A decoupling drama plays out in San Jose
Over the past year I’ve blogged about my research with Youlang Zhang and David Switzer on public and private water utilities’ responses to the drought that gripped California from 2014-2017. One of our most interesting findings was that California’s private, investor-owned utilities conserved significantly more water than government utilities. We argued that a main reason for the difference was politics and California law, which allows rate decoupling for private water utilities.*
The timing of the San Jose story was uncanny: I wrote my 2018 water conservation update just as SJWC was filing its request for the rate increase. The story of conservation and rates in San Jose is a useful illustration of why decoupling is so economically effective but politically perilous.
One city, three water systems
San Jose is unusual among large American cities in that three separate utilities provide drinking water service to its residents. The San Jose Municipal Water System (SJ Muni) is governed by the San Jose City Council, which sets the utility’s investment, operating, and financial policies. Two private water systems also serve San Jose: Great Oaks Water Company and San Jose Water Company (SJWC). Corporate boards and executives make investment and management decisions for these systems. Serving a population of more than a million, SJWC is the giant of the trio; but SJ Muni and Great Oaks are also large, each serve populations of around 100,000.
Importantly, very different processes govern price-setting for the three systems. San Jose’s elected City Council sets rates for SJ Muni. As investor-owned systems, SJWC and Great Oaks set their rates through the California Public Utilities Commission, whose members are appointed by the governor. That means San Jose voters can influence SJ Muni’s rates through their elected councilmembers. Rate-setting for SJWC and Great Oaks is a more technocratic affair, with the process handled mostly by lawyers, engineers, and economists at the CPUC.
All three systems charge fixed monthly service fees plus volumetric prices. However, their volumetric rate structures differ in subtle but important ways. The two private utilities employ inclining block rates, which charge progressively higher unit prices as volume increases. For example, SJWC customers pay $3.20 per hundred cubic feet (ccf) for the first three ccf; prices jump to $4.80/ccf for the next 15 ccf, and then to $6.40/ccf for volume beyond 18 ccf per month. Great Oaks uses a similar three-block rate structure, although its rates are considerably less progressive. SJ Muni uses a flat rate: customers pay the same unit price for all water, regardless of how much they use.† Here’s how these prices translate into bills for demand ranging from 0-30 ccf per month:
Great Oaks’ prices are lowest overall. SJ Muni’s and SJWC’s prices are similar at low volumes, with the private company’s total prices about $7-10 higher through the first 15 ccf. Without detailed financial, operational, and customer data, it’s impossible to say whether that gap is justified. We can say that the gap widens at higher volumes due to SJWC’s more progressive pricing: at 40 ccf/month a SJWC customer pays $52.09 more than a SJ Muni customer. That means SJWC likely gets significantly more of its revenue from the high-volume customers who pay high prices for water.
Is water consumption in San Jose consistent with those differences in pricing? This chart shows SJ Muni’s water conservation from 2015-2018, and population-weighted conservation for SJWC and Great Oaks for the same period, compared with the same month in 2013:
Notice how the green (private) line is close to but usually slightly above the blue (SJ municipal) line? Overall conservation tracks pretty closely for public vs. private over the four-year period, but San Jose’s private systems have averaged about 1% more savings.
The difference in per capita water use is much more noticeable; here’s residential gallons per capita per day in 2018:
San Jose’s private utility customers are much more conservative with water than are SJ Muni’s customers, using about eight gallons per person less water on average. The disparity is greatest during the seasonal peak period when supply stresses are also greatest.
Decoupling to the (utility’s) rescue!
In 2018, SJWC’s water customers were so conservative that the utility had a $9 million shortfall in sales revenue. California’s policy of rate decoupling allows the company to make up that shortfall with a rate increase in 2019. San Jose residents and lawmakers are angry that their reward for conservation success is a rate hike. Flat rates help keep SJ Muni’s revenues steadier and so spare the city council from the citizen wrath that such a rate increase might unleash.
Lots of things cause people to use more or less water, and so we can’t say for certain that prices drove the conservation patterns we see in San Jose without detailed customer-level data and a carefully-designed study. But it’s fair to say that San Jose’s experience is consistent with the public-private differences we see in the rest of California. Without decoupling, it’s unlikely that private utilities would use progressive pricing and risk the kinds of revenue losses that they experienced in 2018.
Economics is supposed to be the dismal science and politics the art of the possible. But for California water, the opposite seems to hold: decoupling makes conservation economically viable for private firms, while politics forces governments into difficult choices that can mean financial success at an environmental cost.
