Increasing Block Tariffs in the Water Sector: An Interpretation in Terms of Social Preferences

Meran, Georg and von Hirschhausen, Christian, Increasing Block Tariffs in the Water Sector: An Interpretation in Terms of Social Preferences (September 2014). DIW Berlin Discussion Paper No. 1434. Available at SSRN:http://ssrn.com/abstract=2553084 or http://dx.doi.org/10.2139/ssrn.2553084


Abstract

Many developing countries around the world apply progressive water tariffs, often structured in the form of discretely increasing block tariffs (IBTs). These tariffs have been criticized in the welfare economic literature due to their perceived inefficiency: many of the prices charged under IBTs do not correspond to marginal costs and thus violate the principle of allocative efficiency. In this paper we explore an alternative interpretation of the widespread use of IBTs, in terms of social preferences and fairness considerations. For this, we rely on an extension of the Fehr and Schmidt (1999) utility function, including inequality aversion, to which we add another parameter representing a preference for redistribution, which reflects a societal preference to correct for income difference perceived as unfair. In addition, the paper also includes household size in the analysis, finding that as poor households are on average larger (in per capita terms), a simple IBT tariff disregarding household size may not be "fair" at all. We conclude on a methodological note on the importance of addressing allocative and distributional issues simultaneously.

The Benefits Of Reusing Wastewater

Only 2.5 percent of the world's water is fresh water, and of that, only 1 percent is accessible as much is trapped in glaciers and snowfields. As a result, only a tiny fraction of the planet's water is available for everyday use. By one estimate, global fresh water demand will exceed supply by a staggering 40 percent in 2030 if current trends continue.

As corporate citizens, businesses must look at their impact on the environment and assess how their operations affect the communities they operate in and serve. By reducing their source water requirements, food and beverage companies of any size can do their part to reduce environmental impact, while reinforcing their corporate social responsibility. Many companies also realize substantial cost savings from water-related investments. 

Integrated Water Resources Management and its Contribution Towards Achieving the MDGs

The interface of water resources and development and the achievement of the MDGs is complex and includes many specific linkages.  Examples of the linkages between water and achieving the MDGs are emphasized in the previous section.  This wide array of important linkages that present many synergies, explains why pursuing each goal separately reduces the complex process of human and economic development to a series of conflicting, and unsustainable interventions.  In addition, the interface of water resources and the achievement of the MDGs occurs at several different institutional levels, explaining why water resource policies in many countries have evolved in a fragmented and piecemeal fashion.  Under this framework, policy objectives have been set without consideration of the implications for other water users and without consultation across sectoral and institutional boundaries.  This traditional approach to water management has, in general, proven to be an ineffective policy strategy due to the fact that these problems fall outside of the normal purview of the agencies tasked with addressing them and, thus, require cooperation from multiple sectors.  In order to optimize water resources for development and the MDGs, countries must overcome constraints through appropriate investments and management arrangements within broad planning and policy iniciatives.

Saleth and Dinar (1999, 2004) also emphasize that institutional changes are needed to improve water management since previous institutions were developed during a water surplus era.  Moreover, as Global Water Partnership (2000) points out, water management is usually left to top-down institutions, the legitimacy and effectiveness of which have increasingly been questioned. However, it is important to highlight that the effectiveness of these sectoral improvements will be affected by the country’s institutional and  macroeconomic environment since many of these reforms depend on economic, ecological, and political constraints (Saleth and Dinar, 2004) and reflect the fact that institutional reform is path dependent (North, 1990). 

An IWRM approach, defined as a process that “promotes the coordinated development and management of water, land, and related resources, in order to maximize the resultant economic and social welfare in an equitable manner without compromising the sustainability of vital ecosystems” (Global Water Partnership website), provides an opportunity to attack these problems more effectively, identifying root causes and solutions that lie outside of any one specific sectoral area and focusing on investment as well as management issues. IWRM is not a reform whose objective is just to achieve a more efficient management of water as a resource, it considers reforms whose objectives are to improve governance and financial systems at all levels, in order to meet each country’s development goals.

