more efficient do not contribute to peak demand eventual leakages network management with discretionary water use Seasonal tariffs • Induce sustainable consumption • Regressive impact on regular • Knowledge about network capacity • Used in cities or countries facing and avoid demand fluctuations to residents when applied in response • Information on household demand increase in certain months achieve financial stability to demand increase due to tourism consumption profiles to establish or seasons (i.e., seasonal tourism) • Promote water savings by (as residents are asked to pay a an overconsumption penalty • Also applied to promote water penalizing high water consumption higher rate while not contributing threshold and differential tariffs conservation and avoid water when demand is higher, or to the demand increase) depending on the season resource depletion in periods when availability is lower water becomes scarce Overconsumption • Induce consumers to reduce their • Can be very regressive for large penalties seasonality and adopt regular water families if the number of people per consumption connection is not considered • Contribute to cost recovery and • Difficult to determine the threshold mitigate network externalities for applying the penalty when network capacity is reached Location-based pricing • Reflects changes in the costs of • Often perceived as unfair as • Information on customers’ location • Relevant for decentralized supplying customers in different customers living farther away are with respect to the water network water service provision and the locations within the utility’s service typically poorer households development of a market for area • Does not promote service microstations and supply systems • As simple and easy to implement as expansion to unserved areas the customer classification method table continues next page TABLE 3.1. continued Tariff complement Strengths Weaknesses Requirements Context for implementation Integrated water reuse • Achieves full cost recovery in both • Complex to implement (depends • Water regulations on the use of • Good option in water-scarce regions pricing potable and reused water services on technical feasibility of a double recycled water as a solution to droughts and • Improves environmental network and setting of the tariff • Sufficient demand and revenue for constraints in resource availability sustainability of water operations levels) reused water • Promotes the use of recycled water • Decrease in potable water demand at a price below its cost can significantly reduce revenues Affordability measures: • Help poor customers pay part of • Risks for water utility’s financial • Information on households’ • Appropriate for targeting not • Free essential the water bill stability and cost-recovery socioeconomic situation only low-income customers but minimum • Flexibility in the amount of the objective • Funding for subsidy from also pensioners, the unemployed, Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services subsidy /rebate, depending on • Does not promote water savings government, utility, or donors and other groups facing payment • Uniform surcharge household’s social circumstances problems and indebtedness • Tariff rebates • Distorts efficiency pricing as • Can target low-income households subsidized households do not face • Vouchers or subsidies and vulnerable groups the full cost of supply • Not always dependent on specific • Requires strong administrative tariff structures capacity (complex to implement and manage) 55 TABLE 3.2. Price Elasticity of Demand Estimates Study PED range Study PED range Sebri 2014 -3.05 to -0.002 Baerenklau et al. 2014 -0.76 Yoo et al. 2014 -0.66 to -1.55 Klaiber et al. 2014 -1.93 to -0.13 Nataraj and Hanemann 2011 -0.12 Kenney et al. 2008 -0.34 to -0.75 Olmstead et al. 2007 -0.33 to -0.61 Dalhuisen et al. 2003 -7.47 to 7.90 Pint 1999 -0.04 to -0.29 Espey et al. 1997 -3.33 to -0.02 Renwick and Archibald 1998 -0.11 to -0.53 Source: Lu, Deller, and Hviid 2017; Asci, Borisova, and Dukes 2016. Note: PED = price elasticity of demand. The environmental aim of IBTs is to prevent responsive to higher tariffs and is particularly relevant excessive and nonessential water consumption by to IBTs. Various studies have investigated the impact high-income customers, based on the assumption of billing frequency on customers’ reactions to price that low-income households consume less water. In changes and have shown that increased billing fre- practice, however, this is not always the case. Low- quency improves customers’ understanding of their income households may be larger than assumed by water usage, allowing them to respond to updated the tariff design and may consume higher levels of price signals. The impact on water consumption is, basic water. Despite these caveats, in the context however, unclear. Frequent bills might make house- of water consumption, there is generally a high level holds more sensitive to higher tariffs and increase of overlap between income and water demand, with PED. On the other hand, as water bills account for a wealthier customers usually consuming more water small proportion of a household’s income, it might for outdoor water use (e.g., gardens, swimming also reduce price sensitivity of demand. pools). High-income customers, however, are typi- Residential water consumption generally displays cally less responsive to price increases in block tar- seasonal fluctuations, which significantly affect PED iffs, as water bills account for a smaller percentage of estimates. Summer water demand has been shown to their income. The evidence on the effectiveness of be considerably more elastic than winter demand, IBTs in promoting water savings is mixed and the and outdoor use more elastic than indoor use conclusion is that IBTs can have a perverse effect on (table 3.3). This makes a strong case for applying IBTs water consumption if there is limited information on as the elastic segment of the water demand curve is the sociodemographic characteristics of households likely to reflect nonessential or discretionary use. and their impact on total water demand. Various empirical findings on the short-run When the frequency of billing increases, customers impacts of IBTs highlight that PED is considerably are likely to have a better understanding of how water higher in the long run, reflecting households’ clearer bills reflect their water consumption. This increased understanding of the IBT structure and their own transparency may allow households to be more consumption pattern. Costly information may limit 56 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services TABLE 3.3. Seasonality of Water Demand Country Study and key findings • Xayavong et al. (2008) estimate water demand in Perth and suggest that a large percentage of water consumption involves nonessential water use for outdoor purposes. Australia • Kenney et al. (2008) assess residential water demand in Aurora (Colorado) between 1997 and 2005 and find that water usage is 30 percent higher in summer months compared to the rest of the year, highlighting that increasing block tariffs should target the more elastic summer period. USA • Klaiber et al. (2014) find that high-volume customers in Phoenix (Arizona) are more responsive to water tariffs in summer, but their elasticity of demand drops substantially in dry years. They also conclude that high-consumption customers are less sensitive to price changes, regardless of weather and season, in line with the earlier discussion of sociodemographic variables. Source: Lu, Deller, and Hviid 2017. customers’ responsiveness to price signals in the rainy season is in winter). Tariffs could be modi- short run. Similarly, it might take a long time to fied to induce customers to use water resources change consumption habits even for customers with efficiently in these periods through environmental more accurate perceptions of their water usage and sustainability complements. willingness to respond to pricing incentives. Tariff structures that best achieve environmental Tariff Complements for Water Conservation sustainability by promoting water savings are those The effectiveness of tariff structures in inducing that incorporate some form of seasonal pricing or responsible water consumption can be enhanced by overconsumption penalties to reduce water con- tariff complements aimed to address environmental sumption during periods of peak demand and/or sustainability objectives. Tariff complements can be lower resource availability: applied to different core tariff structures to create • Seasonal tariffs are the most effective complement incentives toward water conservation and promote to promote water conservation and are based on the sustainable use of resources in water-stressed differential rates to price water depending on the countries, particularly when the utility faces: season. The tariff is higher in periods when water • Demand-side constraints. Some regions experi- demand is higher (e.g., summer/drier months) or ence sharp demand peaks in certain periods of when water availability is low to induce sustain- the year due to tourism, when supply availability able water use. Seasonal tariffs act as a peak-load needs to be increased to match the higher pricing scheme, shifting water consumption demand. toward off-peak periods. • Supply-side constraints. Water becomes scarcer in • Overconsumption penalties consist of adding certain periods of the year (e.g., summer if the a  penalty on regulated prices if water Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 57 consumption exceeds a threshold for a certain generate incentives to adjust consumption to avoid period. This complement is often applied in incurring the higher cost of consuming water during combination with seasonal tariffs. An example is peak hours. This pricing structure is typically used as Santiago (Chile), where customers pay a fixed a demand management strategy and is often applied charge and volumetric rate depending on the by water utilities to acquire information on demand season and incur an additional charge if their behavior before introducing specific water conserva- consumption exceeds a threshold of 40 m / 3 tion measures. TOU tariffs are, however, very com- month during the high season (box 3.2). plex as they require sophisticated metering technologies such as automated meter reading TOU tariffs may also incentivize water consump- (AMR) and there are very few applications in the WSS tion. Time-varying tariffs reflect the underlying cost sector. Various research studies draw out useful of supplying customers at different hours of the day insights on the role of dynamic pricing on water con- and encourage water customers to shift their water servation (see box 6 in background paper 7, listed in consumption toward off-peak periods. TOU tariffs appendix A). BOX 3.2. Seasonal Tariffs and Overconsumption Penalties in Chile Water utilities in Chile apply a penalty on water consumed after a threshold in the high demand season (December to May) to avoid reaching the capacity limits of the water distribution network. The thresh- old is defined by the customers’ average yearly consumption if above 40 cubic meters per month. If consumption in the high season surpasses the threshold, customers pay an additional overconsumption charge on top of the regular tariff. In the case of Santiago, the unit price is more than doubled. FIGURE B3.2.1. Usage Patterns and Tariffs 1.0 Tariff schedule 0.8 Consumption Off- Peak threshold peak 0.6 US$/m3 Fixed 0.77 0.77 N/A charge US$ US$ 0.4 0.35 0.34 0.2 0–40 m3 US$/m3 US$/m3 Variable charge 0 0.35 0.87 0 20 40 60 80 100 >40 m3 US$/m3 US$/m3 Off-peak Peak Source: Termes-Rifé and Bernardo 2015. 58 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services Nonpricing Measures for Water Conservation benefits of water consumption is to enable trading of Price-based approaches to managing water demand water permits and abstraction allocations between offer multiple benefits in terms of ease of implemen- water customers to optimize the allocation of water tation, monitoring, and enforcement. However, the rights while monitoring overall water demand. tariff levels required to induce sufficient reduction in Restrictions on water use or rationing of water sup- water consumption might be too high to be politi- ply to households are typically applied during peri- cally acceptable. In other cases, price does not seem ods of severe water shortages. This is usually done a significant determinant of water demand. by establishing a “water hierarchy” setting out a Therefore, pricing approaches to water demand ranking of priority uses. For instance, drinking water management should be complemented by nonprice supply is typically considered a priority use, interventions to promote water savings among exempted from restrictions on water abstractions. households. An example is the restrictions on washing sidewalks Nonpricing tools to reduce water demand take dif- and driveways and prohibiting lawn and landscape ferent forms, ranging from command-and-control watering as well as filling of swimming pools intro- approaches involving regulatory restrictions, tech- duced during a drought in California (the United nological tools such as water-efficient household States) in the late 1980s. Water use restrictions effec- appliances, and informational campaigns aimed at tively reduced nonessential water use and total increasing public awareness of water scarcity and municipal water consumption by approximately 30 the importance of water conservation. These mea- percent. Water use restrictions are often used in sures can also be used in combination to exert a combination with other nonpricing tools to promote stronger influence on a household’s consumption water conservation when water becomes scarce. patterns. Another water demand management approach is The allocation of water rights and licensing of to improve water use efficiency in houses and build- abstractions are the main tools of integrated water ings. Water-saving devices include low-flow fixtures resource management. Reforms of water rights and such as shower heads and dual-flush toilets, and the refinement of licensing schemes have become an more efficient dishwashers and washing machines. imperative in countries where growing water scar- These can be promoted by local authorities through city poses serious environmental threats. Licensing various means: (1) direct distribution of devices of water abstractions can take many different forms among households is typically triggered during peri- according to legal frameworks in different countries. ods of low availability of water resources; (2) regula- The key challenges with water licensing and rationing tion and standards can also be applied to promote concern the costs and complexities of administrative the uptake of water-efficient appliances during and enforcement mechanisms. Licensing is most periods where water scarcity does not pose effective when licensed volumes are close to water serious challenges; and (3) awareness and educa- demand and tailored to the environmental and eco- tional campaigns can also be an effective means to logical conditions of local water bodies (e.g., season- inform households about the impact of water-saving ality and variability of water flow). Another relevant devices on their water consumption, and therefore and effective strategy for maximizing environmental total water bills, as well as the environment. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 59 The effectiveness of water-efficient appliances in water conservation, several challenges with their reducing water demand and consumption can be implementation exist. reinforced by complementary measures to the instal- lation of water-saving appliances. These include: Alternative Strategies for Ensuring 3.3  Affordability and Increasing Access • Metering technologies. Measuring water usage makes customers more aware of their consump- Increasing access to water is critical to achieving the tion levels and the savings achieved by adopting SDGs. Commonly included as part of the primary more efficient water conservation tools. The role policy objectives, this chapter discusses the chal- of metering and the latest technological innova- lenges of tackling this essential yet conflicting tions in smart metering are discussed in chapter 5. dimension of tariff design. This section explores the • Leakage reduction measures. Water conservation role and effectiveness of tariffs and subsidies in tools can also be an effective means of reducing net- ensuring accessibility, with a particular focus on work leakages. Reducing water losses in the water IBTs, given their global prevalence. A detailed dis- infrastructure is often a difficult task and a major cussion on connection charges and related subsidies driver of inefficiencies. The assessment and moni- is presented before delving into the rationale for toring of leakage levels has therefore become a key nonnetworked services in urban areas. strategy for many utilities. Water leakage reduction Affordability complements can help address the measures usually include improved asset and pres- impacts of tariff structures on different income cate- sure management through regular pipe replacement gories to mitigate the burden of water bills on low-in- and repairs and active leakage control. come customers. These complements include uniform surcharges, cross-subsidies generated However, it is important also to note that poor through IBTs, a free essential minimum, tariff design and inadequate maintenance of devices that rebates, vouchers, and direct subsidies. The key are supposed to be water saving can lead to perverse challenge in designing social tariffs is effectively tar- results. A case in point is the recent study in the geting the households facing affordability con- United Kingdom of dual-flush toilets “wasting more straints, avoiding errors of inclusion or exclusion. water than they save” (The Guardian 2020). Common affordability measures include: Finally, awareness-raising and educational cam- paigns are aimed to drive behavioral change among • Integrated water pricing for reused water. This mech- households and highlight the benefits of water sav- anism consists of strategically setting the prices of ings (box 3.3). Informational campaigns take several potable and recycled water to achieve full cost forms, including the distribution of information recovery in both services. The unit price of reused through websites, social media or mailings, events water is set below its unit cost of production, while and workshops, and efforts to gather comparative the price of potable water is set above costs to feedback and raise awareness of water scarcity recover part of the costs of nonpotable water. Water issues. While the adoption of nonprice measures to reuse schemes are often adopted in water-scarce reduce water demand is an effective tool to promote regions, such as Australia and Cape Verde. 60 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services BOX 3.3. Behavioral Nudges Implemented in Chennai (India) “A nudge is any aspect of the choice architecture that alters people’s behavior in a predictable way without forbidding any options or significantly changing their economic incentives” (Thaler and Sunstein 2009). In a program to save water among residential consumers in Chennai, India, nudges were designed to address behavior bottlenecks identified in consumer discussions, underlying the knowledge-action gap. The intervention sought to encourage two fundamental behaviors: • Pause and think at decision points • Social norms of being frugal and caring about others FIGURE B3.3.1. Example Graphics Informational and reminder stickers were placed at points of water use in households, creating deci- sion points. One of the biggest challenges in behavior change is addressing the attitude of discounting future gains. When future gains are equated with the needs of future generations, they are not so easily discounted. Postcards were also sent out, highlighting: • The plight of have-nots in the rural countryside • Positive actions of peer groups in reducing water consumption • Quantifiable water-saving actions Nudges such as these trigger the pressure of social norms to change individual consumption behaviors. Source: IJBSS 2017. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 61 • Free essential minimum. Some countries have Reducing the Cost of Connections attempted to address the issues of IBTs by intro- Connection charges, particularly one-time charges, ducing a first block that provides basic water vol- can be a major barrier for the poor in accessing water. umes for free. Tax revenues are typically used to Given the positive externalities of access to piped fund this free quantity. water, the social benefits of making connections • Uniform surcharges. These are applied to the unit affordable affect society as a whole. Moreover, maxi- price of water to provide a direct income-related mizing access may also benefit the utility as it ensures subsidy to poorer households. The surcharge the full capacity utilization of its infrastructure. increases the water price for all customers and the Globally, the use of full connections by WSS utilities additional funds are subsequently redistributed varies significantly. Of the 70 countries providing among low-income customers. data to the IBNET database in 2010, at least one util- • Social rebates. Poor households receive direct cash ity in each of 26 different countries provides “free” transfers to assist them in paying a fraction of the water connections (i.e., the connecting party does bill. The amount of the rebate can be determined not pay an up-front connection charge). However, in according to the socioeconomic situation of the most countries (44), no utilities provide free connec- household. tions. Examples of utilities providing free connec- tions can be found across the world (box 3.4). • Vouchers, transfers, and subsidies. These can be When the options to ensure that connections are provided by the government, water utilities, pri- affordable are not feasible or do not go far enough, vate sector, or development partners. Hence, pol- it may be necessary to seek alternative solutions icy makers must take the challenge of coordination and approaches that can reduce the costs of con- into account when designing transfers and subsi- necting to a household (table 3.4). This can be done dies. Vouchers often provide a better solution as by the household opting to provide materials or they can only be spent on water bills. BOX 3.4. Piped Water Access and Connections in Selected Countries The poor often find it difficult to access piped water, for two main reasons: geographical exclusion and high connection charges. That is, service providers may not offer services in areas where the poor tend to live and even if the poor live in areas where services are available, high connection charges may prevent them from connecting. A recent study (Abramovsky et al. 2020), using the latest available household survey data, highlights the importance of focusing on increasing access to services, particularly for the poor. Data from four African countries—Ethiopia, Mali, Niger, and Uganda—show that poor households tend to have a lower probability of: (i) being located in an area where services are available, and (ii) being connected to a water network (conditioned on being located in a service area). In three countries in Latin America and the Caribbean—El Salvador, Jamaica, and Panama—the probability of living in a service area is high for both poor 62 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services BOX 3.4. continued FIGURE B3.4.1. Actual vs. Potential Connection Rates in Select Countries, by Poverty Status a. Actual connection rate b. Potential connection rate South and Southeast Asia South and Southeast Asia 63 84 Vietnam 63 Vietnam 80 Bangladesh 36 Bangladesh 38 16 29 Latin America and the Carribean Latin America and the Carribean 100 100 Brazil 100 Jamaica 100 93 100 Panama 85 Panama 100 82 97 El Salvador 72 El Salvador 95 70 85 Jamaica 56 Brazil 79 Sub Saharan Africa Sub Saharan Africa 47 59 Mali 26 Nigeria 51 Ethiopia 44 45 10 Ethiopia 26 Niger 43 33 4 Uganda 20 26 24 Uganda 5 Mali 4 23 21 Nigeria 21 Niger 3 0 20 40 60 80 100 0 20 40 60 80 100 Connection rate, for those with access (%) Potential access to service area (%) All Poor Source: Abramovsky et al. 2020. and non-poor households (figure B3.4.1, panel b). However, connection rates are significantly lower for poor households (panel a). These countries would benefit from focusing on making connection charges afford- able for the poor. In Brazil, the opposite problem of providing services persists, although where services are available the poor tend not to be excluded. Bangladesh falls in between African and Latin American countries: both service provision and connection