† SJ Muni’s flat water rates vary by geographic zone. The graph here uses a simple average of those rates.
The Garden State has quietly enacted a law that could transform water infrastructure in America.
Signed during Governor Christie’s waning days in office, New Jersey’s 2017 Water Quality Accountability Act (WQAA) introduced a series regulations requiring local water utilities to develop asset management plans, report on infrastructure conditions, and reinvestment adequately in their systems. For outsiders to the water sector, the WQAA might seem like a set of narrow, technocratic rules. But it’s really much, much more—not because of the rules themselves, but because the data that the rules will generate can change the way that people think about the crucial but unseen systems that sustain American cities.
A renaissance artifact in a German village helps explain why.
Drinking water and credit claiming
While Governor Christie was signing the WQAA, my wife and I were sightseeing in Germany. There we visited Wertheim, a small town nestled on the banks of a river. Right in the village square stands the Engelsbrunnen, or “Angel’s Well.” The village has been there since the 8th century, but this well was constructed in 1574. The well’s construction transformed life in the village—before the well was built, villagers had to walk 100 yards down to the river to fetch water.
But the really interesting thing about this well is the structure that surrounds it. This wasn’t just a utilitarian bit of public works—it was, and remains, a jewel at the heart of the village. It’s named for the twin angel sculpture at the top of the structure, but what really stands out is the sculpture in front, at eye-level:
That is the mayor of Wertheim in 1574. He didn’t just want his people to have water, he wanted them to know who delivered it. And every day, when the villagers filled their pails of water, they’d do so standing face to face with the image of the mayor who built it. For Wertheim, the well was a major improvement in quality-of-life. For the Mayor, the Engelsbrunnen was what political scientists call a credit-claiming opportunity.
Politicians then, like politicians now, like to claim credit for good things. In the 19th and early 20th centuries, modern drinking water systems provided politicians with ample credit-claiming opportunities. And with good reason! Drinking water systems are amazing! They are the everyday miracles of the modern age.
Blame avoidance and infrastructure neglect
Unfortunately the politics of American drinking water have changed. For decades Americans have had the luxury of taking drinking water for granted. Maintaining or upgrading drinking water systems doesn’t offer the same kind of credit-claiming opportunity as building them.
When the public takes water for granted, leaders fear anger over rate increases, which they must balance against the fear of a disaster. As National Association of Water Companies CEO Rob Powelson put it: “No president or governor wants to have a Flint Water Crisis on their hands.”
That’s what political scientists call blame avoidance.
The thing is, blame-avoidance isn’t a very good motivator for infrastructure investment. If my political goal is to avoid blame for a disaster, then my tradeoff is tax or rate increases today vs. the risk of disaster on my watch. Rate increases today are immediately visible and unpopular; to politicians, the risk of disaster can feel remote—my successor’s problem, not mine.
From fear of failure to expectation of excellence
That’s where New Jersey’s WQAA has the chance to transform the politics of drinking water. With the data generated under this new law, researchers will be able to trace the full nexus of the relationships between costs, water quality, system performance, and capital reinvestment. We’ll be able to show how to maintain affordability while also maintaining public health and economic prosperity.
But most importantly, all that analysis can make water infrastructure a credit-claiming opportunity again. We’ll be able to quantify the health and environmental benefits that come from water infrastructure, and so give leaders a reason to brag about their investments in these critical systems.
My only gripe with the WQAA is its name: the word “accountability” implies a threat of punishment for failure, rather than opportunity for success. With due respect to the NJ legislature I’d have preferred a different name: the Water Quality Accountability Achievement Act. Water system maintenance, reinvestment, and public reporting on performance shouldn’t be feared as a cause of punishment, but embraced as a chance to celebrate excellence.
Hats off to New Jersey’s water leaders for seizing this moment and blazing a promising trail. New Jersey’s WQAA gives water sector leaders the chance to make this moment an inflection point: the time when water stopped being an afterthought and became a core policy concern again; when the water sector turned away from fear of failure and back to visionary achievement.
During California’s recent drought, the utilities that own their supply sources conserved more than the those that purchase water from wholesale suppliers
-Warning: this post contains hardcore wonkery-
A while ago I blogged about my ongoing work with Youlang Zhang and David Switzer on water conservation in California. The first of our studies is now published at Policy Studies Journal; more are on the way. There we saw that financial incentives and institutional politics led to the surprising result that private, for-profit companies out-conserved local government utilities during a recent drought.