Thus, an IWRM approach considers the diverse linkages between water resources and the achievement of the MDGs, ensuring that investments across sectors work together, producing greater returns by exploiting the synergies between the linkages.  In addition, the involvement of multiple sectors highlights opportunities that are often hidden by sectoral thinking. For example, examining domestic water and sanitation needs along with food security issues generates opportunities to provide communities with water for domestic and food production purposes at a lower additional cost compared with traditional water planning approaches (Global Water Partnership, 2004a).  IWRM also helps reduce the negative consequences of undesired environmental impacts associated with water development and the costs associated to the environmental damage. For example, the annual cost of mitigating the effects of land and water degradation in Asia associated to water development strategies has been estimated at US$35 billion (Global Water Partnership, 2004a). Finally, since IWRM considers in an integrated manner social, economic and environmental goals, it promotes a more strategic and socially efficient water allocation than traditional approaches driven individual sectors interests.  The UN Task Force on water and sanitation, based on the advantages of IWRM, is convinced the MDGs as a whole will not be met unless an IWRM Plan, which considers deliberate planning and investment in sound water resources management and infrastructure, is implemented (Lenton, 2005).

1.  Saleth, R.M. and Dinar, A. 1999. Evaluating water institutions and water sector performance Tech. paper 447, World Bank, Washington D.C. Available at: http://www-wds.worldbank.org/external/default/WDSContentServer/IW3P/IB/1999/09/21/000094946_99090305381648/Rendered/PDF/multi_page.pdf

2.    Saleth, R.M. and Dinar, A. 2004. The institutional economics of water: A cross country analysis of institutions and performance Edward Elgar, Mass. 398 pp.

3. Global Water Partnership. 2004a. Catalyzing Change: A Handbook for Developing Integrated Water Resources Management (IWRM) and Water Efficiency Strategies. Technical Advisory Committee, Global Water Partnership, Stockholm, Sweden. www.gwpforum.org

4.   Lenton, R. 2005. Water Resources Management and the Millenium Development Goals. Presentation at the Seminar Water and the Millenium Development Goals: It’s Contribution to Development. Organized by IDB. Okinawa, Japan, April 6, 2005.

Environmental Sustainability and #Water

Reduced water quantity and quality have serious negative impacts on ecosystems. The environment has a natural absorptive, self-cleansing capacity; however, if this is exceeded, biodiversity is lost, livelihoods are affected, natural food sources are damaged and high clean-up costs result. Unesco (2003) points out that increased environmental damage has led to a greater occurrence of natural disasters, such as floods where deforestation and soil erosion have prevented natural water attenuation. More specifically, between 1991 and 2000 over 665,000 people died in 2,557 natural disasters— 90% of which were water-related and 97% of the victims were from developing countries.  Based on this marked increase, Hideaki (2005) proposes that the target to halve human loss due to water disasters by 2015 be added to the MDGs.

Additionally, unsustainable agricultural activities such as the draining of wetlands for agriculture and land clearance, among others, lead to significant negative impacts on the future availability of water (Unesco, 2003). The reduction and degradation of natural water courses due to deforestation and over-extraction of water have put many wetlands and marine ecosystems at risk.  Therefore, ecosystem health, in turn, is critical to the quantity and quality of freshwater supply and, thus, sustainable water resources management requires ecosystem-based management.  IWRM Plans do not regard the ecosystem as a user of water in competition with other users, but as the base from which the resource is derived and upon which development is planned (Jewitt, 2001).

Furthermore, water quality is an aspect of freshwater availability that also has a major impact on environmental sustainability (see e.g. Lenton, Wright, and Lewis; 2005).  Water quality currently represents a significant problem in several countries created or aggravated by anthropogenic causes, such as pollution discharges into surface water bodies and leaching of contaminants into underground water sources.   Adequate treatment and disposal of waste contributes to reduce the pressure of freshwater resources. Therefore, improved water quality management is a key factor in maintaining ecosystems integrity.