rates are low in general, and especially low for poor households. Final- ly, in Vietnam, service provision and connections for the poor are high, with the inference being that policy makers could improve water access by improving expansion of services to unserved areas. Source: Abramovsky et al. 2020. labor or accepting a lower level of service. These Spreading Costs Over Time approaches equate to a subsidy based on self-selec- In some cases, households are willing to pay a tion. An alternative approach is to pursue innova- connection charge but face a liquidity constraint tive, alternative models of supplying WSS services, in doing so. This is because they may budget on a for example, through supplying several households short timescale and lack the ability to save over with a shared connection. time. In such cases, the connection charge can be Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 63 recovered if it is spread over a longer period. This Connection Subsidies can either be facilitated by the utility spreading Connection subsidies are broadly categorized as the cost over time via ongoing use charges, or either targeted (a subset of connecting parties through a third party, such as a microfinance receives the subsidy, e.g., properties in specific organization, covering the connection charge and neighborhoods or properties below a predefined subsequently recovering the costs from the household income threshold) or untargeted (e.g., all households (table 3.5). connecting parties receive the subsidy). Given that it TABLE 3.4. Reducing Connection Costs Approach Description Evaluation Self-provision of labor and Households contribute labor and/ Opportunity to engage households and lower administrative materials or materials to lower the connection costs cost Only feasible in smaller communities Quality of connections may be poor without clear guidelines and supervision Provide Lower-cost Smaller connections, connections Reduce costs and facilitate additional connections alternative connections using cheaper materials or ones that May not be efficient in the long run solutions only reach the yard are laid instead Disparities in service quality Shared/ Connection is provided to a group of Reduce costs significantly condominium households Useful in informal or dense, low-income settlements connections Exploit scale economies Universal service obligations lead to Reduction in average cost of connecting scale economies High administrative costs Some households may continue to face barriers Source: Original compilation. TABLE 3.5. Spreading Connection Charges Over Time Approach Description Evaluation Absorb connection costs Connection costs are fully absorbed into Reduces barriers to connection into the regulatory asset the utility’s RAB and recovered through Benefits from economies of scale and lower administrative costs base (RAB) consumption tariffs Small additional financing costs Absence of price signals Explicit recovery through Connection costs are recovered through Recovered as a customer-specific asset bills the connected households’ water bill Utility can offer financing at a lower cost than the customer Microfinance Microfinance lenders provide a loan to Households can opt in to a financing scheme cover the connection charge Need to pay financing charges Opportunity for partnerships between utilities and microfinance organizations 64 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services is predominantly poor households that are not con- benefits to this approach, including its simplicity for nected, the lack of a connection acts as a proxy for regulators and utilities to administer and for custom- being poor. This means even untargeted connection ers to understand. Further, it significantly reduces subsidies can be an effective way to target subsidies the up-front capital costs for network connection, toward the poor, particularly when compared to incentivizing network connections that increase the common consumption subsidies. customer base and can drive down average costs There are two key untargeted subsidies: full subsi- across all customers through economies of scale and dies and a subsidized interest rate for connection loans scope across WSS networks. Data indicate that utili- (table 3.6). Targeted subsidies include flat charges and ties with a full subsidy for connections tend to have administratively selected subsidies. Within this con- higher levels of access than those that do not, which text, there may also be no subsidy at all. can be observed through variation in connection The most comprehensive subsidy is to fully subsi- subsidies for utilities globally. However, full subsi- dize the connection charge. There are multiple dies can be very expensive for the taxpayer or the TABLE 3.6. Subsidies for Connection Charges Subsidy Description Evaluation Untargeted Full subsidies Government pays for the connection Easy to understand and administer. charge for all new connecting Significantly reduces barriers to connections, lowering average customers. costs as customer base increases. No price signals, leading to inefficiencies and potentially higher costs. Expensive to implement, requiring transfers. Subsidized Government subsidizes the interest Removes high up-front costs as connecting parties are interest rate rate for financing of new connections. incentivized to take out a loan with low-interest payments Targets all new customers using (rather than paying the full connection cost up front). finance. Locational price signals intact. Easy to understand and administer. Reduces incentive to choose low-interest debt and can cause inflation of interest rate by debtors. Targeted Flat charge Same connection charge for all new Removes connection barriers to those with the highest costs residential customers. Indirectly and thus the largest barriers. targets new customers with The flat charge can subsidize all customers if it is set low connection costs above average. enough (i.e., if it is not simply set at the level of average cost). Simultaneously removes locational price signals. Highly simplistic. Poor targeting. Administrative Subsidies based on geographical More accurate targeting, but not necessarily perfect. selection discrimination, means testing, etc. Requires costly administration. Directly targets new customers meeting the requirements. Can include developer charges. Source: World Bank 2019; Irish Water 2018; Ofgem 2003. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 65 donor providing the subsidy. Further, there is a dis- The subsidy removes barriers to connections for tortion in locational pricing. That is, connecting cus- those with higher costs, and thus the highest barriers tomers do not seek to connect to the network at a to connection. If set below the average connection location with lower connection costs, which may charge, a flat charge can also target customers with include remote infrastructure costs to support addi- -than-average costs. This approach can be lower​ tional capacity. This can lead to cost inefficiencies credited for its simplicity. It may also be particularly that undermine the gains achieved through econo- effective where the cost of connecting low-income mies of scale. Without cost-reflective pricing, there is households is generally higher than connecting also a risk of asset stranding. richer households, as low-income households could A subsidized interest rate for loans to cover the be situated in geographically difficult locations or are up-front capital costs might allow a party to over- poorly accessible, leading to higher costs. come the high up-front connection costs by taking However, this is not always the case and if out a loan if they ordinarily could not afford the full low-income households—for example, in urban or debt interest payments (box 3.5). It could therefore peri-urban areas—face a marginal connection cost incentivize an increase in connections without lower than the average, such an implicit cross-subsidy expensive subsidies of the full cost. The approach could be poorly targeted. It simultaneously erodes also ensures that relative locational price signals are the locational price signal and allows inefficient intact, which prevent inefficiencies associated with connections at the expense of existing customers. full subsidies. Further, the approach is simple to The indirect targeting may also fail to reach customers understand and administer. As a degree of self-selec- who merit a subsidy. For example, a large dwelling on tion is required in taking out such a loan there may the outskirts of a settlement would have higher con- be an element of targeting of such subsidies, as only nection costs than a small dwelling within the settle- households who face a liquidity constraint require ment, yet the former would receive greater subsidies such a loan. However, a subsidizing interest rate than the latter. This subsidy also necessitates that could diminish the incentive to choose low-interest there is a sufficiently large number of households that options or could result in the inflation of interest face a connection cost below the average and are will- rates by debtors, so careful policy design is required. ing to pay an above-average charge. A flat charge is a flat connection charge for all new An administratively selected subsidy directly customers. It indirectly targets new customers targets subsets of new customers, for example, whose connection costs are above average. households in certain neighborhoods with large BOX 3.5. Interest-Free Loans in Tangier, Morocco In 2007, Amendis, the utility serving Tangier, Morocco, initiated a social connection program. This of- fered low-income households in three zones in the city a water (and sanitation) connection at full price with interest-free credit. The credit could be paid at US$15 a month over a three-, five-, or seven-year period, depending on the zone’s distance from the grid (which determined the cost of connection). Source: Devoto et al. 2012. 66 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services proportions of poor residents, households earning Subsidizing Adaptation Costs below a predefined income threshold, or those Although these have often received little attention with a certain plot size (box 3.6). This approach is from utilities and policy makers in the WSS sector, more precise than indirect flat charges. However, these adaptation costs form a crucial complement to there is a trade-off within administrative a piped connection. Consequently, the barriers to approaches; geographical selection is cheaper but paying adaptation costs must be addressed in tan- less precise than means testing. The cost here dem with the barriers to connection charges. refers to the level of administrative work required Adaptation costs are simpler than connection for implementation. charges as there are no remote costs, meaning assets BOX 3.6. Subsidies Based on Plot Size in Hyderabad, India In Hyderabad, India, connection charges are distinguished by the size of the plot for the property requesting connection (and individual houses are considered separate from multistory apartment buildings). Smaller properties pay lower fees, for example, a house on a plot size of less than 200 square meters (m2) pays a fixed charge of only ₹2,500, while a household on a plot of 400 m2 pays a fixed charge of ₹90,000 (figure B3.6.1). The intention of this approach to subsidies is to target poorer households, under the assumption that lower-income households are on smaller plots of land, without requiring expensive means of testing or other more complicated approaches to administrative targeting. FIGURE B3.6.1. Connection Charges Across Various Water Connection and Plot Characteristics Size of water Plot area in square conection meters Connection charges Rate per each square meter of plot area in excess Fixed mm Inches From Up to of the area in column(3) to be added to amount the fixed amount in column(5) 1 2 3 4 5 6 up to 200 Rs.2,500 Nill 81 200 Rs.2,500 Rs.47.92 201 300 Rs.8,250 Rs.82.50 15 1/2 301 400 Rs.16,500 Rs.75.00 Rs.24,000 Rs.60,000 401 and above Subject to a maximum of Rs. 48,000/- Up to 200 Rs.15,500 Nill 201 400 Rs.15,500 Rs.150.00 20 3/4 Rs.45,500 Rs.75.00 401 and above Subject to a maximum of Rs. 72,000/- Up to 400 Rs.90,000 Nill 25 1 Rs.90,000 Rs.90.00 401 and above Subject to a maximum of Rs. 1,80,000/- Source: HMWSSB 2020; ADB 2010. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 67 are simpler to confine to the connecting property. property to accommodate the WSS connection. This Again, the discussion can equivalently be framed in could include full installation of bathrooms, drains, terms of the subsidies connecting parties receive to plumbing, or the installation of individual fixtures, cover these costs. There are two key untargeted subsi- such as toilets (World Bank 2019). A problem is that dies: partial subsidies and a subsidized interest rate some households cannot afford these often-over- for loans to cover adaptation costs (table 3.7). Targeted looked adaptation costs due to high up-front costs, subsidies include self-selected and administratively which can produce a barrier to connecting. selected subsidies. There may also be no subsidy at In the case of partial subsidies, the cost of adapta- all. An alternative to subsidies is to adopt an approach tion is partially covered through subsidies. This has used in the energy sector whereby energy service most of the strengths and weaknesses of fully subsi- companies provide services to customers, typically dizing the connection charge, although locational around energy conservation, and recover the costs of price signals are irrelevant. The cost per household is these investments from the utility via on-bill financ- also low, representing a lower cost than subsidies for ing. This approach helps households address liquidity sewer networks and wastewater treatment works, constraints in paying adaptation costs. which are typically ongoing over years (GIZ 2019). Without subsidies, the connecting party is Furthermore, if one household can buy a toilet expected to pay the full cost of adapting their through subsidies, it may further encourage nearby TABLE 3.7. Subsidies for On-Premise Adaptation Costs Subsidy Description Evaluation No subsidy Connecting party must pay the full High up-front costs can produce barriers to connection, adaptation cost. particularly in low-income countries. Untargeted Partial subsidies Government pays toward the Similar strengths and weaknesses as untargeted subsidies adaptation costs for all new for connection charges, but locational price signals are customers who require adaptation. irrelevant. Subsidized Government subsidizes the interest Subsidizing private assets may be unpopular with existing interest rate rate for financing adaptation where customers, policy makers, and development financiers. new customers are using finance to Postconstruction subsidies can be conditional on meeting cover its costs. government standards. Low implementation cost per household. Can encourage nearby houses to purchase a toilet or latrine too. Targeted Self-selection Subsidies for customers providing Similar strengths and weaknesses as untargeted subsidies for materials/labor, or for certain connection charges. service levels or technical designs. No locational price signals. Directly targets new customers Subsidizing private assets may be unpopular with existing choosing these. customers despite positive externalities of more connections. Administrative Subsidies based on geographical selection discrimination, means testing, etc. Directly targets new customers meeting the requirements. Source: World Bank 2019. 68 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services households to get a toilet, overcoming behavioral or consumption or billed according to their water usage. cultural barriers to increasing access (Rosenboom Flat rates are the simplest tariff structure for shared et al. 2011). Further, it can ensure that facilities are taps as each customer household pays a fixed fee constructed in line with government standards if the regardless of the water consumed. In its simplest subsidies are given post construction. form, the total amount of money required to operate A key distinction from subsidizing the connection and maintain the water system is equally split charge is that the subsidy covers private rather than between the number of households using the water. public assets. Although there are positive externali- Flat rates are easily applied to shared taps or commu- ties from reducing the barrier to connections associ- nity standpipes when the customers are known and ated with the subsidy, subsidizing private assets can feature similar consumption profiles. Flat rates, be unpopular with the public and policy makers. however, raise several problems as they impose a Further, and perhaps linked to this negative percep- heavier burden on low-income households and do tion, is that development financiers typically finance not take into account the amount of water con- larger projects related to infrastructure and the sumed. Once it becomes clear that certain house- behavioral change of citizens than programs involv- holds consume considerably larger volumes of water ing a multitude of small transactions (GIZ 2019). than others, it is preferable to fit a meter and charge However, recognition has been growing that current customers for the exact amount of water consumed. approaches to WSS subsidies must challenge precon- As households are collectively responsible for pay- ceptions to overcome existing shortfalls in perfor- ing the water bills, shared yard taps and communal mance seen in practice (World Water Week 2020). standpipes face several challenges: Greater openness to subsidizing private assets could • High consumption rates. The collective water be part of this development process. Many of the consumption of a group of households may same parallels can be drawn between interest rate exceed the lifeline block established by the util- subsidies for loans covering the connection charge ity and could result in families having to pay a and the adaptation costs. higher average tariff than wealthier customers As with the connection charge, administrative or with a private household connection, depending self-selection can be used for targeting connecting on the structure of the tariff. Utilities should parties for subsidies. Again, these bear similar therefore consider the number of households strengths and weaknesses to their connection charge served by each connection when calculating the counterparts, and subsidizing private assets may shared water bill. Multiplying the number of prove unpopular with existing customers on the net- households using the standpipe by the lifeline work, despite positive externalities. Due to adminis- tariff allocation could be one way to prevent trative limitations in low-income countries and low-income customers from paying commercial incomplete records of low-income residents, geo- rates. graphical targeting is sometimes relied upon for tar- • Free riding. Shared yard taps and public standpipes geting these. are not usually staffed and rely on trust and social Leveraging Nonnetworked Services cohesion among community members to ensure Customers with access to shared yard taps are typi- that every household pays its share of the water bill. cally either charged flat rates for unrestricted water A key issue with communal standpipes is that some Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 69 customers will pay their water bill while others may The underlying cause of high standpipe water prices not, increasing the risk of disconnection by the util- therefore lies with the price-setting agent operating the ity if there is a shortfall in the payments. standpipe or kiosk, who may be a private individual or Disconnections penalize all customers, regardless of community member under a delegated management whether they paid their share of the bill or not. model. In standpipes and kiosks managed by utility Hence, utilities need to implement solutions to staff, there is no price-setting agent and the tariff paid avoid this outcome. One option is to create water by customers is more likely to match the formal retail customer associations among participating house- price. Meanwhile, where kiosks and standpipes are not holds with responsibility for payments of bills. directly regulated by the utility or regulatory agency, customers are likely to incur a disproportionally higher Public standpipes and kiosks are located in a public tariff, due to the lack of resources and monitoring place and shared by several households individually capacity of local authorities. paying the bill. This option is most appropriate for Hence, standpipes and kiosks should ideally be densely populated low-income communities with operated by utility staff or by private operators with small infrastructure investment requirements and light-handed regulation to close the gap between for- can be efficiently managed through prepayment mal and informal tariffs and ensure affordable access mechanisms. The initial versions were prepayment to water supply among poor households in off-grid standpipes, which have recently come to be referred areas. Utilities can absorb the costs of supply through to as water ATMs. Prepayment mechanisms are imple- economies of scale and charge lower tariffs than pri- mented through customers topping up electric card vate operators, ensuring that the cross-subsidy systems or tokens (increasingly through mobile phone applied for nonnetworked services targets poor cus- transactions), and then drawing whatever quantity of tomers in informal settlements. Alternatively, private water they would like to buy at any point in time. operators can supply these services subject to Recognizing the affordability constraints of custom- increased light-handed regulation to prevent stand- ers relying on communal standpipes and water taps, pipe attendants and kiosk managers from applying a utilities typically set formal/wholesale standpipe prices markup on formal tariffs. A third option gaining below the unit price applied to private household con- greater traction and on course to become the domi- nections. As most households living in rural and nant model in the future is fitting prepaid meters or income segment peri-urban areas fall within the lower-­ water ATMs as a means of avoiding the markups of the population, standpipe prices are usually subsi- charged by intermediaries to pass on additional costs dized to allow these customers to benefit from afford- to households and absorb the costs within the overall able water services. However, evidence from several costs of the utility. countries shows that the prices charged by standpipes or kiosk operators can be considerably higher than net- Mobile Vendors worked water supply, even higher than the tariff paid Many people in villages, small towns, and rural areas by low-consumption piped customers. throughout the developing world are served by ven- While numerous utilities and governments are dors taking the water from available sources and increasingly trying to set a formal retail price for stand- delivering it in containers (jerry cans or storage tanks) pipe water, standpipe managers tend to determine to households. This category of nonnetworked water the  final “informal” tariff paid by customers. service provision includes pushcarts, animal-drawn 70 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services carts, and tanker trucks. Regardless of the delivery the extent to which customers rely on alternative method, the distribution of water by mobile vending water providers. remains quite expensive when compared to alterna- Another survey of water tariffs applied by different tive service providers, due to the cost of delivering types of mobile vendors was carried out in 2010 water directly to households. Prices for water vending among households and small-scale service providers can be set competitively or determined at various in peri-urban and urban areas of Nairobi (Kenya). points in the vending system. For example, distribut- The water supply system in Nairobi involves a broad ing vendors may buy water from wholesale vendors range of service providers. In addition to the water with monopoly power. On the other hand, wholesale utility supplying individual households as well as vendors may compete freely unless distributing ven- fixed-point sources through piped connections, dors organize themselves to control prices. water carters and tanker trucks serve households on Data from the Africa Infrastructure Country the outskirts of the city. Details on the price-setting Diagnostic (AICD 2007) WSS database show that strategy of different service providers show the there is little difference in the tariff charged by differ- importance of various factors when setting tariffs. ent types of mobile vendors (water carters and tank- The average water tariff across vendors and the range ers) in Sub-Saharan Africa, possibly due to the strong of water unit prices charged by service providers (as competition between the two categories of service well as the share of households they serve) are illus- providers in many areas lacking access to private trated in figure 3.3. connections to the network. Water tariffs vary con- Pushcart vendors and tanker trucks charge the siderably across cities and countries, depending on highest average tariffs for water and exhibit the FIGURE 3.3. Average Water Pricing across Vendors in Nairobi, Kenya 25 20 Kshs per 20-liter jerry can 15 10 5 0 Pushcart Tanker truck Borehole Tap water Water kiosk vendors vendor Mean Min Max % of HH served Source: Original elaboration, based on UNDP (2011). Note: HH = households; Kshs = Kenyan shillings. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 71 highest degree of price differentiation. This suggests Interventions aimed at removing mobile vendors that despite setting their tariffs based on the price from the market are likely to push these operators charged by competitors, pushcart vendors also col- back into unemployment. This is expected to further lude on prices. Approximately one-third of carters undermine the precarious livelihoods of already vul- declared setting prices based on a cost markup (sup- nerable households. Pro-poor interventions should porting the hypothesis of price collusion). Critically, therefore aim to reduce the poverty premium paid by the Nairobi survey also found that low-income customers while considering service providers. households buying water from pushcart vendors pay While mobile vendors should be granted some form over 30 times the tariff charged by the utility through of legal recognition, applying very stringent regula- a piped connection. tions is likely to drive them out of business. This will The higher water tariffs likely reflect the wider not only push many service operators into unem- range of water resources mobile vendors rely on and ployment but also deprive informal dwellers of their discretion in setting prices. The large price vari- access in a context where the main utility may not be ance also captures the lack of regulation of this type able to fill that gap. Light-handed regulation is a of small-scale water provider, which remains largely means to achieve this: unregulated in terms of tariffs and service quality. • A potential strategy to formalize independent pro- Water kiosks and tap vendors, on the other hand, viders was adopted in Colombia (see box 10 of offer lower tariffs on average, reflecting the higher background paper 13, listed in appendix A). degree of compliance with official water tariffs, par- • Without a regulatory agency with legal powers, ticularly in the case of licensed kiosks buying water customers could alternatively be mobilized to at a subsidized bulk rate from the utility. Mobile ven- insist on lower water tariffs or municipalities dors tend to charge higher tariffs given that their could publish the water prices charged by differ- main reason for entering the market is often unem- ent vendors to ensure fair pricing and reduce ployment. Most tanker trucks and carters start oper- markups. ations because they need a source of income and mobile vending is perceived as a profitable activity. Box 3.7 summarizes best practices for regulating In contrast, tap vendors and kiosks are mainly driven informal water providers, as observed in Colombia by community needs to enter the business. and Peru. BOX 3.7. Differentiated Regulation of Informal Water Providers in Colombia and Peru In the 1990s, Colombia introduced a comprehensive sector policy of decentralization to increase water and sanitation investments through targeted transfers to municipalities, improving service quality and efficiency by promoting private sector participation where public utilities were not performing well, establishing autonomous regulatory agencies at the national level, increasing cost recovery, and protect- ing the poorest through cross-subsidies in the form of area-based tariffs. 72 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services BOX 3.7. continued There are several different delivery models available for WSS provision in Colombia. Service provid- ers that wish to be considered “public service providers” have to follow a registration procedure at the Superintendency of Public Services (Superintendencia de Servicios Públicos Domiciliarios, SSPD), monitoring and enforcing the performance of WSS operators. Nevertheless, the population outside small towns is too dispersed to make centralized water supply economically viable, and many organizations still provide WSS services informally without having registered at the SSPD. TABLE B3.7.1. Tariff Differentiation by Provider Size in Colombia Large providers Small providers The tariff methodology is based on a “building block” approach The tariff methodology applying to small providers serving less with operation and maintenance costs set based on target than 5,000 connections in urban areas and rural operators aims levels to incentivize efficiency improvements and capital costs to ensure affordability by making provisions for government passed through based on actual expenditures to minimize the contributions to the investment cost, rather than setting a risk to service operators. maximum tariff. Tariff Tariff Fixed charge Government (national Consumption charges User per user & local contributions) Administrative Environmental Administration, OPEX CAPEX CAPEX costs cost O&M Note: CAPEX = capital expenditure; O&M = operation and maintenance; OPEX = operating expenditure. To address the issues of informal service provision, and minimize the number of nonregistered providers, the SSPD issued a regulation defining the procedures for the subscription, update, and cancellation of WSS providers in the national register, splitting service providers between: • Large providers which are subject to regulation and may therefore only charge regulated tariffs for the provision of WSS services. • Small providers which are subject to a different tariff methodology as of 2014. They can be registered with the SSPD or unregistered. In the latter case, they are considered informal providers as they do not follow the legislation or the norms related to the provision of WSS services. Regulating the rural and peri-urban WSS sector remains a big challenge in many Latin American coun- tries. Throughout the past 20 years, the heavily decentralized structure of the WSS sector in Colombia and the distinction between large- and small-scale service providers has proved a useful source of knowledge for many other countries (Baskovich 2018). In Peru, a recent reform in the WSS legal framework has extended the regulatory role of the Superin- tendence of Water Supply and Sanitation Services of Peru (SUNASS) beyond urban areas to include small towns and rural communities. In the attempt to develop a regulatory framework for small and rural water operators, SUNASS has been exploring different regulatory models to gain key insights into what tariffs should be charged in these cases. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 73 3.4  Simulating the Effects of Different other customers, for example, nonresidential have Tariff Structures on Efficiency and to pay a significantly higher tariff to fund the sub- Affordability sidy. The more targeted tariffs are, the more afford- One of the most pressing challenges faced by water ability can be addressed without compromising cost utilities, particularly in developing economies, is recovery and efficiency. how to make water tariffs affordable for low-income A simulation1 was designed to test a tariff struc- residential customers without inadvertently also ture’s ability to achieve affordability without com- subsidizing other customer categories with greater promising cost recovery and with minimal distortions ability to pay. For example, under an IBT tariff, all to economic efficiency (figure 3.4). Two policy objec- residential customers typically receive the first block tives were held constant—cost recovery and afford- of water consumption at a low rate, regardless of ability—while tariff levels were varied to achieve the income. When some customers are subsidized best economic efficiency. Theoretically, the tariff unnecessarily, the subsidy “burden” is higher, and structures that result in the least distortion to eco- assuming there are no external sources to fund the nomic efficiency will be the most targeted and are subsidy, either cost recovery is compromised or therefore optimal. FIGURE 3.4. Efficiency Ranking of Core Tariff Structures and Complements CORE TARIFF STRUCTURES TARIFF COMPLEMENTS Tariff TOU / Location- Over One- Two-part Jump tariff Affordability Flat rate IBT DBT Dynamic based consumption objective block tariffs (VDT) measures pricing pricing penalties PRIMARY OBJECTIVES Cost recovery 2 3 4 2 3 2 4 3 3 2 Economic 1 2 4 2 3 2 4 3 3 1 efficiency Affordability 2 2 3 4 4 1 2 1 1 4 and equity SECONDARY OBJECTIVES Environmental 1 2 2 3 3 1 4 3 4 2 sustainability Simplicity and ease of 4 3 3 2 2 2 1 3 3 2 implementation Transparency 1 4 4 2 2 2 4 3 3 2 Acceptability 3 4 4 2 2 1 3 1 3 2 Financial 4 2 3 2 2 2 4 3 4 2 stability Note: IBT = increasing block tariff; DBT = decreasing block tariff; TOU = time of use; VDT = volume-differentiated tariff. Full methodological details are included in background paper 12, listed in appendix A. 74 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services The appropriateness of tariff structures depends as fixed costs are spread across increased con- very much on the country- and utility-specific cir- sumption), but are rarely applied because they cumstances. Nonetheless, this analysis illustrates make tariffs less affordable for low-consumption the trade-offs inherent to different tariff structures— customers and do not encourage water some are better than others at improving affordabil- conservation. ity without too much distortion to efficient price • One-block tariffs (without fixed charges) are gen- signals. In summary: erally worse than two-part tariffs, because they do a poorer job reflecting the underlying cost of • When affordability concerns do not pose signifi- supply. cant constraints, two-part tariffs send the most efficient pricing signals because they can reflect • Flat rate tariffs (fixed charge only) do nothing to both fixed and variable costs of supply. However, a incentivize efficient water use and make afford- large proportion of water supply costs are fixed ability challenging and should therefore be and having a high fixed charge often does jeopar- avoided. dize affordability. The more utilities shift recovery of fixed costs to volumetric charges, the less effi- 3.5 Conclusions cient the tariffs become and jump tariffs start to Tariffs serve multiple purposes, such as allocating become a more efficient option. the costs of service among customers and creating • When affordability is challenging, jump tariffs (also incentives to affect the production and improve the known as VDTs) are preferable to IBTs because they use of water. Tariff design therefore inevitably entails cross-subsidize in a more targeted manner and trade-offs between different, often conflicting, pol- therefore send more efficient price signals. Because icy objectives. Such trade-offs can potentially be jump tariffs do not subsidize the first consumption mitigated through the application of tariff comple- blocks of high-consumption customers (as IBTs ments. These include affordability measures to tar- do), the tariffs for high-consumption blocks do not get lower-income households or efficiency concerns need to be as high and therefore can be closer to to ensure that customers are charged according to efficient levels. their underlying costs of supply. The challenge of • Despite jump tariffs being a more effective means water tariff design therefore consists of achieving an of cross-subsidizing, IBTs are still commonly used, appropriate compromise. perhaps because they are perceived as fairer. IBTs Tariff complements can be used alongside the also have the advantage of not leading to a large core structures to target specific objectives. jump in the water bill when a customer moves Dynamic tariffs that reflect the real-time cost of from the upper reaches of one block into the lower supply are the ultimate means of encouraging eco- reaches of another. nomic efficiency. They are particularly useful • DBTs are useful in cases where affordability is not when costs vary significantly by time and there- a concern but the utility is unwilling to set high fore provide an incentive for large consumers to fixed charges, perhaps because they are unpopular shift water consumption to off-peak periods. with customers. DBTs capture the same econo- However, they are very costly and complex to mies of scale effect (of average costs coming down implement as they require smart metering Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 75 technologies. But they are expected to be increas- economies, the proportion of poor customers is ingly used in the water sector, as seen in the elec- much higher, and targeting them is problematic. tricity sector in recent years. Ideally, this should not be made the responsibility of Price-based approaches to manage water demand the water utilities, whose core business is supplying offer multiple benefits in terms of ease of implemen- water rather than alleviating poverty. tation, monitoring, and enforcement. However, Having tariffs that focus on the sustainable household demand is not highly responsive to financing of utilities, with affordability being changes in water tariffs in many countries. At the addressed through nontariff interventions, is rela- same time, required tariff increases to induce suffi- tively rare. For a variety of reasons, including the cient reduction in water consumption might be too inherently political nature of the tariff-setting pro- high to be politically feasible. Therefore, pricing cess, tariff structures that claim to be pro-poor will approaches to water demand management should be continue to be designed and applied. The most complemented by nonprice interventions to pro- common structure is an IBT with the first block mote water savings among households, ranging from being a heavily subsidized “lifeline” centered on a command and control approaches, water-efficient minimum amount of water required for basic lev- devices, or informational and awareness-raising els of water consumption. The free essential mini- campaigns. mum model is a variant of this. As the success of water conservation plans in Addressing poverty through the provision of water reducing water demand has often been achieved by therefore requires finding ways of ensuring that the the combination of multiple price and nonprice majority of low-income households do gain access interventions, an integrated approach to water to water that is properly treated by the utility. demand management with better pricing schedules Reduced tariffs for intermediate technological solu- that reflect the true cost of water and promote water tions have been shown to work. An alternative solu- savings among high-volume customers as well as tion is to spread the cost of the connection over a nonpricing incentives to install water-efficient fix- longer period. This can be achieved through the tures and reduce nonessential water use is recom- utility providing an indirect loan to the household mended. This has more recently come to the fore in and recovering the cost over a longer period or light of the significant impact the COVID-19 pan- through a third-party microfinance organization. demic has had on household water demand. This is particularly effective in situations where Using the structure of water tariffs to address pov- households may be able to afford the connection but erty is a blunt instrument. Economic theory and struggle to make a large up-front payment. These practical experience in cross-subsidy systems of dif- measures can also be combined with subsidies (e.g., ferent forms lead to the conclusion that water tariffs subsidized interest rates) to reduce the cost to the should be designed to secure financing for sustain- household while reducing the overall level of subsi- able service provision, while affordability is best met dies required. through targeted social measures. This is easier to Finally, utilities may seek to reduce the cost of con- achieve in developed countries, which have estab- nections. This can be done through offering alterna- lished social welfare systems through which the tar- tive, lower-cost solutions, including connections get beneficiaries are already defined. In developing shared by several households. Such measures may 76 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services be necessary to ensure that access to piped water can are therefore disproportionally affected by unregu- be achieved in rapidly growing urban settlements. If lated pricing of water services and the poverty pre- a universal service obligation requires a utility to mium applied by informal water service providers. provide connections to all households and the con- Although most water government strategies include nection barriers are overcome through a selection of nonnetworked water supply, subsidies are primarily the above measures, economies of scale can be targeted at networked services, benefitting the achieved, lowering average connection costs. wealthiest customers at the expense of sustainable Informal service providers often charge higher tar- service provision. iffs, severely penalizing customers in off-grid areas. Meanwhile, it is the poorer segments of society that Note are forced to rely on nonnetworked services. These 1. Full methodological details are included in background paper 12, customers typically live below the poverty line and listed in appendix A. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 77 © Getty Images CHAPTER 4 Regulatory Levers to Control Pricing and Increase Efficiency No discussion of tariff design would be complete without considering the role of regulation. Given the potential for natural monopolies and significance of affordability, the case for regulation is not difficult to make. Tariff regulation does not exist in a vacuum but forms part of the overall regulatory environ- ment in the water sector that pertains to service standards for water quantity and quality, accountability and governance, and regulatory standards for performance. Tariffs are directly affected by price or revenue controls and indirectly affected by regulatory standards. For instance, regarding service ­ quality and quantity, a discussion of prices and revenues naturally leads to a conversation on incentivizing cost efficiency and inducing cost cutting through regulation. There is no “one-size-fits-all” solution for the economic regulation of WSS services, and importing regulatory models designed for other countries is seldom a wise option. In this context regulatory arrangements should be suited to the specific needs of the country. But first, the desired objectives should be defined and the potential contribution of economic regulation to the overall sector accountability framework identified. Next, the regulatory functions and choice of legal instruments and organizations within which to embed them should be identified (McPhail, Locussol, and Perry 2012). This chapter begins by outlining the rationale for regulation before entering a discussion on the relationship between price controls and revenue. The chapter then discusses the regulation of tariffs and services and the four primary mechanisms through which a comprehensive regulatory regime can be achieved: command and control, suasive instruments, economic instruments, and cus- tomer empowerment. Finally, the chapter concludes with a discussion on the importance of transparency, and offers practical solutions to realize this goal. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 79 4.1  Rationale for Regulation fixed investments. A third situation is where the In competitive markets, firms compete to sell their existence of market power also creates the opportu- products and services. A key parameter upon which nity for utilities to price some services below and customers base their purchase decision is price, others above cost to prevent competition, through resulting in downward pressure on a firm’s prices predatory pricing, thus creating unfair competition toward the short-run marginal cost (SRMC), inclu- for existing competitors and barriers to new entrants. sive of a competitive profit margin. Since water sup- Regulation is a policy intervention that aims to pro- ply networks exhibit economies of scope and scale mote sector goals in the public interest—balancing (primarily due to high start-up costs), and average the competing interests of the various stakeholders costs typically are higher than marginal costs, it is to generate second-best outcomes. Economic regula- more efficient for a single utility to provide all ser- tion refers to the “setting, monitoring, enforcement, vices within a defined area, creating natural monop- and change in the allowed tariffs and service olies. This can lead to situations where the monopoly standards for utilities” to affect the behavior of con- adopts pricing strategies that can lead to departures sumers and utilities, eventually leading to more from allocative efficiency. For instance, this market efficient outcomes (Groom et al. 2006). power allows utilities to sell at a price above the Determining what constitutes fair or competitive SRMC with a supernormal profit margin, resulting in costs is not straightforward, as there is information network tariffs that are “too high.” At the other asymmetry between the utility and regulator on how extreme, under a monopoly, those utilities driven efficiently the utility is operating. In a competitive only by social welfare maximization motives would setting, firms naturally compete to lower their costs incur losses if they follow marginal cost pricing since in order to lower their prices, or ease of entry allows they will not be able to cover the cost of up-front more competitors to join the market and the exit of FIGURE 4.1. Rationale for Regulation Promote sector goals Leading to more in the public interest efficient outcomes 80 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services the higher-cost ones. Water utilities do not face this A second area of increasing concern in the present pressure due to their monopolistic characteristics. context of climate change and climate variability is This can lead to overall costs far exceeding competi- the need for regulators to ensure that water scarcity tive costs, known as “X-inefficiency.” Another is reflected in prices, especially given the service primary role of regulators is thus to incentivize utili- provider’s limited incentive to accomplish this. ties to cut their costs even without the regulator Furthermore, in the absence of regulation, opportu- necessarily fully knowing the utility’s efficient costs, nity costs associated with competing water demands due to information asymmetries. are generally not properly addressed. For example, In markets with many sellers, customers also base since supplies are finite, the abstraction of irrigation their purchase decisions on quality of service, result- water means the same water cannot be used for ing in pressure on firms to offer a better quality of drinking. In a regulatory vacuum, the monopolist is service than their competitors (or to offer lower free to impose these costs on third parties to maxi- prices for lower quality). This situation may be rele- mize profits at the expense of the best interests of the vant in those segments of the water market where wider sector and beyond. informal providers tend to operate. However, in many cases, the customer is limited to a single water 4.2  Controlling Price and Revenue provider. Without adequate regulation, the market The overarching administrative arrangement gov- power of the utility allows it to reduce the quality of erning price controls can take various forms that dif- service to customers and increase its profits and fer across countries, usually according to their legal extract rent from customers. Thus, a role of the regu- context. The most common administrative arrange- latory framework is to account for this perverse ments for regulation include regulation by an agency incentive and ensure quality of service commensu- or a municipality, or a contract between the govern- rate with customer needs and wants. This problem is ment and utility. Two regulatory instruments are also compounded by the pervasive information used in mitigating monopoly pricing under these failures in the sector, for example, the quality of regimens: price (tariff) controls and control of drinking water is not readily discernible and there- revenue earned from prices (tariffs). fore consumers might lack the capacity to determine Within each of the administrative arrangements, the required standard. the price or revenue control mechanism must spec- In providing services, utilities also produce envi- ify how often the control is updated and whether the ronmental and opportunity costs. When utilities do control should be determined using the utility’s not provide clean water devoid of chemical or bio- actual costs or forecasted costs. Based on these fac- logical contaminants, customers face negative exter- tors, the underlying pricing schemes can be split into nalities that tend to be costly for them as well as the distinct regulatory regimes, including rate of return environment. Such costs include an increase in the (ROR), cost plus, revenue cap, and price cap. They cost of water treatment, health costs, and productiv- are often combined in practice. While these regimes ity losses associated with waterborne diseases, as usually refer to regulation by agency, they can also well as a reduction in fish populations, among be used to describe the terms of regulation in others. contracts. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 81 FIGURE 4.2. Controlling Price and Revenue Cost-based Incentive- Mechanisms for regimes based regulating service and regimes environmental costs These regimes can be further split into incentive- constraint by cutting costs, it may keep all or part of and cost-based regimes. the difference as a reward. This incentive can lead to Cost-based regimes. These regimes, including ROR greater efficiency. Incentive-based regimes can trade and cost-plus approaches, attempt to equate reve- off the cost-cutting incentive and the financial risk nue with cost. While this minimizes the utility’s by adjusting the duration of the regulatory period financial risk by preventing costs from exceeding and/or by calibrating the incentive mechanisms (e.g., revenues for prolonged periods, there is limited by allowing the utility to retain savings for set periods incentive for the utility to operate cost efficiently, of time that may stretch across regulatory periods). although “regulatory lag” does allow some degree of A benefit of incentive-based regimes is that further incentive. This is exacerbated by information asym- direct incentives can be built into the individual ele- metry between the utility and regulator on efficiency ments of the framework, such as efficiency factors. and the inherent incentive to inflate costs in the cost- plus regime to earn a higher return, such as through 4.3  Incentivizing Cost Efficiency “gold-plating” investments (Averch and Johnson While a broad incentive-based regime can encourage 1962). While cost-based regimes may be beneficial to cost reduction, incentives can be placed in the details ensure financial security in the short term, the result- of regulatory mechanisms to prevent X-inefficiency ing inefficiencies can jeopardize long-term financial and encourage cost minimization and innovation. sustainability, since efficiency is essential for ensur- Furthermore, the regulatory mechanism must be ing cost recovery. Further, cost-based regimes can designed with care to ensure that it does not distort lead to a greater unpredictability in price, as cost- incentives and encourage inefficient behavior. These plus regimes renew the tariffs regularly, while ROR ideas are discussed in the context of calculating O&M regimes set them at unspecified intervals. Despite costs, the regulatory asset base (RAB), and in using these shortcomings, cost-based regimes tend to be efficiency factors. simpler methodologically, making them easier to implement in newly established regulators. Efficiency Factors Incentive-based regimes. These regimes, including A benefit of incentive-based regimes is that the regu- revenue and price caps, attempt to overcome infor- lator can incentivize efficiency improvements over mation asymmetry on utility efficiency by encourag- time. There are two components of efficiency that ing the utility to cut its own costs while improving regulators are usually interested in: performance. They set a budget constraint, in this case the allowed revenue, over a predetermined • Relative static efficiency (“catch-up”). The differ- time interval. If the business can outperform the ence between a utility’s current level of efficiency 82 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services and that represented by the most efficient firms at accumulation of debt. Conversely, costs could be this point in time (defined as those firms lying on reduced below expectations through efficiency mea- the “efficiency frontier”). sures, resulting in accumulation of profit, which pro- • Productivity growth or dynamic efficiency (“frontier vides the cost-cutting incentive. shift”). This represents the expected movement of The risk can be reduced through indexation to the efficiency frontier over time. Even the most inflation or currency fluctuations. There are different currently efficient firms will have scope to con- indices for inflation across countries. What precisely tinue to improve efficiency over time as new tech- is indexed also matters and differs across regulatory nologies and work practices become available. regimes. For example, in a revenue- or price-cap regime, the cap can be adjusted in line with CPI-X or These efficiency improvements can either be RPI-X, where the CPI or retail price index (RPI) are assumed at the general level of total costs or at a inflation indices and X is an X-efficiency factor. more granular level. An efficiency factor at the gen- Alternatively, individual cost items can be indexed to eral level is known as an X-efficiency factor and typi- inflation. In this sense, price reviews, where the tar- cally captures productivity growth. In a price- or iff is reset, represent “noncore” changes in the tariff revenue-cap regime, the cap is usually allowed to (i.e., changes for technical, political, and other rea- grow in line with CPI-X, where CPI is the inflation sons), while annual adjustments in the tariff between rate (consumer price index), and X is the efficiency these regulatory reviews represent “core” changes in factor. At a more granular level, the regulator can use the tariff (i.e., resulting from core inflation or an O&M efficiency factor that assumes efficiency long-term price trends) (Borja-Vega 2020). Studies improvements in O&M costs over time. The regulator have found that this noncore change in the tariff was could be even more granular and assume improve- over double the core change on average globally ment in particular O&M costs, for example, by between 2016 and 2017 (Frankson 2017). assuming a reduction in nonrevenue water (NRW) in each year. This may take the form of informed deci- Mechanisms for Regulating Service 4.4  and Environmental Costs sions about reasonable reductions that differ in their proportional reduction in each year. Tariff and nontariff regulatory mechanisms can be used to incentivize utilities to cut costs through Allocation of Risk efficiency improvement. Some of the nontariff mech- In a cost-based regime, there is generally a low finan- anisms, such as service coverage and service quality cial risk to utilities since allowed revenues are either standards, are often used to exert pressure on utili- frequently reset or can be reset quickly if costs ties to improve their efficiency. Further, nontariff exceed revenues. However, there is a risk for the util- regulatory mechanisms can also encourage the ity that regulators may disallow expenditure ex post ­ internalization of environmental costs in the (if it is considered imprudent, that is, unnecessary or decision-making of a water utility. inefficient). There are three primary mechanisms within the In an incentive-based regime with multiyear tariff gamut of tariff and nontariff regulation that have reviews, there is a higher level of financial risk to been utilized in isolation or in combination for regu- utilities since costs could end up exceeding revenues lating the standard of service and environmental throughout the regulatory period, resulting in the costs (O’Connor 1999; IPART 2001) (table 4.1): Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 83 TABLE 4.1. Advantages and Disadvantages of Tariff and Nontariff Mechanisms to Regulate Services and Costs Service Environmental costs Advantages Disadvantages Advantages Disadvantages Command and control (C&C) • Observable and • Ineffective at achieving anything • Prescribed in law or as • Without adequate quantifiable, thus easy to above minimum requirements part of license conditions, enforcement capacity, monitor and enforce • May create compliance mentality, thus licensee is obliged to license conditions can be • Effective for guaranteeing e.g., connecting least expensive internalize costs easily broken, e.g., research minimum technical customers to achieve coverage • Quantifiable and verifiable in Australia has shown that requirements, e.g., targets standards are relatively easy noncompliance in water chemical quality to enforce abstraction typically occurs • Difficult to decide between trade- when there is low probability offs in price and level of service, of successful prosecution or therefore less appropriate for small penalties (Greiner et al. regulating peripheral aspects, e.g., 2016). customer service standards • Efficient design of fine system requires detailed knowledge of production costs and customer preferences • Fine systems can be highly complex • Cost of complying may be higher than noncompliance (Gunningham and Sinclair 2002) • Threat of fines ineffective at controlling state-owned utilities Suasive instruments • Creates transparency • Utilities are often motivated more • Light handed (often • Studies indicate that suasive • Reputational incentive to by vested economic and political voluntary) and market instruments work best perform well interests than pro-poor outcomes oriented under threat of regulation (Heymans et al. 2016) • Can be placed on scale of (Antweiler and Harrison • Theory suggests utility • Without financial incentive may lack increasing coercion (Harrison 2007). managers may have underlying intrinsic teeth as utilities may not pursue 1998), e.g., from raising incentive to achieve good high-cost improvements awareness to voluntary outcomes (ECA 2017b) • May not be appropriate for achieving codes and agreements to Sustainable Development Goals in a flexible enforcement • Considered as a stepping stone to economic timely fashion • Initially perceived to have instruments (EIs) greater cost-effectiveness than C&C approaches, but this concept has been challenged in recent years table continues next page 84 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services TABLE 4.1. continued Service Environmental costs Advantages Disadvantages Advantages Disadvantages Economic instruments (EIs) • Step up from simple fines In the case of customer compensation: • Prices and charges can be • Designing optimal effluent • Light handed • Only workable where failures for used to raise revenue to charge can be challenging, specific customers can be identified cover cost associated with since it requires detailed • Efficient trade-offs and verified externality or incentivize information on prevalence • Can be adopted to behavior to reduce cause of pollutant in area covered, motivate progression • Level of compensation is arbitrary of externality. In this cost- and requires information toward the SDGs and inadequate to counter the cost incentive case, money raised on quantity of pollutant of disruption • Minimal regulatory from financial instruments discharged. burden In case of tying outcomes to revenues: can be used to address • Since some pollutants are • Only viable when customers accept environmental costs, e.g., typically associated with trade-offs between price and quality irrigation system operation one another, permits for of service and maintenance and water the entire set of associated resource management pollutants would be • In the context of high-stake key performance indicators, e.g., time • Example of EIs include: required, in contrast to spent collecting water, small sewerage charges, effluent effluent charges. pecuniary incentives can potentially charges (e.g., based on • Compared to abstraction undermine or erode any intrinsic volumes of biochemical permits, the location of the incentives, so it is important to oxygen demand, chemical discharge heavily determines ensure that rewards or penalties oxygen demand, heavy the environmental reflect stakes metals, etc.), and tradable consequence of a pollution pollution permits (e.g., permit. • Weighing trade-offs often maximum permissible considered subjective amount of pollutant) • In the case of incentive- based instruments, such as tradable abstraction permits, a cap is placed on abstractions and the price of the permit is naturally determined by the market, making pricing efficient • Command and control (C&C). The historically stan- • Suasive instruments. A suasive approach is based dard approach to reduce certain undesirable on persuasion and voluntary compliance, and behaviors of monopolists, including the achieve- monitoring and reporting of performance. ment of service goals, has been C&C tools, in which Suasive instruments that rely on voluntary com- certain requirements are prescribed in the license pliance, in particular to address environmental terms. However, it is difficult to design efficient concerns, have been used in many countries C&C instruments when the underlying costs where the role of media and public response is incurred by the utility are unknown and would relatively strong. Recently, this discussion has only work when the expected benefits from com- been complemented by a circular economy narra- pliance are more than the expected costs. tive. While untreated water expelled into the Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 85 BOX 4.1. Key Performance Indicators in Albania The allowed revenue for each water supply and sanitation utility is calculated according to three key steps (see figure B4.1.1). First, the costs are analyzed and benchmarked against comparable utilities. Second, an analysis of the performance of the utility is undertaken by observing key performance indi- cators (KPIs) related to cost efficiency, quality of service, and prosocial outcomes. Third, the allowed revenue is determined by adjusting the calculated fair costs based on this performance analysis, using rewards and penalties. To analyze performance, the regulator looks at 11 KPIs: (i) nonrevenue water (administrative losses, technical losses); (ii) the metering ratio (household, nonhousehold); (iii) water quality (level of chlorine residue, coliform level); (iv) water supply hours (service hours); (v) efficient energy use (three groups based on the service provided); (vi) staff efficiency (staff/1,000 connections); (vii) water supply cover- age; (viii) sewerage coverage; (ix) regulatory perception; (x) special efforts and measures to improve efficiency, service, and performance; and (xi) the collection rate. To tie these KPIs to allowed revenue, the first 10 KPIs receive points that may reach a total minimum of -150 across the 9 KPIs or a total maximum of +150. The points are awarded according to the achieve- ment of agreed objectives. The points are converted into rewards or penalties when adjusting the total costs into allowed revenues. These rewards and penalties are capped at +/-5 percent for some compa- nies where operation and maintenance cost recovery has not yet been achieved, while they are capped at +/-10 percent for companies where it has already been achieved. Albania’s approach thus represents a good example of benchmarking efficiency to determine fair costs and incentivizing good quality of service and prosocial outcomes without placing utilities at undue financial risk. FIGURE B4.1.1. Determining Utility Revenue Calculate Adjust based on Determine efficient performance allowed costs analysis revenue Source: Water Regulatory Authority 2015. environment imposes a cost on third parties, it rely on financial incentives rather than laws and also represents a lost opportunity to the service regulations alone or voluntary compliance. provider to sell nutrients from treating the water, Albania (box 4.1) provides a good example of a from reusing treated water for human consump- regulatory mechanism that ties KPIs to allowed tion or irrigation, and a lost opportunity for gen- revenues (EIs). Common EIs for addressing the erating energy. cost of pollution include sewerage charges, efflu- • Economic instruments (EIs). An approach in more ent charges, and tradable pollution permits recent decades has been the adoption of EIs, which (table 4.1). Typically, tariff regulations fall under 86 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services the class of economic instruments of regulation, The same problem extends to customers who which can affect the service-provision-related rarely know the utility’s true efficiency and who are decisions of the utilities as well as the consump- often excluded from accessing information on a util- tion decisions of customers. Water pricing, sewer- ity’s costs and thus the extent of subsidization. They age charges, and water trading are various types of may also lack information on the procedures used to EIs used in the water sector. calculate the tariff. Beyond customer awareness of the importance of Measures to empower customers, especially those cost recovery, needed to prevent resistance to tariff within the remit of larger utilities, can be used to increases, it is important for transparency and complement regulatory mechanisms. This has a dual accountability across the whole chain of the regula- purpose. First, it can enhance the protection of cus- tory process to ensure legitimacy, public acceptance, tomers under existing rules. For example, bills of and to apply pressure on people in positions of rights for customers can be introduced (as in the responsibility to deliver good sector outcomes. United Kingdom and the United States), or custom- Regulatory decision-makers should be accountable ers can be empowered through education on their to customers for their decisions, utilities should be options of remedy. Second, it can provide customers accountable for the service they provide, and the with a voice that can guide the formation of rules, for government should be accountable to citizens for its example, through the representation of various decisions affecting the sector. customer groups in advisory boards or customer ­ councils. The latter is essential for the effective for- Promoting Transparency Before the Regulator mulation of EIs as the regulatory framework can While incentive-based approaches might encourage effectively gauge whether, and if so how, customers efforts to find efficiencies, if the regulator cannot wish to trade off aspects of service quality for price obtain sufficiently reliable information on a utility’s or access. Thus, it can be used to gauge how citizens costs—for example, through direct examination of its wish to trade off the speed of increasing access to business plan, historical costs, or benchmarking— WSS services against the level of service provided. utilities can game the process to obtain high revenue This compromise approach, which relies on commu- allowances. Therefore, to reap the efficiency gains of nity engagement, could be important for meeting incentive-based approaches, it is important to ensure SDG targets 6.1 and 6.2 within the tight deadlines there are mechanisms to provide a consistent and that have been set out. reliable information flow from the business to the regulator. Such mechanisms could include: 4.5  Rationale for Transparency • Regulatory reporting guidelines and templates Information asymmetry that exists between the util- that ensure that cost information can be provided ity and the regulator is exacerbated by difficulties in and compared consistently over time; estimating the utility’s actual costs or level of effi- • A requirement that businesses prepare business or ciency relative to other utilities. This gives the utility investment plans that have been subject to a con- a bargaining advantage that can lead to high levels of sultation process and rigorous internal governance inefficiency, inflated costs, and poor quality of procedures; service. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 87 • Requirement that financial and regulatory state- However, disseminating information is also import- ments are routinely audited by independent ant for holding regulatory decision-makers to ­parties; and account. Accountability depends on decision-makers • Publication of the above information in the public being required to explain their decisions, exposing domain. these to scrutiny, establishing a right to challenge decisions, and having open and committed consulta- Promoting Transparency Before Customers tion on important proposals so interested parties Ensuring transparency before customers on pricing can understand the rationale and direction of and the wider regulatory process is important for policy decisions and choices (OECD 2014). Relevant ensuring cost recovery and the accountability of information could extend to financial flows, staff ­ decision-makers. These, in turn, are important for information, and other data intended to prevent cor- securing good sector outcomes and information pub- ruption and misconduct. “Sunshine regulation” lication. Grievance redress mechanisms (GRMs) and consists of the public disclosure, comparison, and ­ customer engagement can play a part in this. metrics often discussion of a set of performance ­ based on KPIs. Accordingly, poor performance of Publishing Documentation ­ service providers is publicly exposed, incentivizing To improve customer understanding of the level of service providers to improve their performance. It is cost recovery achieved by existing tariffs, utilities particularly effective in improving the quality of ser- can publish regulatory information online. vices. The examples of the state of Ceará in Brazil or Information on utility total costs and how these costs of Zambia are noteworthy as is the case of Portugal are covered through the three Ts are best for achiev- (box 4.2) or the state of Victoria in Australia. ing this purpose and could be used by customers or While the publication of information for the bene- by news outlets for communicating this information fit of customers is often discussed in theory, it is to customers. Documentation could also relate to the ­ generally overlooked otherwise. In practice, an processes used to arrive at existing tariffs, including: information pipeline occurs between the regulated the allowed revenue methodology, tariff and allowed entity and customers, typically including the collec- revenue calculation models, tariff proposal consulta- tion of information by the regulated entity at the tion papers, comments from stakeholders, and final beginning and the receival of accurate information regulatory decisions. Without this transparency, by the customer at the end (figure 4.3). customers tend to overestimate the level of cost Any leaks in this pipeline can undermine the effec- recovery through tariffs. This can lead to resistance tiveness of the dissemination of information. For to tariff increases even when customers can afford example, poor cooperation of utility workers can the tariff increase. cause leaks at various steps of the pipeline when Publication of information on utility costs and the mechanisms designed to disseminate information procedures used to determine the tariff are important are scaled up. Thus, robust systems and procedures for improving customer awareness of the level of cost are required to ensure that the intended information recovery, which must take consideration of total is sufficiently and accurately generated and reaches ­ economic costs and costs relative to other utilities. the targeted customer. 