As California heads into a fourth year of drought, water agencies are scrambling for new ways to conserve.

Gov. Jerry Brown has mandated 25 percent water reductions, and called on resource managers to create new incentives for conservation. Tiered pricing – charging more per gallon to customers who use more – could be an effective mechanism. In fact, many water utilities in California and elsewhere already use tiered pricing structures. However, a recent court decision in a case brought by ratepayers in San Juan Capistrano may stymie such efforts.

Stanford Woods Institute-affiliated economics professor Frank Wolak has been working to develop a model of customer-level water demand that can be used to design tiered water rate schedules to meet conservation and utility revenue objectives. Water in the West, a joint program of Woods and the Bill Lane Center for the American West, spoke with Wolak.

How do tiered water rate structures - sometimes called increasing block price schedules -  work? 

Increasing block price schedules provide strong incentives for customers to conserve water. The lowest price block or tier typically corresponds to an amount of water sufficient to meet basic indoor needs like drinking and bathing. Each subsequent tier charges a higher per-unit price for additional consumption, and is designed to discourage households from using water for non-essential things like watering lawns and filling swimming pools. 

What is the San Juan Capistrano case? How does it relate to tiered water rate structures?

A group of ratepayers in San Juan Capistrano challenged the city’s tiered water rates structure. They argue that the amount they were being charged does not correspond with the actual cost per unit of water, thereby violating a voter-approved initiative called Prop. 218.

Passed in the early 1990s, Prop. 218 requires local government agencies to set service charges that match the actual cost of providing that service. For water, this means that each customer would pay no more than the cost of providing the water that he or she consumes. 

What did the court decide?

The court explained that while tiered rates are not unconstitutional, Prop. 218 requires agencies to provide evidence that tiered prices correspond with actual costs of providing water at each tiered level. I read this to mean that your monthly bill must equal the cost of the water that you consume. The model I have developed can be used to design tiered price schedules that achieve this goal.

What is the goal of your work on a model for tiered water rates?

My work on tiered water rates is intended to help water utilities meet their conservation goals and provide revenues that cover their costs while incurring the least amount of revenue risk. My model of the customer-level demand for water can be used to design tiered price schedules that achieve a range of policy goals for the utility. For example, given an average cost per gallon, my model could be used to design tiered price schedules for different types of customers – households with a certain number of children or a large lot, for example. This way, the utility recovers revenues from each type of customer equal to the total cost of serving that customer, as Prop. 218 stipulates.

How does your work potentially help water utilities in the era of Prop. 218?

My work provides water utilities with a tool that they can use to predict a customer’s demand, and hence their water bill, for any given price structure. It can used to design a price schedule such that the customer’s expected monthly water bill is equal to what it costs the utility to provide that customer with water. This would help the utility make the case that it prices meet the requirements of Prop. 218. 

What advice would you offer water utilities? 

Data and analytics will need to play a very big role for water utilities moving forward. Our research demonstrates that there are substantial economic benefits to knowing your customers. This recent court ruling provides even stronger incentive for utilities to take steps to do so.

There’s plenty of low hanging fruit, such as online surveys, that can provide utilities with data that can feed into my model to better estimate water consumption for any given price schedule. A utility’s rates can then be better correlated with cost of service to withstand court challenges like the recent one. 

Frank Wolak is the Holbrook Working Professor of Commodity Price Studies in Economics at Stanford University; Director of the Program on Energy and Sustainable Development; Senior Fellow, by courtesy, at the Stanford Institute for Economic Policy Research; Senior Fellow at the Freeman Spogli Institute for International Studies; and faculty affiliate at the Stanford Woods Institute.