#Water is required to achieve MDG 5. Improve Maternal Health

Access to adequate water in quantity and quality affects maternal health by reducing labor burdens and health problems resulting from water portage; improving nutrition which reduces the susceptibility to anemia and other conditions that affect maternal mortality; and malaria is particularly dangerous to pregnant women, and better water management reduces mosquito habitats.  Thus water available to women affect their health and maternal health problems impacts and prevent the proper care of children, undermining development efforts. Additionally, educated women with access to adequate resources are better able to care for themselves. Thus, meeting the MDGs for education and women’s empowerment by improving the management of water has a positive impact on maternal health

Most water related diseases effects impact negatively maternal health and, thus, must be considered as an integral part of the necessary strategies in order to achieve this goal

Increasing access to safe water and thereby reducing child mortality

While most countries are committed to increasing access to safe water and thereby reducing child mortality, there is little consensus on how to actually increase access to safe water and sanitation coverage and to improve water service.  Some developing countries have implemented a strategy based on the privatization of water provision companies.  Galiani, Gertler, and Schargrodsky (2005), using the variation in ownership of water provision across time and space generated by the privatization process in Argentina, found that child mortality fell 8 percent in the areas that privatized their water services; and that the effect was largest (26 percent) in the poorest areas.

Galiani, S.,  Gertler, P., and Schargrodsky, E. 2005. Water for Life: The Impact of the Privatization of Water Services on Child Mortality. Journal of Political Economy, 113 (1), 83-120

Urban Water and Sanitation Sector in Chile

During the 1980s, the sector was dominated by governmental water-supply utilities, which supplied water and sanitation (WSS) services to most of Chile.  The inclusion of private operators began in 1988.  The urban water supply coverage in 1993 was 97.6%, and the service was provided mainly by state owned water supply operators (see Figure 1).  Furthermore, only 85.9% of urban population had access to sewer collection and only 13% of wastewater was treated. The driver of this situation was the low investment in infrastructure; the estimated investment cost deficit for the 1993 – 2000 period was $2.4 billion.  A 63% of the deficit was in wastewater treatment.  Before 1993, the average annual investment of the state owned operators was $150 million. 

Figure 1: Growth and Evolution Regulated Water and Sanitation Sector (Own elaboration based on SISS, 2013)

During 1994, several of the 13 state owned WSS operators presented losses; for example Essat presented -4.1% and Emssa -3.2%.  This was, in part due to a 30% increase in average costs between 1990 y 1994. Administrative costs increased during this period; ESVAL incremented its administrative costs in 140% while EMOS increased by 40%. Furthermore, non-revenue water varied between 24% and 43%. 

The actual legal framework of the WSS sector established in 1988, establishes the following objectives that water and sanitation tariffs must satisfy:

a)      Full recovery of operation and maintenance costs;

b)      Fund necessary infrastructure reposition and development plan investment;

c)      Tariff reductions when operators increase efficiency; and

d)      Operational margins that are consistent with the opportunity cost of capital.

The legal framework of the Chilean water and sanitation tariff system establishes that tariffs must satisfy the principles of i) economic efficiency, ii) water conservation incentives, iii) equity, and (v) affordabiliy (Chavez, 2002).

In order to comply with economic efficiency, the WSS tariffs are based on a two Part Tariff, following Coase’s Solution: a variable and fixed tariff. The variable tariff is set following Hotelling’s Principle; thus, variable water tariff is consistent with the first best solution where marginal benefits are equal to long-run marginal costs[1] (MC) and social welfare is maximized (Figure 2).  However, this variable tariff set at MC does not cover the operator’s average costs; that is, the WSS providers operate with losses.  In order to satisfy the full cost recovery principle, a fixed tariff is included so as to cover the natural monopoly’s losses at the first best solution. 