88 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services BOX 4.2. Successful Regulatory Practices in Portugal The success of the Portuguese water sector’s governance owes to the strong insti- tutional framework of state-level bodies and municipalities as well as the degree of participation of other stakeholders. The Portuguese National Water Council is the con- sultation body engaging in discussions between municipalities, public administration bodies, nongovernmental organizations, customers, and research centers on water sector policy. Two other consultative bodies are in place within the water sector regulatory framework—the Consultative Council and Tariff Council—including all relevant stakeholders in policy making and tariff setting. The regulatory authority in Portugal has also recently developed a mobile app to provide relevant informa- tion about the quality of service provided by different suppliers to water and wastewater customers. Indicators are compared for 278 municipalities across various geographical areas in mainland Portugal, and display information on service quality, tariffs, as well as advice to reduce water consumption. Source: Original compilation. FIGURE 4.3. Information Pipeline between Regulated Entities and Customers Entity collects Entity analyzes Entity provides information information information Respondent Respondent Information is receives registers accurate information receipt Source: Figure 3 in Kumar, Post, and Ray (2017). Benchmarking Performance comparison is needed. Indeed, benchmarking is a Comparison across utilities in different regions or tool that can be useful not only to customers but also countries is important for placing the level of cost to utilities, to help them identify their own weak- recovery or efficiency into context. Such benchmark- nesses and work toward the top of the rankings, ing would need to be mindful that total cost defini- which can be motivated financially through tying the tions adopted at utilities or regulators differ across outcomes to allowed revenues. the globe, and the total economic cost includes Performance management using benchmarking external environmental and resource opportunity and monitoring KPIs is widely implemented across costs. Further, it is important to account for variation Latin America. Benchmarking generates competi- in supply sources, customer composition, demand tion between service providers and creates the patterns, age and configuration of the networks, incentive to improve performance, and public disclo- geography, topology, and other factors. Thus, fair sure of utility performance indicators can highlight Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 89 poor-performing utilities. Some countries in Latin customer engagement can build trust in necessary America have developed information systems that tariff increases. collect, organize, and (to a greater or lesser extent) Preventing Corruption, Fraud, and Misconduct disseminate data from service providers at the According to Transparency International, corruption national level. Among these systems, the perfor- is estimated to increase the cost of a water connec- mance indicators and regulatory benchmarking of tion by 30 percent at the household level. Poor SUNASS (Peru) stand out (World Bank 2018a). households are especially affected given their reli- Grievance Redress Mechanisms ance on informal connections, which are more prone GRMs are important for customers to be able to hold to corruption. Corruption in the water sector is far providers to account. GRMs are “institutions, instru- reaching and is the result of numerous factors, ments, methods, and processes by which a resolu- including noneconomic, institutional, and gover- tion to a grievance is sought and provided.” Utility nance factors. performance in addressing GRMs can be measured as • There are multiple tools for preventing financial a KPI and tied to allowed revenues. Some examples corruption. Some new technologies offer a more of KPIs could include number of complaints, cus- secure and transparent means of payment than tomer satisfaction, number of timely connections, traditional methods, with the added layer of verifi- responses to emergencies, and availability of call cation systems. Mobile banking has become an centers. These instruments create an economic especially prominent and effective method for incentive to effectively address complaints and customers to pay their monthly bills. improve the standard of service. For this reason, it is • In theory, increasing the availability of informa- unsurprising that data demonstrate that water utili- tion that can reveal corrupt transactions may lead ties with GRMs tend to exhibit greater efficiency, to a reduction in corruption as corrupt officials water supply coverage, and quality of service due to know they have a greater chance of being caught a greater level of accountability to customers. and punished. This is more effective when the Communication Programs potential victims are enforcing anticorruption Regulatory processes can engage customers through crimes, implying that freedom of information customer stakeholder groups, designed to gauge (FoI) through requests or publication of data could customer priorities for different aspects of service reduce corruption. However, the corresponding quality and their preferences regarding the trade-off reduction in bribery has been shown to negatively between service quality and the tariff level. While affect poorer customers. For example, a recent such processes are intended to ensure transparency study found that FoI laws in India increased voter and accountability to customers, it is important that registration processing times for slumdwellers rel- these processes are themselves transparent, given ative to wealthier households, coinciding with a that they ultimately affect the price determined. reduction in the rate of bribery. Such transparency can be ensured, for example, • Procurement corruption typically equates to offi- through publishing data from customer engagement cials awarding contracts based on personal con- and clearly detailing the processes online. Beyond nections or as a result of bribery, rather than in the gauging their preferences on quality of service, high interests of customers. This can result in inflated 90 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services costs and the prevention of the development of extended to nonnetworked service providers to the most competent parties for providing services. grant them some form of legal recognition and incen- A standard solution to this problem is to use an tivize service quality, performance, and profession- open tender. In creating corruption-resistant pro- alization. In practice, it is easy to find examples of curement processes, it is important to ensure they countries that provide nonnetworked services, but it are effective not only on paper but also in practice. is difficult to find examples of regulatory frameworks For example, contractor cartels (collusion between that govern them, either due to poor governance or competing contractors to drive up the value of the lack of formal regulation. winning bid) and political influence in contractor Currently, small-scale independent service provid- selection can take place even within an open pro- ers (SSIPs) often operate in parallel with the utility, curement process and, in the case of the latter, providing a complement to or substitute for utility even when auditing is used. water for households that do not have access or are dissatisfied with the quality or reliability of water Nonnetworked Services utility provision. To maximize connection rates to Millions of people in low- and middle-income coun- high-quality water supplies, be this from a large util- tries are not connected to water supply services ity or SSIP, it is preferable that boundaries are set either because they live below the poverty line and regarding the responsibility and roles of each to facil- cannot afford a connection, connections to informal itate this. An example is the institutional arrange- settlements are illegal, or they live too far from the ment between the utility and water tankers for water network. Thus, the discussion is not complete with- ATMs in the urban slums of Nairobi (Kenya), where out considering the regulatory framework for non- water tanks are currently filled up by tankers sent networked services. Regulatory frameworks must be from the public utility (box 4.3). BOX 4.3. Water ATMs in Nairobi Slum, Kenya According to the National Water Services Strategy for 2007–15, it was estimated that approximately 60 percent of residents in Nairobi live in slums and informal settlements, lacking access to safe and affordable drinking water. In line with achieving Sustainable Development Goal 6 and ensuring access to affordable and reliable water to the unserved urban poor, water ATMs were introduced in 2015 for the first time in urban Kenya in the Mathare slum of Nairobi through a public-private partnership with the Danish engineering company Grundfos. Water ATMs are coin-operated- or smart-card-operated standpipes dispensing a given amount of water. They are considered a better alternative to standpipes and water taps, which feature a high risk of misappropriation of funds by kiosk managers or standpipe attendants, while also providing availability and cost advantages to customers. Water ATMs were initially designed to obtain water from the utility network. However, due to illegal cutting of water pipes, the pressure was not sufficiently high for the water to reach the tanks, which are currently filled up by tank- ers sent from the public utility Nairobi City Water and Sewerage Company. box continues next page Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 91 BOX 4.3. continued Water cards cost Ksh 300 (US$3) and can be topped up at a kiosk or through a mobile app. Water is priced at half a Kenyan shilling (half a US cent) for 20 liters, and payments per unit volume are fixed and processed through the cards, without the need for ATM managers. As tariffs are fixed, ATMs have been shown to provide water at lower costs than standpipes and water vendors, selling water for 50 to 100 times the price of ATM water. Table B4.2.3 compares tariffs for various sources of water available in the Mathare slum. ATM managers were also given a master ATM card with 40 percent water credit fee of cost as profit. In 2019, the Water Services Regulatory Board of Kenya (WASREB) published guidelines for water vend- ing. Water vending is defined as a “formal or informal reselling or onward distribution of water from other sources by small-scale vendors for domestic use.” The purpose of the guidelines is to include water vendors in the regulatory framework, through licensing, to regulate and monitor water and service qual- ity provided to customers. The license should be renewed annually subject to an inspection of the ven- dor’s water sources, premises, transport, storage containers, equipment, and water handling practices. TABLE B4.3.1. Tariffs for Different Water Sources in Mathare Slum Water source Tariff per 20-liter jerry can Water ATMs 50 cents (US$0.005) Water standpipes Ksh 2–10 (US$0.02–0.10) Water vendors KSh 2–50 (US$0.02–0.50) Source: Sarkar 2019. Nonnetworked providers could also be regulated utilities can result in inflated prices, inefficiency, and through contracts, either with the utility or with the an eroded quality of service. The presence of other municipality or local government, or even with the market failures may also mean that external environ- local community. Guidelines or other regulations mental costs and resource opportunity costs are not can provide market rules to promote competition for addressed. Another important objective of regula- such contracts, thereby ensuring that the cost of pro- tory regimes is to address social concerns, such as vision remains at efficient levels. In Latin America, affordability and access to services, which solutions the piped water and other sectors such as off-grid to problems must be weighed against. electricity and solid waste management have shown Three broad problems can hinder governance in that contracts and licenses can spur competition pricing: from local and international firms. • Information asymmetry between the utility and regulator regarding the utility’s efficiency can give 4.6 Conclusions the utility a bargaining advantage that leads to Since water utilities are natural monopolies, there is inefficiencies, inflated costs, and poor quality of a clear rationale for regulation. The market power of service; 92 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services • A lack of transparency and accountability of utili- of such determinations. These regimes can be split ties and regulatory decision-makers before cus- into cost- and incentive-based approaches, in tomers can lead to customers overestimating the which there is a trade-off between recovering the degree of cost recovery, leading to resistance to utility’s costs and ensuring its financial sustainabil- tariff increases, and to poor sector outcomes; ity (in the former) and ensuring cost-cutting incen- • A lack of scrutiny and transparency can lead to tives (in the latter). The efficiency trade-off is corruption that undermines sector performance. evidenced in Europe, where cost-based ROR regimes exhibit a higher labor cost as a proportion To regulate prices, regulators usually work within of total costs than incentive-based price and reve- a wider overarching regulatory framework, which nue cap regimes. While cost-based approaches may can include sector-specific, multisector, municipal, be beneficial in newly established utilities with and contractual regulation. The adopted approach higher financial risk, this evidence indicates that is highly dependent on the legal, institutional, and incentive-based approaches are important to historical and cultural background of the country ensure efficiency in the long run, which itself is in question. Within this overarching framework, important for the financial sustainability of the the regulatory regime outlines the methodology for utility as it is the only way of ensuring recovery of determining the price or revenue and the frequency costs through tariffs. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 93 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services © Corepics VOF/ Shutterstock CHAPTER 5 Key Elements of an Effective and Efficient Tariff Reform Strategy Successful tariff reform requires more than a sound design. Without an appropri- ate strategy that garners support for its implementation from across the spec- trum of interested actors, there is a strong likelihood of failure. An effective strategy should generally entail the following four key elements: (1) strong polit- ical leadership; (2) enhanced performance that leads to a service quality that is acceptable to customers; (3) increased stakeholder engagement; and (4) widely socializing the tariff design process and underlying costs of provision. 5.1  Strong Political Leadership The one incontrovertible element of successful reforms has been strong politi- cal leadership to comfort advocates of low tariffs, or at the other end of the scale, actively support reforms. This is not static, and part of the virtuous cycle is that as the reforms produce tangible benefits and consumer willingness to pay (WTP) improves, politicians are more likely to back off from populist posi- tions and start putting their weight behind the reform process. Governments are often reluctant to increase tariff levels and implement tariff reforms as the political attraction of “free water” makes it an alluring target for dispensing policy favors—it can be marketed as a commitment to poverty reduction or as support for rural development. However, a number of case studies suggest that not only are tariff reforms possible but farsighted leaders can exploit catalytic events such as a cholera outbreak, or a change in the polit- ical landscape, to create momentum and build informed alliances that can alter the balance of political payoffs. In Zambia (box 5.1), a cholera outbreak precipitated a long-overdue reform process needed to address fundamental weaknesses in urban water supply. Elevating the importance of efficient water tariffs was one of the major achieve- ments of the reform process. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 95 BOX 5.1. Zambia’s Water Sector Reforms In the 1980s and early 1990s, there was very limited water supply in Zambia’s urban areas. Water was available for only 6–8 hours a day, there was low service coverage and poor quality of water that caused serious health risks. The municipal water departments had the primary responsibility for water supply, but there was no national policy or regulatory framework, the legislation left gaps and overlaps, and there had been inadequate investment over prior decades. Numerous attempts at water sector reform through decentralization had been tried in the period 1980–90 but policies were either not implemented or followed up, or were not consistent with the gov- ernment’s policies on decentralization. A new government in 1991 brought policies of market liberaliza- tion more in line with the water sector requirements, and cholera outbreaks in 1991, 1992, and 1993 put water into the limelight. In 1994, a new National Water Policy was introduced, thereby initiating a radical reform of urban water. The policy articulated seven main principles which guided the reforms, the one on tariffs being: achievement of full cost recovery for water services (capital recovery, operation, and maintenance) through customer charges in the long run. The key phrase is “in the long run.” From around 2000, the municipal water departments were replaced by “commercialized utilities” (CUs) but in their first 15 years the CUs failed to achieve financial sustain- ability. This had multiple causes, including low tariffs, poor commercial performance, and continuing inefficiencies, notably a failure to reduce nonrevenue water. These issues have been systematically addressed over time and from the latest benchmarking report it appears that 8 of the 11 CUs had reve- nues projected to be at or above full cost-recovery levels by 2019. Effective stakeholder communication has been crucial to achieving sector improvements that have involved significant increases in the average tariff level. This has been achieved partly through the innovative scheme of the regulator, the National Water Supply and Sanitation Council (NWASCO), which is aimed at improving communication with local communities to give them proper representation with the CUs servicing their towns. The scheme centers on water watch groups, the first being established in Lusaka as a pilot project in 2002 to increase NWASCO‘s presence on the ground and handle unresolved complaints. These groups are voluntary and have operated in as many as 12 towns across Zambia, but as of 2019 there were only 6 in operation. Source: ECA 2017a; NWASCO 2019 sector report. In 2020, COVID-19 brought a new health-driven At the end of the civil war in Mozambique in 1992, focus on water, with particular attention toward urban water supply systems were in a parlous state. accelerating Sustainable Development Goal 6 in rural Decades of underinvestment had been compounded areas. In urban areas, commercialized utilities are by damage to water assets during the civil war and being assisted by the World Bank and other donors there were very few trained personnel able to effec- and nongovernmental organizations to formulate tively run water utilities. A comprehensive reform and implement emergency response strategies. process, embracing major policy, institutional, and 96 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services regulatory changes coupled with intensive training mid-1980s and early 1990s, the rate of annual infla- and capacity building, was imperative. The struc- tion was in the hundreds, with grave implications tures that were established required setting for livelihoods, public service provision, and wel- cost-recovery tariffs, fundamental to the sustainabil- fare, particularly among the poor. This experience ity of Mozambique’s reforms (box 5.2). paved the way for the Law of Fiscal Responsibility, If water tariffs are denominated in nominal terms passed in 2000, which stipulated that state-owned and are not regularly reviewed, high levels of infla- enterprises must cover their costs (box 5.3). Over tion sharply diminish the real value of tariffs, the last two decades, this federal law has guided wreaking havoc on a utility’s finances. In the municipalities, which are tasked with setting water extreme case of hyperinflation in Brazil in the tariffs. BOX 5.2. Mozambique’s Water Sector Reforms By the mid-1990s, the water sector in Mozambique was in dire need of improvement. Tariffs were set well below cost-recovery levels, which meant that the public sector service providers were losing money on every unit of water supplied. Piecemeal solutions would not have worked. With the support of inter- national donors (led by the World Bank) a set of comprehensive reforms were formulated for the water supply and sanitation sector. The reforms began with the approval of a new National Water Policy in 1995, which outlined the principles for water sector reform and defined water as an economic as well as a social good. This paved the way for financially sustainable water services to be established. Reduction of nonrevenue water was an important factor in achieving financial sustainability, but there were also significant tariff increases. To regulate tariffs, the Water Supply Regulatory Council of Mozambique (CRA) was created in 1998 with the authority to review and approve tariffs, regulate service quality, protect consumers, and promote and improve the delegation of water supply services to third parties. Services were not only delegated to public sector bodies, but the private sector was also permitted to provide services and charge cost-reflective tariffs. In peri-urban areas this is mainly done through private water providers supplying water derived from boreholes. At first, the tariff they charged was often more than double the tariff for the main water utility in Maputo, but a regulatory framework was subsequently developed to provide incentives for efficiency improvements and competition, thereby reducing tariffs. A sector expert close to the reforms noted “a great deal of progress has been made and it has been sustained, with some setbacks, over 18 years. The fact that it was messy, that mistakes were made, and lessons learned has made the process more sustainable . . . credit is due to the government’s commit- ment to institutional reform” (Thelma Triche’s comments on an earlier draft of the Mozambique case study). With the reforms taking place over a long period, tariff increases were made in stages, thereby avoiding public resistance. According to a regulatory peer review, CRA could have done more to engage customers in tariff setting, but credit was given for the CRA’s systemic inclusion of local delegates and commissions. There have been good initiatives in reaching out to customers, including being on hand to react to consumer complaints. Sources: ECA 2017a; Wilson and Carilho Dias 2016. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 97 BOX 5.3. Countering Inflation in Brazil and Uganda Brazil is a large, federal country with a complex water sector history. The states have an important quasi-autonomous, meso-level role between the federal government and the local government struc- tures (the municipalities), which have direct responsibility for water supply and sanitation (WSS). There have been periods where strong political commitment, through forcefully articulated national policies, well-formulated WSS plans, and the backing of adequate allocations of financing for WSS investments, have provided strong incentives for improved WSS performance. However, the incentives deliver positive outcomes in already strong and capable municipalities, particularly with growing disparities with weak municipalities. In recent times, the lowest point in sector performance was during the years of hyperinflation in the mid-1980s. The real value of tariffs dropped precipitously, and utility viability was dramatically under- mined. Hyperinflation was brought to an end by the Plano Real, launched in 1994, which produced a restoration of normal commercial conditions. The crucial legal step that followed was the 2000 Law of Fiscal Responsibility, which stipulated that state enterprises had to cover their costs. In Brazil, there is no national economic regulator for the water sector and tariff setting is left to the municipalities, but the federal Law on Fiscal Responsibility has been a crucial anchor that imposes implicit cost-recovery requirements on publicly owned service providers. While fiscal transfers provide resources for major investments, tariffs generally cover recurrent costs, so WSS is not treated purely as a social service, and there is private sector participation in a variety of forms in some parts of the country. In Uganda, inflation in the 1980s was at very high levels and the 1990s started at 45 percent but declined to under 5 percent by the end of the decade, with commensurate declines in the value of the local currency versus hard currencies. As tariffs of the National Water and Sewerage Corporation (NWSC) at the time were denominated in nominal terms, high inflation had the effect of eroding the real value of tariffs with adverse consequences for the utility’s finances. For example, by the year 2000, the real value of the tariff was only 45 percent of the value set in 1994. In 2002, the government addressed this problem through gazetting a Statutory Instrument (No. 23 of 2002) that specifies an indexation formula for NWSC tariffs. This allows an annual adjustment to the domestic component of tariffs and an exchange rate adjustment to the foreign component, thereby preserving the real value of the tariffs. This had the effect of protecting NWSC’s revenue base from the impact of inflation. At the time, NWSC was rightly commended for service improvements attributed to dynamic leadership but it is also to be acknowledged that the stability in NWSC’s financial posi- tion arising from the indexation formula provided the base for effectively shifting the utility into the self-reinforcing virtuous cycle. When the reforms started, the utility had unserviceable debts to the government. During the 2000s, it achieved financial self-sufficiency largely through expenditure reduction and efficiency improvements rather than through tariff increases other than indexation. Half of an ambitious US$100 million invest- ment program between 2002 and 2011 was financed from internally generated resources. Sources: ECA 2017a; ECA and Mott MacDonald 2012; Heymans et al. 2016. Data on inflation rate in Uganda from: https://www.statista​ .