But another interesting pattern emerged from that study: a significant difference in conservation between utilities that draw their water supplies from wholesale sources.
Where utilities get their water
The drinking water utilities that serve American communities get their water in one of three ways*:
1) Pumping groundwater from wells that tap underground aquifers;
2) Drawing surface water from lakes and rivers; or
3) Purchasing water from a wholesale water utility.
In the first two cases, local utilities own wells, surface water intakes, and treatment plants. About 29% of American utilities fall in the third category, getting their water through wholesalers. In these cases, the local utility owns a distribution and/or storage system, but the supply works and perhaps the treatment facilities belong to another utility. Sometimes these wholesale utilities have retail customers of their own, sometimes they are purely wholesale suppliers.
In California, more than a third (36%) of water systems get at least part of their water from a wholesale supplier. A handful of very large wholesale water suppliers like Metropolitan Water District, San Diego County Water Authority, and Santa Clara Valley Water District manage major supply works, and then sell water to cities, special districts, and investor-owned retail water utilities.
Spreading the risk
A major advantage of big wholesale water utilities is that they allow a region’s water supply to be managed holistically and comprehensively. Rather than individual communities competing and depleting water supplies, regional wholesalers can plan and balance water supply needs. From the local perspective, wholesale utilities help diversify supply and so guard against catastrophic supply shortages. They also allow communities across a region to pool their capital for greater efficiency. Together these features spread both supply risk and financial risk across many local utilities.
Sales agreements between retails and wholesalers vary widely across the country, so generalizing is difficult. But one common feature of wholesale contracts is the take-or-pay provision. Under take-or-pay arrangements, the wholesaler agrees to supply and the retailer agrees to purchase a fixed volume of water over a given period of time for a given price. If retail demand exceeds the contract volume, the retailer pays for more on a volumetric basis. If retailer demand falls short of the contracted volume, the take-or-pay provision requires the retailer to pay the wholesaler anyway, as if it had used the entire contract volume.†
In other words, under take-or-pay contracts, the retailer pays the wholesaler the same amount, even if the retailer uses far less water than the contracted volume.
Wholesale supply & the logic of conservation
Got all that? Still with me?
Here’s what it all means for conservation. Wholesale supply arrangements reduce supply risk and long-term financial risk to local utilities. Take-or-pay contracts make a lot of sense for long-term stability for supply systems that have high fixed costs.
But in the short-term, these wholesale arrangements create disincentives for retail conservation during a drought. Under wholesale agreements, short-term supply risk from drought is shifted from the local utility to the wholesaler: the wholesaler is legally responsible for maintaining adequate supply. Meanwhile, fixed take-or-pay contracts leave retailers on the hook for the same amount no matter how much water their customers actually buy. The retailer may suffer significant sales declines if it rains all summer, or if the state imposes drought restrictions, but the retailer still has to pay the wholesaler as if demand was normal.
Together, these factors create structural disincentives for emergency conservation for retail utilities under wholesale agreements.
Does diluting risk also dilute conservation? As I explained in an earlier post, the recent drought in California prompted that state to impose conservation rules on retail water utilities from June 2015-May 2016. Each utility was assigned a specific conservation target and the state recorded overall conservation by each utility.
Did utilities that operate under wholesale supply arrangements perform differently from utilities that own their own supplies?
Our analysis of data from the drought mandate period is pretty striking. After accounting for a host of organizational and environmental conditions, we found that water systems that rely on wholesale water supplies were 42% less likely to meet state conservation standards, compared with systems that own their own supplies.
We also found that, after accounting for other factors, utilities under wholesale contracts conserved an average of 2.6% less each month relative to systems that use their own wells or surface water sources. In a state as large as California, this small percentage difference equates to tens of billions of gallons.
Follow the money
These patterns don’t prove that wholesale contracts caused California utilities to slack on conservation. But the data certainly align with the short-term incentives that wholesale supply arrangements create, and there aren’t other obvious reasons for the disparity. The lesson here is to pay close attention to wholesale contracts when setting conservation rules, so that conservation and financial incentives work in concert.
*Technically there are other sources, too—desalination and water reuse, for example–but they’re so rare that they don’t allow for much meaningful analysis.
†”Take-or-pay” is a weird phrase, since there’s really no “or” to the arrangement. Seems like “fixed fee” is a more accurate label, but then I’m not a lawyer.