Figure 2: Tariff setting Principles

The Executive Decree 453 of the 1988 Law N° 70, of the Ministry of Public Works (Ministerio de Obras Públicas, MOP) establishes a variable tariff which is set for periods of high demand, during summer months, (peak variable tariff $/m³) and for non-peak periods (non-peak variable tariff $/m³). The peak and non-peak tariffs are considered so as to internalize changes in seasonal demand and thus cover differences in the provision costs of the service. As previously pointed out, the current tariff structure also considers a fixed charge per customer (connection), which depends on the diameter of the connection. 

In order to estimate the variable charge, the Chilean tariff law introduced the concept of the incremental development cost, which is defined as the value that applied to the incremental forecasted demand generates the necessary revenues, so as to cover incremental operation efficient costs and the required investment associated to an optimized expansion project the WSS firm.  The incremental development cost is determined such that the net present value of the optimized expansion project is equal to zero (D.F.L. No 70/1988).

The variable tariff also considers the value of water so that consumers consider the scarcity of water in their consumption decisions[2].  This generates correct incentives to conserve water in resource scarce areas.  For example, average variable non-peak and peak tariffs in the Dry Pacific arid system are $1.3/m³ and $2.2/m³. In the Southern Humid Pacific System, on the other hand, they are $0.88/m³ and $1.3/m³, respectively. Fixed tariffs also vary according to water scarcity representing $1.9/m³ and $0.8/ m³ in the Dry and Southern Humid Pacific systems, respectively (SISS, 2013).  Additionally, evidence that tariffs send the right signals to consumers is that average monthly household consumption has significantly fallen since 1998 from approximately 25 m³/household/month to 18.6 m³/household/month in 2013 (Figure 3).

Figure 3: Average monthly household water consumption (m³/household/month) (SISS, 2013)

The affordability criteria is met by the provision of subsidies directly to the most vulnerable households. Households are classified based on an annual survey (Encuesta Casen) which estimates household per capita income.  In order to qualify for the subsidy, households must not have payment arrears with the service provider. The central government transfers the block subsidy to the municipalities; the latter use this to pay a share of each of the eligible household’s water bill; the payment share ranges from 15 to 85 per cent of the water bill, with the poorest families getting the highest share. The subsidy covers a consumption of up to 20 m³. The Social Development Ministry (Ministerio de Desarrollo Social, MDS) uses the household survey information for each Region of Chile to determine the size the block subsidy that needs to be transferred to the municipalities. The WSS providers bill the benefiting households for the net of subsidy amount, but indicating the full consumption cost, and then charge the municipality for the subsidies granted[3]. The municipality will be charged interest for late payment, and the WSS provider can discontinue service to benefiting households if there is non-payment by the municipality. In 2011, 15% of WSS provider customers were benefited (6% of total sales), at a cost of $80 million, and an average monthly subsidy per household of $10.

In order to obtain the necessary investment funds to improve its performance the WSS sector’s indicators, during the period 1989-99, an institutional model was put in place where the regulatory and supervisory functions were separated from the investment, production and sale of service functions.  The new regulatory regime, which considered concessions to establish build and operate water and sanitation services by private providers, led to an increase in private participation in the provision of WSS services from 5% in 1999 to 95.5% in 2013.  This process also led to a significant increase in average annual investments from $200 million to $500 million in 1999 and 2013, respectively (Figure 2).  This is mainly due to the increased rate of return on capital, due to increases in tariff rates. Tariff rates are determined so that investors receive a low-risk return of at least 7% on capital expenditures and therefore private WSS providers have the incentive to invest in water provision, wastewater collection and treatment (Hearne and Donoso, 2005). For example, sewage treatment coverage increased from 17% in 1999 to 99.8% in 2013 (Figure 2).