­com/statistics/447810/inflation-rate-in-uganda/. 98 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services Inflation was very high in Uganda in the 1980s, principle that the criteria for tariffs are to include peaking at 215 percent in 1987. In the 1990s, rates costs and economic efficiency as well as solidarity declined as fixing tariffs in nominal terms severely and income redistribution. Although tariffs were sig- undermined the financial viability of the National nificantly increased, and the water service providers Water and Sewerage Corporation (NWSC). The intro- are financially viable, fiscal transfers still remain the duction of an indexation formula in 2002 was the main source of sector financing (box 5.4). basis for their successful turn-around under a dynamic management team (box 5.3). In Colombia, water tariff reform was delivered as 5.2  Timing of the Reform part of a much broader public sector restructuring Catastrophic events that influence the attitudes of and decentralization program. The key starting point customers—for example, the cholera crisis in Zambia, was the 1991 Constitution, which established the the end of the civil war in Mozambique, and the end BOX 5.4. Colombia’s Water Sector Reforms In the late 1980s, many issues faced the water supply and sanitation (WSS) sector in Colombia. Service provision resembled a “low-level equilibrium” characterized by low tariffs and low levels of coverage and service quality (Sánchez Torres and Pachón 2013). In many of the country’s important cities the poor provision of water was critical. Many utilities were experiencing financial distress and there were some bankruptcies (Andres, Sislen, and Marin 2010). As part of a broader program of economic reform the Government of Colombia in the early 1990s adopted a significant package of reforms aimed primarily at incorporating competition and strengthening the business capabilities of entities providing domestic public services, including WSS, while retaining the social elements of cross-subsidies. This was enshrined in the Constitution of 1991 and elaborated in the comprehensive utility law of 1994, which inter alia created the Water Supply Regulatory Council of Mozambique (CRA) with responsibility for promoting competition among service providers and economic and tariff regulation in water. Another major aspect of the reforms was decentralization, which in the water sector took the form of devolution of responsibility for WSS services to the municipalities. Although the national regulator, CRA, which issued its first tariff methodology in 1995, has overall responsibility for tariffs, the municipalities have a “residual regulation” capacity in tariff issues. Municipalities at the time of assigning the services to an operator through a bidding process can arrange a “contract” tariff as long as this has been part of the selection criteria in the process. The mayors and the municipal council are in charge of establishing the subsidies and “solidarity” contributions although the maximum percentage of subsidies that can be granted to low-strata customers are defined by law and can only be modified by the National Congress. box continues next page Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 99 BOX 5.4. continued Colombia’s comprehensive reforms began 35 years ago and much has been achieved in terms of perfor- mance and outcomes. They have been successful in both increasing local participation and voice in the management of WSS services and in opening the door to a range of innovative public, private, and mixed approaches with often positive impacts on service delivery. In particular, the reforms have created the financial stability in the sector, which underpins the improve- ments in coverage and service continuity in urban areas. Defining tariffs on the basis of production costs has been found to send adequate signals for rationalizing consumption with a positive impact on the environment (Andres, Sislen, and Marin 2010). However, while the tariff component of utility financing has increased steadily due to the CRA tariff methodologies, improved collection, and higher levels of willingness to pay, the decentralized revenue sharing system has remained the most important source of funds for the sector. Source: ECA 2017a. of hyperinflation in Brazil—often lead to successful regulator. In Africa, a similar comparison can be reforms. The political focus on water, which feeds made between Zambia and Uganda, though the role into populist resistance to water tariff reforms, can of strong regulators in improving sector perfor- also be diminished when water sector reforms are mance, such as in Kenya, should also be noted. part of a broader restructuring of the provision of pri- vate services, coupled with decentralization as was Utility Performance and Quality of 5.3  the case in Colombia. While these examples provide Services useful lessons on how resistance to tariff reforms can Revenues collected through tariffs, taxes, and trans- be mitigated, there will always be differences in fers are insufficient to cover the full costs of water political and institutional culture, not just between supply in many countries. This is a consequence of different countries, but even within countries when low tariffs, low levels of revenue collection, and oper- different historical periods are considered. ational inefficiency, notably the large amount of NRW It is therefore inherently difficult to identify char- lost due to leakages and water theft, which drive up acteristics that can be factored into the design of costs of supply and forces service providers to post- future tariff reform or broader water sector reforms. pone investment and maintenance of infrastructure. Even something as obvious as specifying that there As a result, service quality deteriorates, decreasing should be a national economic regulator to have customer WTP and acceptance of tariff increases. independent oversight of water tariffs cannot be To address this negative spiral, revenues need to claimed to be essential. While the role of the regula- be increased. Before considering an increase in tar- tor in Colombia (CRA) has proven to be crucial, iffs, utilities should focus on improving billing and Brazil’s state-owned enterprises have managed to collection rates and increasing the efficiency of water improve services despite the absence of a national utilities, as well as the quality of services. 100 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services • Improved billing. Utilities often do not know all and street view data, combined with machine learn- their customers or how to contact them. This can ing, can be used to design more precise, effective, be addressed by compiling a robust database of and efficient tariffs. the customer base served by the utility and digitiz- A number of technological innovations in the ing billing to help the service provider plan and wider domain of water are important, but the focus compare revenues across years. of this chapter is on those technologies that help • Improved revenue collection systems. Even when shape and provide tariff design and that facilitate the customers are billed accurately, the money does interaction between customers and tariffs. not always reach the utility’s account. In these Technological innovations leverage the power of cases, service providers should carefully analyze real-time data collection and big data analytics to trends in NRW and leverage mobile phones and minimize water losses in the distribution system and online networks for digital payments of bills to maximize operational efficiency, service quality, and ensure transparency and close the gap between environmental sustainability. Given the size of the billing and collection. challenges, it is not surprising that many key agen- cies across many countries are increasingly urging a • Increased efficiency. The problem of efficiency is more strategic approach to technological innova- particularly important as improved operations tions among water utilities. For example, the water and reduced NRW can often be achieved through services regulatory body for England and Wales, leadership and better management without signif- OFWAT, stated in 2017 that water companies would icant investment being made. in future be required to put innovation at the heart of As discussed in chapter 2, addressing inefficiencies their corporate strategies. Big data is central to many should be the first point of call to raise revenues as discussions about new technology in the water sec- the total cost savings will also increase consumer tor. The term is often used to “describe data that is WTP and hence improve bill payments. high volume, velocity, and variety; requires new This occurs because when billing and collection technologies and techniques to capture, store, and rates improve, service quality also improves, and analyze it; and is used to enhance decision making, customers are then less likely to resist price increases. provide insight and discovery, and support and opti- In some cases, the drop in NRW and increase in reve- mize processes” (Adamala 2017, 10). Big data is rele- nues might even make tariff adjustments unneces- vant to advances in machine learning, digitalization, sary to achieve cost recovery. and artificial intelligence (AI). Adoption of advanced technologies by the water Using Technology to Improve Tariff 5.4  sector lags behind many other industries (Li et al. Design and Utility Performance 2021; Ghernaout et al. 2018). Some of these innova- Many tariff structures require accurate data. Data tive, legacy-disruptive technologies are, however, collection and monitoring can be difficult and expen- already in operation in select areas; others are more sive. Technology holds out the prospect of cost-​ nascent. For example, in the latter category satel- effective solutions. For example, manual inspection lite-based remote sensors linked to the Internet of of water use is expensive and, in many cases, inaccu- Things are at an early stage but carry the potential to rate or insufficient. Smart meters, remote sensing, align satellite surveillance with smartphone-based Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 101 surveys and online big data tools. Likewise, high-​ expenditure. If this information is communicated resolution smart water meters and advanced data ­ effectively, for example, through an in-home dis- analytics allow for a new era of using the continuous play or an online information service, customers big data generated by these meters to create an intel- become more informed and more responsive to ligent system for water management. Drones and price signals. Customer service is more efficient unmanned aerial vehicles offer further opportunities and cost-effective as queries can be answered to harness new technologies. automatically. 5. High-frequency data allow the utility to detect Smart Metering unusual usage patterns that may be indicative of Smart metering is a key enabling technology for leaks or inefficient usage. dynamic tariff structures and a variety of other capa- 6. Smart metering is often effective in enhancing rev- bilities that utilize their ability to log and transmit enue collection because high-frequency transmis- high-frequency data in real time. Smart metering is sion of usage data limits opportunities for theft set to be a foundational technology for utilities of the and collusion between customers and meter read- future, acting as a key enabler for other technologies ers (World Bank 2016a). and innovative ways of managing and supplying water. However, a number of challenges are also associ- Smart meters fall on a spectrum of varying degrees ated with introducing smart meters: (1) potential job of sophistication. Smart metering systems can be losses and subsequent unemployment of manual placed in two categories: (1) automated meter read- meter readers; (2) large capital costs associated with ing (AMR) allows automated one-way collection of the initial introduction of smart metering; (3) resis- meter readings without physical inspection, and tance by some customers to smart metering due to (2) advanced metering infrastructure (AMI) involves negative perceptions of the technology; and (4) lim- a two-way communication with water meters. ited engagement with the technology by some cus- Utilities receive water usage information and can tomers (box 5.5). issue commands for the meters to undertake specific functions. Smart metering provides a number of Digital Customer Engagement benefits: In addition to in-home displays, web-based or mobile services can also present information to 1. High-frequency meter readings enable more customers on their consumption and bills. These sophisticated tariffs such as time-of-use (TOU) tar- systems can include an interactive element that iffs to be applied. allows two-way communication between the cus- 2. Utilities can reduce costs, given that traditional tomer and the utility. AI chatbots, for instance, meter reading services are no longer needed. allow customers to ask questions and receive alerts 3. Additional sensors can be installed that record and and information on their consumption and conser- transmit data on water quality and temperature as vation. Communication systems may also be inte- well as volumes. grated with payment management options to help 4. Smart meters increase interactions with cus- create a central hub for customers to engage with tomers, providing information on their use and their water service provider. 102 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services BOX 5.5. Prepayment Meters Are Not a Panacea for Utilities or Customers In the electricity sector in developing economies, prepayment meters (PPMs) have been extensively rolled out and have made an enormous difference to revenue collection, but have thus far failed to have the same impact in the water sector. In a major study of prepaid water in Africa (World Bank 2014), the authors examined three applications of PPMs: prepaid standpipes, PPMs for institutional customers, and PPMs for individual domestic connections. PPMs for institutional customers consuming large volumes were found to facilitate customer demand management and reduce the debt risk for utilities. For households, prepayment was found to be appeal- ing because it allowed customers to manage their own consumption, without the risk of arrears, dis- connection, or unexpected debt, but not all PPMs have the capability of delivering an initial subsidized block. For the utilities, PPM systems were considered difficult to implement for individual households, and not a panacea for inefficient billing and collection and the avoidance of customer debt. This is primarily because water PPMs are relatively more expensive than electricity PPMs and require closer operational monitoring. Utilities need to establish rapid response teams to deal with problems and still maintain meter reading to track real-time consumption against prepaid sales. There is a need to work closely with customers to deal with faults that may affect the supply that customers have already purchased. There is also the risk of poor households losing access to water if their credit runs out. Similar concerns arise regarding PPMs for institutional customers such as hospitals, schools, and prisons. Technological advances that reduce the cost and improve the reliability of water PPMs will undoubtedly lead to higher levels of uptake. But there have not been any breakthroughs in this regard. The World Bank study referred to above is six years old, but recent studies are reaching much the same conclusions. Komakech, Kwezi, and Ali (2020), for example, assessed the performance of prepaid technologies in Tanzania and found an increased burden on water customers, suggesting that PPMs “can simplify water revenue collection, but are not a panacea to deliver sustainable and equitable water services.” The high- light: “strong institutional capacity and knowledge is required alongside the technology.” Automated Water Kiosks paper 13, listed in appendix A). Automated water Automated water kiosks provide automated water kiosks ensure subsidies are directed to the intended dispensing services purchased with cashless pay- recipient. Lastly, cost savings to utilities or vendors ment systems using mobile phones, prepaid tokens, mean that more water access points can be installed. or cards. Automated water kiosks allow for a sharp Mobile Payments reduction in distribution costs and benefit custom- ers by reducing the time it takes to collect water, and The term “mobile payments” refers to payment for providing unrestricted access at favorable rates. goods and/or services through a mobile device such Kiosk operators often mark up the price of water as a mobile phone. When water tariffs are of a block despite having purchased it at a subsidized rate to payment type—for example, bundled with local taxa- support low-income consumers (see background tion—mobile payments provide limited added value Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 103 for customers or their water providers. But where vision, machine learning is the subset of AI that tariffs are more individualized and variable accord- seems likely to have the most useful application for ing to volume, for example, changing with the sea- the water sector. Machine learning refers to systems sons, then payment methods that allow more that learn to recognize patterns in data. This may frequent, variable payments become advantageous range from simple approaches using traditional sta- for both provider and customer. Under these circum- tistical techniques such as regression analysis or stances, cumbersome postal notifications followed more complex systems such as artificial neural net- by a requirement to travel to a payment office become works that use an architecture that loosely approxi- inconvenient and expensive. mates a biological brain. These advanced Innovations in mobile payments generate more data-processing methods are at their most effective reliable and transparent data records, and reduce when used alongside big data, a term that refers to opportunities for petty theft and corruption by inter- data which are too large or complex to be analyzed mediaries. Mobile payment methods also allow quar- using traditional methods. AI and machine learning terly and monthly bills to be split into multiple provide a route to extracting useful information from smaller amounts and allow payments with minimal big data, while large data sets can improve the accu- or zero transaction costs. Additionally, mobile pay- racy of machine learning models by expanding sam- ments allow entry to the wider applications offered ple size. by mobile banking, which in turn carries the poten- For water utilities, the use of AI and big data has tial to extend the reach of financial services to poorer implications for both operational management and households and the unbanked. Finally, water provid- for business processes. On the operational front, AI ers can offer more flexible prices as there is greater integrated with physical sensors can be used to aid transparency and agility in the tariff system. the management of water assets and networks. This allows a transition away from water flow models Water Flow Limiters using physical laws to more sophisticated probabilis- Flow limiters shut off water supplies after a set vol- tic models combining physical laws with probabilis- ume of water has been delivered. They are used in tic insights from AI. Commercial solutions have been the municipality of eThekwini in South Africa to pro- developed to use artificial neural networks to detect vide basic water requirements for free, similar to a pipe bursts in real time (Romano and Kapelan 2014), “lifeline tariff” (World Bank 2016b). Flow limiters machine learning to predict risk of faults in pipes could also be used in cases where there is no free (Myrans, Kapelan, and Everson 2018), and machine water allowance but households wish to limit their learning to predict wastewater treatment needs (IWA use to avoid excess charges. 2020). Such applications hold promise to improve Advanced Data Processing network efficiency and reduce cost of service. AI also allows for more efficient investment in water assets AI creates new opportunities for data processing that and sensors. One way in which investment can be are more sophisticated, on a larger scale, and auto- made more efficient is that AI can help network mated. AI refers to computer systems that can per- design to be planned with the optimal configuration form tasks that would normally require human of CAPEX versus OPEX. With regard to sensors, the intelligence. While many subfields exist in AI, includ- ability of AI to extract greater insights from a given ing language and voice recognition and computer 104 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services set of data allows fewer sensors to be used provided through digitalization. The primary driver of this they are placed strategically. For example, AI can digital transformation is the use of enterprise reduce the required number of smart meters to be resource planning (ERP) systems, such as SAP, installed by classifying customers into groups and Salesforce, and Oracle. ERP systems support a broad exploiting the similarity of behavior of consumers range of activities that help an organization manage within each group (Jenny et al. 2020). its resources (Ngai, Law, and Wat 2008). The chief AI and big data can enhance business processes in benefit of ERP systems is the integration of many the areas of business intelligence, knowledge man- systems such that a single system can be used to agement, and cybersecurity. Business intelligence, manage all financial and nonfinancial information in which can be understood as the use of data at the the organization (Pycraft et al. 2010). This increases managerial level, can make use of AI through efficiency by reducing duplication of information advanced trend forecasting, whereby machine learn- across multiple systems and allowing for a simpler ing identifies patterns in the data that can be used to customer interface for employees. It has been predict the evolution of variables of interest. reported that organizations using ERPs provide bet- Alongside systems that capture and make sense of ter customer service, reflecting improvement in big data, advanced trend forecasting provides a business processes (Al-Fawaz, Al-Salti, and Eldabi richer set of information that can not only be used 2008). Such a system has benefits for water utilities for business decisions within the utility but also for and regulators. Utilities gain better understanding of benchmarking exercises by the utility. Knowledge their costs and revenues and, using this information, management encompasses a broader set of activities regulators can set tariffs that better reflect the costs than business intelligence, including how the organi- of supply. zation creates, structures, and shares knowledge and Despite the benefits of ERPs, implementation of information. AI applications can contribute to an these systems can be difficult. ERP implementation organization’s knowledge-sharing platforms by pro- frameworks, such as the Accelerated SAP methodol- viding enhanced features for messaging, research, ogy associated with SAP software, are generally rec- and collaboration tools. AI is also increasingly being ommended to provide correct training and to ensure used in the hiring process to identify and analyze business processes are redesigned around the new candidates (Jenny et al. 2020). Cybersecurity is a cru- approach without introducing additional complexity cial issue in the water sector both because water is an (Makipaa 2003; Muscatello and Chen 2008). ERP sys- important social resource and because water utilities tems have also been accused of being poor at dis- store private information on individuals. AI tools playing and reporting financial information (Rom have been developed to identify abnormal behavior and Rohde 2006). Following implementation of ERP while “robo hunters” automatically scan for threats software, it has been reported that accountants often and take remedial action once a threat has been continue to use stand-alone systems such as Excel identified. for budgeting and reporting (Granlund 2011; Grabski, Leech, and Schmidt 2011). In a survey of manage- Digitalization of Business Information Systems ment accountants in a South African water utility, In addition to advances resulting from AI, water util- 100 percent of respondents reported a lack of inte- ity business information systems can be improved gration between the ERP system and management Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 105 accounting techniques. Respondents also commonly become increasingly established in some developed cited lack of reporting capabilities in the ERP system, economies, the benefits in developing economies are lack of data cleaning, and lack of customer training still largely unproven. The lack of proven benefits (Mudau 2012). may be a further barrier to adoption of some technologies. Barriers to Technological Innovation in the Despite the many barriers, there are a number of Water Sector factors that can serve to drive the shift toward the A fundamental barrier to the introduction of innova- adoption of innovative technologies to facilitate tive technologies facing water and sewerage utilities advances in tariff design and delivery. is the extent of legacy systems and investment in the Multi-stakeholder governance models may also be status quo. Vested interests may be reluctant to relin- helpful. These may stem from public-private part- quish their hold on familiar systems and activities. nerships. These partnerships can bring extra finan- For example, managers and staff in area utility pay- cial resources, new expertise and experience, and a ment offices may be fearful of losing their jobs to the sharper focus on customer responsiveness. Trials of technologies that enable mobile payments. various types of contract arrangements may prompt Incumbents of legacy systems are often well con- innovation. These can include service contracts, nected to political support networks. Political sys- management contracts, leases, and concessions. tems throughout the world have often been found to Consumer attitudes can be a driver. Consumers offer a defense to their industrial constituents and may come to expect digital and high-quality services supporters. Utility operators in advanced and devel- from their water provider in the manner that they are oping economies alike are often constituted as part accustomed to receiving elsewhere. Far from being a of the actual or quasi civil service. Installing new barrier to innovation, such customers may provide technologies and dismantling existing structures impetus for change. Similarly, as digital natives gain may require the status quo to be challenged. seniority within water service providers, they may Shifting from legacy systems to new technologies become internal agents of change. requires up-front capital and operational invest- ments. Securing such funding can be a challenge. 