Tuesday, June 12, 2012

Is IBT based water pricing always fair?

It is widely believed that Increasing Block Tariff (IBT) based water pricing is a more efficient model for allocating water that uniform rate (UR) pricing. In the former, the unit prices increase progressively at higher consumption slabs, whereas in latter, allocation is at a single unit price irrespective of consumption.

IBT has a striking cognitive appeal in so far as the poorer people, who presumably use less water, enjoy a lower tariff and appear to be cross-subsidized by those with higher consumption, who are more likely to be more well-off. In this context, David Zetland has an excellent post that points to a study by Ronald Griffin and James Mjelde, which highlights why IBTs are much more complicated and how the apparent "fairness" disappears when they are subjected to greater scrutiny. He illustrates it with this example,
  1. Start with a $10/household fixed service fee plus $4/unit volumetric charge equal to the delivery cost.
  2. Assume a poor household consuming 2 units pays $10 plus $4*2 ($18); a rich one consuming 6 units pays $10 plus $4 *6 ($34). Total revenue = $52 covers total cost of $32 + $20.
  3. Now create an IBR by reducing everyone's price for the first 4 units to $2/unit. The rich don't use more (because they face the same price on the margin), but the poor household now uses 3 units of $2 water.
  4. Under the new rates, the rich pay 4*$2+2*$4 = $16 for water. The poor pay 3*$2 = $6 for water. Variable revenue is $22, but cost of delivery is 9*$4 = $36. Fixed charges need to rise by $14 to cover that gap. Since customers pay fixed charges per meter, each one pays $7 MORE. So now the rich pay $33 (less than before to consume the same amount of water) and the poor pay $17+$6 = $23 (greater than $18 from before). 
  5. Sure they are using more water, but the new tariff structure means that extra unit is costing them $5 instead of $2.
In other words, not only do the poor face higher prices and the rich lower prices, but the total consumption is higher. Zetland therefore argues that a fixed charge to cover fixed costs plus a UR to cover variable costs, which is much simpler, is a fairer and more efficient model (than fixed charge plus IBT) to allocate water resources. Zetland's critical point is "that IBRs are not automatically good (as they are often presented), and that URs can probably accomplish more with fewer complications".

This brings us to the importance of the design of IBTs so as to ensure fairness and efficiency. The trade-off is that any design of an IBT model that seeks to meet the twin objectives will fail the simplicity test. IBT models that have to both recover the full cost of service and also avoid the problems in the illustration will have incorporate some variant of atleast one of the following strategies.

1. Very low variable tariff for a basic consumption requirement and steeply increasing tariffs at higher consumption levels.

2. Differential fixed charge pricing for different consumptions slabs. Typically, those within a basic consumption slab will have a much lower fixed charge than those at the higher slabs.

In both cases, the model design is complicated by the likely consumption profiles of buyers. In developing country cities, where the large majority of consumers are likely to be poor, with either of the aforementioned cross-subsidy approaches, the differentials have to be very wide to recover the full cost of service from the smaller numbers of non-poor. But wider the price differentials among different categories of consumers, greater the incentive distortions and difficulty of management. The distortions induced by these differentials become more evident in the middle consumption tiers.

Therefore, as Zetland argues, the IBT models become too complicated to easily administer. In the circumstances, a UR model offers considerable attractions.   

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