This reform period coincided with the era of high economic growth (6.2% per year) with real incomes rising significantly. Williams and Carriger (2006) propose that the transformation of the WSS sector would not have been so successful without these high rates of growth. The level of investment needed to attain this coverage could not have been reached if the Chilean Government were responsible for investment. With tariffs set centrally for water and sanitation, efficiency incentives exist for the companies to increase returns on investment. This has happened and these companies perform well on the Chilean Stock exchange (Bitran and Arellano, 2005).

Currently there are 53 water and sanitation service providers operating in the urban areas of Chile. They function as private companies although the state investment company, ECONSSA, still owns a considerable number of share in most companies (Hearne and Donoso, 2005). Five of Chile's 13 regional water companies were fully privatized with partial sale to multinationals in 1998.

The WSS providers service more than 4.5 million clients[4], 94.4% of clients are domestic, 4.7% commercial, 0.2% industrial and 0.7% other. Additionally, 95% of all clients have both drinking water and wastewater connections. The other 5% have either one or the other, with most having only drinking water connections.

The large and medium service providers (8 of the 53) serve 84.2% of all clients. It is interesting to note that a municipality (SRMPA of the Maipu municipality) owns one of them. Private providers service 95.5% of all clients.

With respect to the service quality, Figure 4 shows that costumer’s satisfaction levels since 2008 are over 99%. WSS clients were quite satisfied with the service, rating it with a 5.3 on a scale of 1 to 7 (GWI, 2013). 

Figure 5: Water service quality (SISS, 2013)

Therefore, the new regulatory scheme in the Chilean WSS sector has provided the right economic signals for an efficient allocation of resources. It has also led to meeting the set goals for service coverage.  Additionally, the transformation of the WSS sector has led to the

a)      Improvement in quality of service

b)      Increase in WSS provision coverage, despite rapidly increasing urban populations; and

c)      Increase in water conservation by customers.

In summary, Chile’s policy of providing water supply and sanitation (WSS) services through privatized regional and local water companies has been a notable success.

References

  1 Bitran, G. and P. Arellano, 2005, Regulating Water Services, Sending the Right Signals to Utilities in Chile, Public Policy for the Private Sector, World Bank, Note number 286, March.2005. Available at Background Document http://rru.worldbank.org/Documents/PublicPolicyJournal/286Bitran_Arellano.pdf.

  2 Chavez, C. 2002, Public-Private Partnership And Tariff Setting: The Case Of Chile, OECD Global Forum on Sustainable Development Conference on Financing the Environmental Dimension of Sustainable Development, 24-26th April, OECD, Paris, http://www.oecd.org/sweden/2083795.pdf.

  3 D.F.L. No 70/1988, http://www.leychile.cl/Navegar?idNorma=4427. 

     4   Executive Decree 453 of the 1988 Law N° 70, of the Ministry of Public Works, http://www.leychile.cl/Navegar?idNorma=98618.

   5 GWI, 2013, Global Water Intelligence Market Insight: Chile. Media Analytics Ltda. UK.

     6    Hearne, R. and G. Donoso, 2005, Water Institutional Reforms in Chile, Water Policy, 7 (2005), 53-69.

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   7  SISS, 2013, Informe de Gestión 2013. http://www.siss.gob.cl/577/articles-10684_recurso_1.pdf

   8 Williams, S. and S Carriger, 2006, Water and Sustainable development: Lessons from Chile, Global Water Partnership, Policy Brief 2, Technical Committee (TEC). Available at www.gwpforum.org/gwp/library/policybrief2chile.pdf.

   9 WRI (World Resources Institute). 2003. Earth Trends Country Profiles. (http://earthtrends.wri.org/country_profiles/index.cfm?theme=2).

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[1] Long-term infrastructure investment costs are included in the water and sanitation services tariff rates.

[2] The value of water for each WSS provider is determined by market prices of traded WUR.

[3] This practice does not distort the price signals. 

[4] A client is determined by the property, rather than the individual, that receives services and is billed for these (more than one person may live in the same property, benefiting from the services).