5.5  Stakeholder Engagement Concerns about short- versus long-term budgets and investments may also be a barrier. For example, the The water sector involves a plethora of stakeholders cost of installing smart meters may be higher than with different interests and incentives with regard to the ongoing short-term budget costs of continuing tariff setting. This institutional fragmentation is with manual meter readings. often the result of weak legal and regulatory frame- Providers may also be slow to adopt new technolo- works that limit decision-makers’ incentives to gies due to lack of incentives and a lack of workforce improve service delivery and their commitment to training in digital technologies. There may be skill address challenges surrounding water pricing. The deficits limiting the capability to make use of data multiplicity of stakeholders and interests, often con- analytics. With new digital technologies, providers flicting, adds complexities to the tariff reform pro- need to handle and manage large volumes of data— cess and requires effective coordination and this may also require new management skills. While engagement strategies. This means considering the some technologies such as smart metering have different stakeholder perceptions of problems and 106 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services incentives through inclusive and participatory stakeholder engagement involves, on the one hand, approaches for the various actors across the water a bottom-up approach that allows the community to chain. express their views and concerns, and on the other, The case study of Saudi Arabia (box 5.6) highlights institutional rules and frameworks to ensure how the lack of public participation in the reform accountability. Governments are increasingly recog- process was the main driver of the strong opposition nizing the demand of citizens to be more involved in to the tariff increase implemented in 2015 in an water tariff decisions and shifting toward “open” attempt to achieve cost recovery. This example adds decision-making and implementation. Several coun- to the extensive literature highlighting that effective tries have started engaging stakeholders in water BOX 5.6. Water Tariff Reform in Saudi Arabia Saudi Arabia’s water resources are extremely limited and meeting water demand is a major challenge for policy makers. However, tariffs have been historically low, with domestic tariff revenues covering only 7 percent of the costs. The fall in oil prices in 2014–15 highlighted the environmental and economic sustainability challenges of the pricing strategy and led to a sharp increase in the domestic water tariff to secure more revenues from public services. In December 2015, the Saudi cabinet announced a revised tariff structure that remains in force today. The tariff rates before and after the reform are illustrated in table B5.6.1. TABLE B5.6.1. Tariff Rates before and after the Reform Block tariff rates before 2015 Block tariff rates after 2015 Block Monthly consumption (m3) Tariff (US$/m3) Block Monthly consumption (m3) Tariff (US$/m3) 1 1–50 0.027 1 Less than 15 0.0027 2 51–100 0.04 2 16–30 0.27 3 101–200 0.53 3 31–45 0.8 4 201–300 1.07 4 46–60 1.067 5 >300 1.6 5 >60 1.6 The revised tariff rate retains the five-block IBT structure, with the size of consumption blocks consid- erably reduced and higher volumetric charges for the second and third block. The tariff revision was aimed at increasing cost recovery to approximately 30 percent of the marginal cost of supply and led to a 10-fold rise in the monthly water bill of most households, spurring unprecedented public criticism. The magnitude of the price increase and resulting opposition were unique for a country such as Saudi Arabia, where open criticism of the government is very rare. Although there is no formal analysis of the extent of the backlash, people publicly expressed their criticism by sharing photos of their new bills online and speaking out publicly. box continues next page Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 107 BOX 5.6. continued Many commentators pointed out the lack of public participation in the decision-making process as a key driver of the opposition, reflecting the changing nature of Saudi society as a result of the Arab Spring. While the country has an established means to ensure public debate to reach consensus (i.e., majalis, diwaniyyat, and istirihat), these types of social gatherings are increasingly mediated via social media. The public reaction to the tariff increase highlighted the lack of dialogue between policy makers and custom- ers, particularly with regard to the true costs of supply and the urgency to address water scarcity issues. Another effect of the higher tariffs was increasing customer awareness of the inaccuracies in their water bills, which exacerbated the wave of public criticism. To overcome the backlash, the minister of water and the CEO of the water utility were replaced. The government also announced that a new tariff sched- ule would be developed and the Ministry of Environment, Water and Agriculture announced a range of awareness campaigns to encourage the preservation of water resources. This case study stresses the importance of community participation in the decision-making process. Public consultation and stakeholder engagement can: • Assess customers’ willingness to pay and design progressive and gradual schedules for increasing prices, considering inputs from customers and other stakeholders. • Raise awareness about the gaps between the costs of supply and revenues, and the limited availability of water resources, including strategies to promote water conservation. In addition to emphasizing the need to carry out publicly acceptable reforms, the case study also shows how tariff structures should address the need for cost recovery while incentivizing utility performance and efficiency gains. Source: McIlwaine and Ouda 2020. sector reforms to facilitate policy implementation by makes the reform urgent as well as the possible mobilizing citizens and customers to make tariff obstacles to its implementation. reforms more responsive to public needs through 2. Identify the relevant interest groups and deter- consultation and other forms of engagement. mine the degree to which they stand to benefit or A well-planned stakeholder engagement strategy lose from the prospective tariff reform. This must be flexible to accommodate shifting political, requires estimating how much subsidy each group social, and cultural factors relevant to the reform receives under the current tariff policy, and how it process. Planners would benefit from taking the fol- compares with the prospective tariff policy. Map lowing steps: the policies according to the proposed simple, political economy framework (box 5.7) to identify 1. Clearly define the strategy’s primary goal, charac- circumstances or actions that could facilitate the terize the political and socioeconomic context in reform. which it will be developed, and understand what 108 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 3. Better understand the views, feelings, percep- broader public. The comprehensive strategy tions, motivations, beliefs, and practices of each should both convey compelling messages that interest group by conducting opinion research, harness the power of emotion and storytelling focus groups, in-depth interviews, and so on. and enable two-way dialogue for more participa- 4. After internalizing how the target audiences tory planning. think, feel, and may react, identify the stake- 5. Implement a “monitoring-evaluation-learning” holder engagement mechanisms with the most process to gauge the impact of the campaign and potential to meaningfully engage with the adjust the strategy if and as required. BOX 5.7. Classifying the Political Economy of Subsidies: A Basic Framework Tariff reform will necessarily shape the amount that the service is subsidized, as well as how those subsidies are allocated across customer groups. Understanding the status quo and how different inter- est groups stand to benefit or lose is therefore a crucial element in both understanding the potential obstacles to reform and in designing an effective stakeholder engagement strategy that can facilitate its implementation. A strategy to both foster supportive political coalitions and mitigate the impact of opponents is an essential element of any tariff reform strategy.1 Broad and diffused interests tend not to be well orga- nized, whereas concentrated interest groups can mobilize more readily and effectively to advance their narrower causes. This basic logic is behind a simple, political economy framework that categorizes the political equilibrium of a country’s subsidy policy (table B5.7.1) along two axes: (i) the size of benefits accruing to all households or individuals in the population (generalized benefits); and (ii) the size of benefits accruing to only particular segments, or interest groups, within that population. It is import- ant to note that an interest group can be any group with a stake in the system; that is, either intended beneficiaries (such as the poor) or unintended beneficiaries (such as the rich who may disproportionately access networked services, or service providers or government actors profiting from inefficiencies in the system). TABLE B5.7.1. Characterizing Subsidy Policy Benefits: Basic Framework Generalized benefits are large Generalized benefits are small Interest group benefits are large Case 1 Case 2 Interest group benefits are small Case 3 Case 4 Source: Adapted from Inchauste, Victor, and Schiffer (2018, 11). box continues next page Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 109 BOX 5.7. continued Ultimately, the goal is to understand how interest groups might support or oppose government efforts toward tariff reform.2 This will depend on the level of organization and political power of the groups concerned, as well as the ability of reformers to choose political allies and to weaken or even win over the political influence of groups that could potentially block a proposed reform’s implementation. A tariff reform may seek to shift this equilibrium, but of the four cases outlined in table 4.2, none is pref- erable in all contexts. For example, a tariff reform that effectively targets subsidies with the primary goal of benefiting the poor should strive toward case 2, while a reform seeking to gradually remove subsidies in order to attain cost-recovery tariffs should strive toward case 4.3 To design feasible reforms and implementation plans, it is crucial to figure out the current political equilibrium in a country and to develop a strategy for how to shift the status quo. For example, when generalized benefits and benefits accruing to interest groups are both large (case 1), the following may improve the feasibility of reform: • The government communicates a strong, simple, and credible narrative, outlining the risks of the status quo and breaking complex economic processes down to a simple relatable logic; • Citizens develop a better understanding of how the existing system is harmful to their interests—by, for example, effectively redistributing public funds to the wealthy—and mobilize to counter it; • The government credibly commits to citizens and interest groups that reform will leave them either better off or the same. This may require offering them medium-term benefits to offset the loss of subsidies; • Interest groups that would oppose reform find it difficult to mobilize, or the government finds a way to satisfy their core aims; • The costs of providing benefits rise sharply (e.g., because of a fiscal crisis or impending water security crisis); • The costs of subsidies are not sustainable, coupled with declining service quality; and • External pressure from donors or lenders changes the political equilibrium. A detailed description of each type of case, as well as possible strategies for reform in each context, is provided in appendix C of “Doing More with Less: Smarter Subsidies for Water Supply and Sanitation” (World Bank 2019). A wide range of mechanisms can be adopted to committees to media-based tools and communica- strengthen decision-makers’ interactions with cus- tion strategies (figure 5.1). tomers and other stakeholders in water tariff reforms. The OECD (2015) has developed a comprehensive These mechanisms range from institutional arrange- taxonomy of mechanisms4 to promote stakeholder ments such as interministerial bodies and citizen engagement and community participation in water 110 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services FIGURE 5.1. Formal and Informal Stakeholder Engagement Mechanisms Formal mechanisms Informal mechanisms Citizen committee Meetings / Workshops / Fora Consensus conference Web-based platforms Polls / surveys Traditional media tools Referendum Focus groups River basin organizations / councils Expert panels Water associations (WUAs) Information hotlines Source: Adopted from OECD (2015). Note: WUA = water user association. sector governance. These also apply to tariff setting become imperative to achieve cost recovery. This sit- and reforms and are usefully classified into two uation has occurred in all continents but is exempli- categories: fied by examples from Sub-Saharan Africa where changes to tariffs in select countries exhibit huge • Formal mechanisms. These are institutionalized, variation across the region, with double-digit swings typically stemming from an official agreement, in both directions (figure 5.2). The negative spiral of and defined by clear operating rules. Examples are production costs and investment needs significantly citizen committees, consensus conferences, polls pushes up tariffs in most of the countries listed. The or surveys, and water user associations. tariff increase of 77 percent in 2019 in Kigali (Rwanda) • Informal mechanisms. These do not have an institu- was particularly drastic and the largest in Africa. The tional or legal basis but deal with a variety of issues only exceptions are tariff reductions in Harare related to water governance, including tariff reforms, (Zimbabwe), reflecting the sharp devaluation of the at the discretion of those involved. These include local currency, and Cape Town (South Africa), where informal meetings or workshops, web-based plat- the increase in heavy rainfall reduced water scarcity forms, media, focus groups, and expert panels. concerns and water restrictions, resulting in the larg- est drop in tariffs. 5.6  Protecting Vulnerable Groups Where large tariff increases are to be implemented, Resistance to tariff increases and restructuring tariff reform proposals should ideally make provi- becomes acute when there is a vicious spiral of bank- sions to compensate vulnerable groups through a rupt utilities providing poor services but not able to targeted subsidy or securing sufficient funding to improve without higher revenues. Such utilities can- improve the quality of water services for all and ulti- not readily increase collection rates and improve ser- mately increase public acceptance of higher water vice delivery, and unpopular tariff increases then tariffs as is the case in Portugal. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 111 FIGURE 5.2. Major Tariff Revisions in Sub-Saharan Africa in 2019 Percentage change from 2018 to 2019 Kigali (Rwanda) ($0.78/m3) 77.1 Lomé (Togo) ($0.61/m3) 19.0 Durban (South Africa) ($2.14/m3) 14.0 Mbabane (eSwatini) ($4.79/m3) 13.6 Pretoria (South Africa) ($2.79/m3) 10.0 Windhoek (Namibia) ($3.14/m3) 9.9 Johannesburg (South Africa) ($2.18/m3) 9.9 Victoria (Seychelles) ($1.64/m3) 8.3 Accra (Ghana) ($1.06/m3) 8.0 Dakar (Senegal) ($0.68/m3) 7.4 Lilongwe (Malawi) ($0.70/m3) 5.0 Cape Town (South Africa) ($0.61/m3) –49.0 Harare (Zimbabwe) ($0.78/m3) –62.0 –80 –60 –40 –20 0 20 40 60 80 100 Source: SIWI (2020), adapted from Figure 2: based on Global Value of Water White Paper 2019. Note: m3 = cubic meter. 5.7 Conclusions getting customers to accept and commit to paying The COVID-19 pandemic has put water at the fore- tariffs commensurate with recovering the costs of an front of the public policy agenda in developing econ- efficiently run utility. In other words, how to use omies. The immediate financial impact on utilities COVID-19 as the launching pad for new reform has typically been negative because industrial initiatives, tying together financial investments, demand has declined, the ability to pay for water stakeholder engagement, and utility performance has been reduced, and in some cases, governments improvements to produce sustainable virtuous-circle have instructed utilities to reduce tariffs or defer outcomes. payments. Technological innovations that will make utilities But as this chapter has confirmed, crises are times more efficient and/or improve billing and revenue that can be exploited by farsighted leaders to bring collection will also indirectly benefit consumers, about positive change through initiating tariff and provided the savings are passed on through lower broader sector reforms. One important area of fur- tariffs. Smart metering has shown promise for appli- ther research would be to investigate how countries cations in the electricity sector and the water sector could turn the adverse COVID-19 impacts into an in developed countries. There are also benefits for opportunity to more rapidly advance targets and the water sector in developing economies but it ensure long-term sustainability of utilities, through remains to be demonstrated whether the costs 112 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services involved would be justified. Providing benefits for of new technologies is being influenced by regulators those already accessing piped water does nothing to and external agencies as well as by the commercial address the needs of the much bigger group of drive of firms developing and manufacturing the low-income consumers who are not connected. new technologies. Resources that would be needed for a water utility to implement smart metering could instead be used to roll out more automated kiosks. Notes 1. This section is borrowed from “Doing More with Less” (World Bank The adoption of some of the innovative technolo- 2019) and based on Inchauste, Victor, and Schiffer (2018, 11). gies discussed is likely to be resisted by incumbent 2. Note that not all interest groups will be politically organized. providers and other entrenched interests. Initial Moreover, within governments themselves, officials may hold con- costs are substantial, and this presents a problem flicting positions regarding subsidy policy. when the return on investment is less clear in these 3. Note that only those situations where costs accrue largely to the government (taxpayers) while benefits accrue to interest groups situations than in those territories where adoption and the general populace are considered in these four cases. In has already occurred. The relevance of the new tech- reality, the costs borne by citizens and interest groups would nologies in the context of developing economies is need to be considered in any comprehensive political economy analysis. variable with a clearer cost-benefit case being more 4. Regulatory public hearings are an equally important stakeholder easily made in regions subject to severe water scar- engagement mechanism. For a summary of this practice in Latin city. It should also be noted that the pace of adoption America, see table 4.3 in World Bank (2018a). Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 113 © Getty Images CHAPTER 6 Final Remarks The purpose of this study was to develop a deeper understanding of the wider implications of tariff structures and pricing on investments and water services, and the people who depend on them. Using real-world data and illustrative case studies collected from utilities across the globe, this report tackles some of the most pressing emerging questions in the water sector today, including: How to identify and recover costs?; How to address affordability?; What is the most appropriate tariff structure for a given context?; Should external costs be recovered through tariffs?; Are tariffs a good mechanism to address water con- sumption?; What role should regulators and policy makers play?; and What are the key elements of successful tariff reform? In discussing these topics, this report also highlights significant gaps in the current knowledge base that have been identified as part of this process and provides practical information to implement better-designed tariffs to further the economic efficiency, afford- ability, and environmental sustainability of services. 6.1  Core Concepts of Effective Tariff Reform The results of this study are summarized in a series of core concepts founded upon longstanding principles of financial sustainability alongside a new para- digm that recognizes the important roles of taxes and transfers in achieving financial equilibrium. 1. Designing an effective tariff requires a sound understanding of underlying costs. Total costs must be determined using the most appropriate calculation method. Improved financial literacy and management can lead to efficiency gains that can translate into increased service quality, willingness to pay, and cost recovery generating the scope to expand access and improve service quality while creating a positive feedback loop. Reconsidering service levels in line with customer expectations may lead to additional cost benefits and enhanced access. 