The case for rate-funded water affordability

Warning: this post contains hardcore wonkery.

One of the most trenchant questions that emerged during the recent California State Water Resources Control Board affordability symposium (pursuant to California AB-401) was whether low-income water bill assistance should be funded through taxes or rate revenue. That is, who should pay for affordability programs: taxpayers or ratepayers?

A couple caveats before addressing that question. First, utilities can do a great deal to reduce rates for many low-income customers without explicitly redistributive programs. For example, small systems might consolidate for economies of scale, and cost-of-service rate design can distribute more system costs to the high-peak customers who drive capacity needs. Utilities ought to exhaust those options before turning to redistributive assistance. Second, states vary widely in the degree to which utilities are legally permitted to fund low-income assistance through rates. In this post I skirt these practical and legal considerations, and instead focus on the more fundamental issue of…

Public goods, private goods, and government revenue

In public finance, the traditional rationale for whether something should be funded through taxes or fees is whether the something is a public good. In economese, public goods are non-excludable and non-rival in consumption. “Non-excludable” means that, once the good is created, no one can be excluded from its benefits. “Non-rival” means that no one’s consumption of the good diminishes the quality of anyone else’s consumption of the same good. Lighthouses and missile defense systems are classic examples of public goods. We typically rely on governments to provide public goods because it is difficult or impossible for private firms to capture revenue for those goods. Instead, governments levy taxes in order to pay for them.

When governments provide private goods—and much of what American governments do is private good provision—it uses some mix of tax and service fees to generate revenue. State universities are good examples: the people of Texas help pay for Texas A&M University through their taxes, and Aggies contribute through their tuition payments.

Drinking water and sewer service as public goods

Environmental protection is another classic public good: everyone benefits from clean air, soil, and water. It’s little wonder, then, that sewers traditionally were financed through taxes. Everyone benefits from sanitary sewer systems that keep raw sewage out of our streets and waterways. Today sewers in America are paid for primarily through service fees, sometimes in some combination with tax funding.

Drinking water is trickier. The vast majority of American water systems today rely on volumetric service rates to generate revenue. In a conventional sense, drinking water isn’t a public good: it’s possible to exclude people from a drinking water system, and two people can’t drink the same glass of water. Drinking water affordability is a problem precisely because it is excludable and rival in consumption: customers can be disconnected for nonpayment and can’t simply free-ride on their neighbors’ water service.

But there is an argument for drinking water as a public good insofar as it has positive externalities–benefits to the community beyond the household using the water. Lush lawns and car washing may not be public goods, but disease control is. Basic water use for drinking, cooking, and sanitation reduces disease and overall health system costs. People who have access to safe, reliable drinking water at home are healthier and more productive. Some basic, universal provision of potable water could be considered a public good. If we think of a drinking water utility as a collective enterprise that provides a collective public health good, then a basic level of service (say, 35-50 gallons per person per day) can be thought of as a public good.

So it’s reasonable to conclude that water assistance programs should be funded through taxes. But tax-funded assistance programs are politically unpopular. When established, tax-funded assistance programs also tend to be under-funded and perpetually threatened with reduction or elimination when hard times come—which is exactly when assistance is needed most.

Fire & Water: The case for rate-funded affordability programs

But there’s a sound rationale for funding basic drinking water service at an affordable price, using rate revenue, under existing cost-of-service principles. The clues to the logic of affordability-through-rates is in the way we fund fire protection through water rates.

Firefighting is a public good. When a building catches fire, it is clearly a loss to that building’s owner. It is also a threat to all of the other people whose homes and businesses might potentially catch fire. So everyone in a community benefits from effective firefighting.

Communities pay for firefighting mainly through taxes, which pay for the buildings, equipment, and staffing needed to fight fires. Less obviously, most communities also pay for fire protection through their water rates, because firefighting relies on a water system to provide large volumes of water at high pressure through hydrants. Consequently, some portion of any city’s water utility capacity is built simply to fight fires. Communities pay for that capacity through water rates.

The principles of cost-of-service water ratemaking are codified in AWWA’s Manual M1, which identifies public fire protection as a reasonable functional cost. That means that utilities across America are already funding a public good—fire protection—through water rates consistent with cost-of-service principles.

To the extent that drinking water for basic health and sanitation are public goods, there also is a solid rationale for development of a cost-of-service rate methodology that provides for a basic level of indoor potable water use. A modification to M1 would—and should—articulate this logic, and so provide a pathway for rate-funded affordability initiatives.