2. Tariff design demands a holistic approach that carefully considers competing policy objectives. Tariff structures should not be burdened with too many Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 115 policy objectives that in any case are context-spe- connections—such as informational campaigns cific. Instead, tariff complements can be applied to publicizing the benefits and prevalence of existing achieve specific aims, for example, addressing water connections—are effective in encouraging affordability and tackling barriers to access, as well new connectivity and should be considered more as water conservation. broadly. 3. Tariff complements are an effective means for address- 6. Regulation can prevent inflated prices and costs, and ing affordability and improving services. Tariffs in iso- encourage standards of service. Lack of transpar- lation are ineffective at ensuring affordability. For ency and accountability can lead to customers example, increasing block tariffs (IBTs) with a “life- resisting tariff increases and poor sector outcomes. line” first block are intended to be pro-poor but are Information asymmetry between utilities and reg- not necessarily fit-for-purpose. Current analytical ulators can give the utility a bargaining advantage methods designed to measure affordability are com- that leads to inefficiencies, inflated costs, and poor monly undertaken at the macro scale, fail to capture quality of service. A strong regulatory agency, local realities, and overestimate affordability. Thus equipped with qualified personnel and leadership, pro-poor tariff structures in urban areas generally can break the cycle of opacity and espouse only benefit households that are already connected. transparency, thereby gaining societal consensus Tariff complements and alternative affordability for increasing cost recovery. measures offer valuable solutions to address afford- In sum, tariffs are essential—but not the only path— ability while well-designed subsidies are intended to to achieving cost recovery, addressing affordability, close residual gaps. and managing water conservation. To maximize 4. IBTs can be enhanced by improving their design and their potential, tariffs must be well designed, com- combining them with tariff complements. IBTs fail plemented by appropriate instruments, adequately to send efficient pricing signals and are ineffective regulated, and understood by customers. at targeting subsidies to poor households. The evi- Finally, new and innovative technologies exist that dence is mixed on price elasticity of demand and can support tariff design and lead to improved effi- likewise their effectiveness at addressing water ciencies. For example, innovations in mobile pay- conservation. However, IBTs are relatively easy to ments provide more flexible payment options, understand and implement, hence their wide uti- reduce transaction costs, and improve transparency. lization. Improving their design and combining Prepayment meters for large institutions facilitate them with select tariff complements can render customer demand management and reduce the debt them more effective. risk for utilities. Smart metering reduces water losses 5. Regulation can help address the needs of unserved and theft. Coupling the introduction of more populations. Light-handed regulation with links to sophisticated tariff structures, such as dynamic pric- off-utility business models in urban areas and ing, with smart meters, can support customers to slums can help ensure affordable and sustainable efficiently manage their demand, thereby reducing access by the poor. Leveraging subsidies toward the costs imposed on the system. 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Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 123 © Getty Images APPENDIX A List of Background Papers Paper 1. Cost of service provision Paper 2. Pursuing cost recovery Paper 3. A classification of tariff structures Paper 4. Tariffs and regulation Paper 5. WSS connection charges Paper 6. What is an affordable tariff? Paper 7. Tariffs for water scarcity Paper 8. Tariffs for poverty alleviation Paper 9. WSS tariff study Paper 10. Tariff structures and incentives Paper 11. Tariffs and technological innovations Paper 12. Efficient and effective tariff design Paper 13. Tariffs for nonnetworked providers Paper 14. Tariffs and transparency Paper 15. Overcoming resistance to tariff reforms Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 125 © SeventyFour/iStock APPENDIX B Data Sources The most comprehensive source of data on tariff structures is the International Benchmarking Network for Water and Sanitation Utilities (IBNET) tariff data- base on which this report primarily relies for analyses. The IBNET database contains data on tariffs for networked services for over 2,000 utilities, of which 75 percent provide both water and wastewater services. Grouping Data for Comparison With data for over 2,000 utilities over the last 30 years, there are a variety of options for summarizing these data meaningfully. They were summarized in three main ways: • By utility. This shows the percentage of utilities applying different tariff structures worldwide. This can skew the results toward countries with many utilities. For example, the database includes 71 utilities for Australia but only 1 utility for Uganda. • By country. This shows the percentage of countries applying different tariff structures worldwide, by using the tariff structure of each country’s most populous city as representative. This comparison obviously treats small and large countries as equivalent—for instance, the Republic of Kiribati has a population of 116,000 whereas India a population of 1.4 billion inhabitants according to 2019 IBNET data, but each will have equal weighting when com- paring tariff structures. • By population served. This shows the approximate percentage of persons being charged different tariff structures worldwide. It relies on population data from the IBNET tariff database, which may vary from the actual popula- tion served. This comparison will obviously skew results toward the tariff structures of the most populous countries, such as China, India, and the United States. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 127 In some cases, a further breakdown by region is • Increasing block tariffs (IBTs), with increasing rates also shown. The regional categorization is summa- for higher tiers of consumption. rized in table B.1. • Decreasing block tariffs (DBTs), with the unit price IBNET also contains data over several years. decreasing with water usage to stimulate high-end Except for graphs that show prevalence over time, users. the data point in the most recent year available for • Jump tariffs, commonly referred to as each utility was employed. In other words, most of volume-differentiated tariffs (VDTs), where every the graphs show the latest available data for each unit of water consumed is priced at the highest tier utility (as retrieved from the IBNET tariff in which total volume of usage falls. database). • Other tariffs. These refer to other types of tariff structures including both fixed and variable ele- Types of Tariff Structures ments that might change depending on the season In assessing the prevalence of tariff structures world- or location of customers (i.e., tariff complements), wide, we rely on the definitions used in the IBNET or other arrangements such as value of the prop- tariff database, which are broadly consistent with erty. The category pools different tariff structures those discussed in chapter 2 and are summarized and complements and does not allow to distin- again here as follows: guish between various types. • Flat rate tariffs. Single fixed charge for water and By IBNET’s definition, one-block tariffs, IBTs, wastewater services, independent of the volume DBTs, and VDTs may or may not also have a fixed of water consumed. component and therefore be two-part tariffs. We • Constant volumetric/“one block” tariffs. A single have done our own analysis on the same dataset and charge per unit volume of water consumed, discuss two-part tariffs, but do not address them in with the same unit price for each consumption the overview section because they are not mutually level. exclusive from other tariff types. TABLE B.1. Countries and Utilities Surveyed by Region Regions Number of countries Number of utilities surveyed Sub-Saharan Africa (SSA) 40 281 East Asia and Pacific (EAP) 38 379 Europe and Central Asia (ECA) 59 910 Latina America and the Caribbean (LAC) 41 606 Middle East and North Africa (MENA) 19 156 North America region (NAR) 3 162 South Asia region (SAR) 7 69 Total 207 2,563 Source: IBNET 2020. 128 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services Data Limitations customers, although in many cases it is reasonable to assume that the tariff structure will be the same as IBNET only provides data for the domestic/residen- for the residential category. tial category. This means that we are unable to assess the prevalence of tariff structures for nonresidential Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 129 © ThomBal/Shutterstock APPENDIX C Simulating the Effects of Different Tariff Structures on Affordability and Efficiency The approach to designing flat rates was twofold: (1) to satisfy the affordability objective, the residential tariff was set based on the affordable level for low-consumption households; and (2) to satisfy the cost-recovery objective, the nonresidential tariff was set to recover the costs of supply. The result is that low-consumption customers cross-subsidize high-consumption custom- ers when viewed on a per cubic meter basis. This is especially true for low-consumption nonresidential customers. The simulation confirms com- mon knowledge that flat rates do not send efficient pricing signals to custom- ers as they fail to reflect the underlying cost of supplying different customer groups (table C.1). The twofold approach to designing one-block tariffs is: (1) to satisfy the affordability objective, the residential tariff is set based on the affordable level for low-consumption households; and (2) to satisfy the cost-recovery objec- tive, the nonresidential tariff is set to recover the costs of supply across all cus- tomer categories. The result is that nonresidential customers cross-subsidize residential customers, but the differentials are smaller than under other tariff structures. Constant volumetric tariffs can be linked to marginal costs, but do not fully reflect the cost of supplying user groups. The average percentage deviation from the efficient tariff is 16 percent across customer categories, assigning one- block tariffs a score of “good” with respect to the economic efficiency objective (table C.2). IBTs can be employed on their own as a fully volumetric structure or be com- bined with a fixed charge. In the latter case, they can be considered a special case of two-part tariffs where the volumetric component is based on a nonlin- ear unit price that increases with the volume of consumption (table C.3). To satisfy the affordability objective, the first block tariff for residential cus- tomers was set based on the maximum affordable monthly bill for residential Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 131 TABLE C .1. Flat Rate Efficiency Ranking Residential Nonresidential Low Medium High Low Medium High Very High Cost of supply (US$/m ) 3 3.3 2.4 2.2 3.0 2.3 2.2 2.0 Average tariff (US$/m ) 3 2.0 1.1 0.9 3.2 2.5 2.4 2.2 Deviation from efficient tariff (%) 40 75 86 394 65 33 93 Summary Average % deviation: 112 Ranking: Bad 1 Note: m3 = cubic meter. TABLE C .2. One-Block Efficiency Ranking Residential Nonresidential Low Medium High Low Medium High Very High Cost of supply (US$/m3) 3.3 2.4 2.2 3.0 2.3 2.2 2.0 Average tariff (US$/m3) 2.0 2.0 2.0 2.3 2.3 2.3 2.3 Deviation from efficient tariff (%) 40 17 9 23 3 5 14 Summary Average % deviation: 16 Ranking: Good 3 Note: m3 = cubic meter. TABLE C .3. IBT Efficiency Ranking Residential Nonresidential Low Medium High Low Medium High Very High Cost of supply (US$/m ) 3 3.3 2.4 2.2 3.0 2.3 2.2 2.0 Three-block IBT Average tariff (US$/m ) 3 2.0 2.6 3.3 1.5 2.1 2.3 2.3 Deviation from efficient tariff (%) 40 8 50 49 5 3 16 Four-block IBT Average tariff (US$/m3) 2.0 2.5 3.0 1.5 2.1 2.3 2.4 Deviation from efficient tariff (%) 40 5 35 49 6 5 19 Ranking Average % deviation: three-block IBT 24 Moderate 2 Average % deviation: four-block IBT 23 Moderate 2 Note: IBT = increasing block tariff; m3 = cubic meter. 132 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services households and the following step changes in the in the four-block scenario. Although the percent- residential block tariffs were applied: age deviation from the efficient tariff is only mar- ginally lower than under three-block IBTs, the • Three-block IBT. The second block tariff is difference would become more pronounced as 50   percent higher than the first block, and the more blocks are added. third block tariff 100 percent higher than the first block tariff. The consumption block thresholds are Using the same block thresholds as the three-block 20 cubic meters (m )/month for the first block and 3 IBT, jump tariff increases were set across consump- 50 m /month for the second block. 3 tion blocks such that they are less steep, while still • Four-block IBT. The second block tariff is keeping average tariff levels the same. The second 20 percent higher than the first block, the third block tariff was 30 percent higher than the first block block tariff is 50 percent higher than the first block, tariff, and the third block tariff 65 percent higher and the fourth block tariff is 100 percent higher than the tariff applied to the first block. To satisfy than the first block tariff. The first consumption affordability, the first block tariff for residential cus- block reaches 15 m3/month, the second block tomers is set based on the maximum affordable bill threshold is at 30 m3/month, and the third block for low-consumption residential households. To sat- covers 80 m3/month. isfy cost recovery, the first block tariff for nonresi- dential customers is set as to cover all remaining To satisfy the cost-recovery objective, the nonresi- costs of supply. dential tariff was set to recover the costs of supply For the same average residential tariffs, jump tar- across all customer categories, assuming the same iffs achieve cost recovery with less steep tariff step changes in the block tariffs as for residential increases across subsequent consumption blocks customers: than IBTs (table C.4). Jump tariffs charge the higher • In the three-block scenario, the resulting tariffs block unit price of all previous units of water con- deviate from the efficient tariff by 24 percent on sumed and avoid subsidizing the first consumption average across all customer categories. blocks for medium- and high-consumption custom- ers as is the case in IBTs. Jump tariffs also appear to • Because the tariff increases are less steep, there is send more efficient pricing signals as the percentage not as much distortion to the efficiency objective TABLE C .4. Jump Tariff Efficiency Ranking Residential Nonresidential Low Medium High Low Medium High Very High Cost of supply (US$/m ) 3 3.3 2.4 2.2 3.0 2.3 2.2 2.0 Average tariff (US$/m ) 3 2.0 2.6 3.3 1.8 2.2 2.2 2.2 Deviation from efficient tariff (%) 40 8 50 42 1 1 10 Ranking Average % deviation: 22 Ranking: Moderate 2 Note: m3 = cubic meter. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 133 average deviation from efficient tariffs is 22 percent difficult and seldom employed to price water and against 24 percent for three-block IBTs. This compar- wastewater services. ison of deviation is however based on average tariffs To satisfy efficient pricing, the fixed charge for and omits an additional effect—under an IBT the two-part tariffs was set to recover the fixed costs for marginal price faced by a high-consuming customer each customer category. To satisfy affordability, the is the rate for the highest block, which is significantly residential volumetric charge was based on the max- more than the jump tariff rate. imum volumetric tariff to ensure affordability. This is The DBT scenario assumes that the second block lower than the residential cost of supply for tariff is 30 percent lower than the tariff applied to the low-consumption residential customers. To satisfy first block, and the third block tariff 60 percent lower cost recovery, the nonresidential volumetric charge than the first block tariff. The same consumption was set such as the costs of supply are recovered. block sizes are also applied. To satisfy affordability, The resulting pricing structure is more efficient the first block tariff for residential customers is set than flat rates but does not fully reflect the underly- based on the maximum affordable bill for ing cost of providing services to different customer low-consumption households. To satisfy cost recov- groups according to their marginal costs of supply. ery, the first block tariff for nonresidential customers This is due to the affordability constraint on is set to recover the costs of supplying different cus- low-consumption residential customers. tomer groups. When affordability constraints are not so stringent, DBTs reflect the higher cost of supplying low-con- however, two-part tariffs are the most efficient pric- sumption nonresidential customers (large custom- ing option (table C.6). Where the volumetric charge is ers are cheaper to supply) and deviate from the based on the maximum affordable bill and on top of efficient tariff by 24 percent on average (table C.5). that, fixed charges are set to recover the fixed costs of However, this tariff structure allows high-end users serving each customer category, the resulting tariff is to pay less than average water tariffs, while penaliz- an efficient structure, which exceeds the 5 percent ing consumers in low-consumption tiers, and is affordability threshold (low-consumption residential therefore often considered to promote unfairness. customers spend approximately 8 percent of their For this reason, DBTs are in most cases politically monthly income on water bills). 134 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services TABLE C .5. Decreasing Block Tariff Efficiency Ranking Residential Nonresidential Low Medium High Low Medium High Very High Cost of supply (US$/m ) 3 3.3 2.4 2.2 3.0 2.3 2.2 2.0 Average tariff (US$/m ) 3 2.0 1.6 1.2 4.1 2.5 2.2 2.0 Deviation from efficient tariff (%) 40 32 45 38 13 1 1 Ranking Average % deviation: 24 Ranking: Moderate 2 Note: m3 = cubic meter. TABLE C .6. Two-Part Tariff Efficiency Ranking Residential Nonresidential Low Medium High Low Medium High Very High Cost of supply (US$/m ) 3 3.3 2.4 2.2 3.0 2.3 2.2 2.0 With 5% affordability constraint Average tariff (US$/m ) 3 2.0 1.1 0.9 3.2 2.5 2.4 2.2 Deviation from efficient tariff (%) 40 56 61 7 10 10 11 Without affordability constraint Average tariff (US$/m ) 3 3.3 2.4 2.2 3.0 2.3 2.2 2.0 Deviation from efficient tariff (%) 0 0 0 0 0 0 0 Ranking Average % deviation—with affordability constraints 28 Moderate 2 Average % deviation—without affordability constraints 0 Very good 4 Source: Original analysis. Note: m3 = cubic meter. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 135 © Getty Images APPENDIX D Simulation of Potential Reductions in Tariff Levels Resulting from Reducing Inefficiencies Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 137 138 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services **Assuming 50%-50% split in nontechnical efficiencies between these two Reduce nontechnical (A) + Reduce nontechnical (A) + (b) +Reduce (A) + (b) + (c) + Reduce inefficiencies by bill inefficiencies by nonrevenue overstaffing inefficiencies CAPEX inefficiencies by collection by 75% (a) water by 75% (b) by 75% (c) 75% (d) Regions Current value (USD/m3) (A) (A) + (b) (A) + (b) +(c) (A) + (b) +(c) + (d) Average Full tariff Adjusted value Adjusted value Adjusted value Adjusted value tariff Variation Variation Variation Variation (USD/m3) (USD/m3) (USD/m3) (USD/m3) (USD/m3) (USD/m3) World $0.90 $2.13 $2.12 -0.36% $2.11 −0.63% $2.11 −0.73% $2.00 −6.06% South Asia $0.18 $0.69 $0.68 −0.47% $0.68 −0.82% $0.66 −4.07% $0.63 −8.03% Europe & Central Asia $0.75 $2.07 $2.06 −0.29% $2.06 −0.51% $2.04 −1.18% $1.86 −10.19% East Asia & Pacific $1.26 $1.12 $1.12 −0.20% $1.12 −0.34% $1.12 −0.63% $1.09 −2.86% Latin America & $0.84 $3.16 $3.15 −0.39% $3.14 −0.68% $3.17 0.25% $3.00 −4.88% Caribbean Middle East & North $0.31 $1.29 $1.28 −0.22% $1.28 −0.38% $1.22 −5.60% $1.19 −7.72% Africa Sub-Saharan Africa $0.79 $2.94 $2.92 −0.73% $2.91 −1.27% $2.86 −2.86% $2.61 −11.28% High income $1.21 $0.97 $0.97 −0.26% $0.97 −0.45% $0.96 −1.43% $0.94 −3.49% Upper middle income $0.81 $3.06 $3.05 −0.40% $3.04 −0.69% $3.05 −0.23% $2.87 −6.34% Lower middle income $0.27 $2.19 $2.19 −0.29% $2.18 −0.51% $2.16 −1.75% $2.03 −7.23% Low Income $0.72 $4.37 $4.35 −0.49% $4.34 −0.86% $4.30 −1.55% $3.98 −8.95% Note: CAPEX = capital expenditure; m3 = cubic meter. Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 139 © World Bank APPENDIX E Estimating Revenues to Meet Financial Objectives The following case is one possible example for meeting financial objectives.1 Let’s assume a water utility’s current annual sales by volume (100 million m3/ year) are expected to grow at an average of 2.5 percent per year. Operation and maintenance (O&M) costs are estimated at US$0.20/m3. Fixed assets have a his- torical value of US$150 million and are depreciated over a 30-year period. A total of US$90 million was financed through loans that have been repaid in full and a total of US$15 million was received through a development grant. A fur- ther US$45 million was recently financed through debt (with a tenor of 20 years at an interest rate of 6 percent), to be repaid until year 15. Future debt is expected to be raised on similar terms. The average annual capital expenditure for distribution network extensions is US$5 million and a major production project valued at US$70 million is expected to be commissioned in year 6. All the above figures are given in constant prices for year 0. The average inflation rate is estimated at 3 percent. The regulator has been requested to propose a sequence of revenues1 that limit future annual increases to 3 percent, i.e., the expected inflation rate. Cash needs. If future capital expenditure (CAPEX) is entirely financed on debt, the revenues needed to cover each year of O&M costs and the debt service would have to be gradually increased from US$0.24/m3 in year 0 to US$0.29/m3 in year 5 and more steeply to US$0.36/m3 in year 6 (a 25 percent increase). This sequence of revenues meets cash needs but does not comply with annual tariff adjustment restrictions. An initial tariff of US$0.2775/m3 increased by 3 percent per year during the following 10 years would cover all cash costs, and initially build a cash reserve that would gradually disappear over the 10-year period. Cash needs with contribution to CAPEX. If 25 percent of the predicted CAPEX is to be financed by cash surpluses, the revenue increase needed in year 6 to con- tribute to the lumpy investment would be almost 80 percent. Such high reve- nues would not be needed after year 6, so to limit increases in annual revenues, a cash reserve would have to be built before year 6. An initial revenue set at Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services 141 US$0.29/m3 and gradually increased by 3 percent per Hybrid utility costs. A “hybrid” model would con- year would be sufficient to contribute to the CAPEX, sist of setting revenues to cover O&M costs, the debt after which cash reserves would be at a minimum. service, the depreciation of equity financed assets Utility costs. If the utility is to cover its O&M costs, and a return on equity of 8 percent. An initial average depreciate its fixed assets and yield an average revenue of US$0.3625/m3 gradually increased by 8 percent return on fixed assets, the tariff would 3  percent per year would meet this objective and have to be set at an initial level of USD$0.4225/m and 3 limit the cash reserves to about US$100 million in gradually increased by 3 percent per year thereafter. year 10. Limiting the return on equity to 2 percent This sequence of revenues would result in a cash would require an initial revenue of US$0.31/m3 and reserve of almost US$200 million by year 10, or about reduce the cash reserve in year 10 to about two-thirds of the value of assets. Lowering the initial US$30 million. revenues to US$0.3225/m would limit the return on 3 assets to 2 percent and the cash surplus to US$50 Note million, while still meeting all cash needs during the 1. In this appendix, revenues refer to average revenues per cubic meter. 10-year period. 142 Troubled Tariffs: Revisiting Water Pricing for Affordable and Sustainable Water Services W21023