Consolidated Report on Urban Water Tariff Reform in Municipality of Shijiazhuang[I]

Lindsay Shepherd
International Water Tariff Specialist

1. Introduction
1.1 Background

This report consolidates the analytical information that has been presented by the International Financial Analyst/Water Tariff Specialist (IWTS) to the Pilot Project Implementation Unit located in the Municipal Science & Technology Commission, Shijiazhuang, over the period April 1998 - June 1999.

The role of the IWTS was to provide technical assistance to the Unit in its task of proposing for the Municipality of Shijiazhuang:
- water and wastewater tariffs which will enable full cost recovery and independence from government subsidies for capital investment; and
- a strategy for implementing these tariffs that will lead to the water and wastewater enterprises operating on a financially self-sustaining basis within an appropriate time frame.

The report does not attempt to provide comprehensive policy and strategic recommendations for water and wastewater tariff reforms. The water supply tariff study funded by the Asian Development Bank provided technical assistance to the Ministry of Construction in its task of developing national guidelines for water sector tariff setting.

Also, water and wastewater financing strategies are outside the scope of the report. Their relevance to pricing is that they determine the extent to which costs are to be recovered through the basic water or wastewater tariff.

1.2 Report Contents

The Report contains four Sections and one Appendix following this Introduction (Section 1). Section 2 reviews tariff setting objectives, while tariff structures are discussed in Section 3. Section 4 presents alternative pricing strategies and scenarios and discusses methodological aspects. Section 5 reviews the current tariff in Shijiazhuang, presents average tariffs for alternative cost recovery options and considers the implications of full cost recovery tariff levels.

Appendix A sets out the procedure and assumptions used to determine the amounts of revenue required under various cost recovery options.

2. Tariff Setting Objectives
2.1 International Experience

A range of economic, financial, environmental and social objectives have been pursued through pricing policies for water services. However, it has been recognized internationally that the primary long term objective of pricing policy should be efficient resource allocation. Financial, environmental and some social objectives are largely consistent with resource allocation goals. However, other social objectives are better achieved through more targeted policy instruments rather than making adjustments to pricing policy.

Efficient resource allocation is achieved through the proper functioning of price signals. The primary role of prices is to allocate resources. Prices are the signal to which consumers respond in deciding what and how much to consume. Prices also prompt producers to decide what and how much to produce and invest.

If resources are to be used in the most efficient way, prices should show each customer the true costs of consuming water or discharging wastewater. Pricing regimes based on user pays and cost recovery principles have been adopted internationally for the reform of urban water pricing. These regimes are consistent with efficient and effective use and provision of water services through the proper functioning of price signals.

International experience in successful pricing reforms has shown that:

- as a general principle, water services provision should be underpinned by an objective of cost recovery
- water authorities must adopt a commercial focus and seek to reduce the costs of service provision;
- water tariff setting must ensure the financial sustainability of water supply companies by allowing for the adequate recovery of all costs including a reasonable return on capital employed;
- effective water demand management requires an economically efficient pricing regime and properly structured tariffs incorporating pay-for-use pricing, as well as measures that promote efficient use of water and conservation practices.

2.2 At National Level

The primary objectives of urban water tariff setting in the past have been affordability, control of price inflation and recovery of operating costs. The last objective has been the primary motivation of water supply companies. The first two objectives have been the main concerns of the municipal governments and the Price Bureaux at the various levels of government, reflecting the State Council‘s desires to manage the adverse impacts on households of the rapid inflation that occurred between 1979 and 1994.

However, there has been a gradual recognition of the importance of water pricing and significant tariff adjustments have been made over the past decade, reflecting the shift in national policy to a more market-based economy and the economically efficient use of resources. Last year, the State Planning Development Commission issued a national guideline for urban water supply tariffs. Article 10 states that "water tariff setting up shall follow the principles of cost compensation, reasonable benefiting, water efficiency and sustainability".

These principles are much broader than the historic emphasis on price stability and affordability. Water tariff setting is recognised as a critical element in the current initiatives to help water supply companies achieve financially and environmentally sustainable operations. The combination of fiscal constraints and water shortages has meant that low water prices are no longer appropriate. Current water tariff setting objectives at the national level are to improve the cost recovery performance of water supply companies and promote water conservation and the environmentally sustainable use of water.

2.3 In Shijiazhuang

The need for a broader approach to water tariff setting has also been recognised in Shijiazhuang. Four problems with the present approach of low water prices have been identified:
- The capacity to continue subsidising water supply operations is limited due to overall fiscal pressures.
- Tariff revenues do not provide adequate funds to repair/maintain infrastructure.
- The tariff does not reflect the use value of water and therefore does not function as a signal for the timing and nature of new investment in the water supply industry.
- The tariff does not reflect the value of water as a scarce resource and therefore encourages overconsumption.

In Shijiazhung it has been recognised that the objectives of water tariff setting should be to:
- ensure the financial sustainability of the water supply industry
- promote the economically efficient use of water
- reflect the economic and social development benefits of water
- assure affordable water costs

3. Tariff Structure
3.1 International Experiece
3.1.1 Water

There are many different types of water tariff structures in place in urban centres around the world. Most are based on the general recognition that metering and billing of individual consumers is the fairest means of charging, as only through measuring consumption or usage and then charging accordingly is a proper supplier/customer relationship created. Without individual metering and billing, however charges are assessed, once an assessment has been made there is no incentive for customers to limit their consumption. This removes the direct linkage between demand and income/price, particularly over the short to medium term. This linkage is critical for demand management by water sector enterprises.

International trends have been to place more emphasis on designing tariff structures which encourage the efficient use of water and water conservation through demand management. This has typically involved moving away from flat rate systems (eg. based on property value) where all costs are recovered through a fixed charge, to user pays systems where some or all costs are recovered from customers based on usage.

Two-part tariff arrangements, comprising a variable (usage) charge and a fixed (access) charge, have been introduced by many water sector enterprises. The usage charge covers both the short run (ie. normal operating expenses) and long run (ie. augmentation costs) associated with each additional unit of water used or wastewater treated - in economics terms, the usage charge equates to the long run marginal cost of the system. The access charge meets the fixed costs associated with ownership of the system (eg. capital servicing costs, some maintenance and renewals) and is independent of use.

Under this arrangement, the usage charge increases over time while the access charge will remain constant or even decline. Variations to the usage charge are possible, such as increasing or declining block tariffs and seasonal pricing.

Stepped or increasing block tariff structures have become very popular, both to assist low income consumers and to discourage overconsumption. However, these structures have often not been as effective in meeting these objectives as originally anticipated:

- significant numbers of consumers consume only within the first block;
- low income households are often high volume consumers due to the number of persons in the household;
- the more complex structures can distort the pricing signals given to customers, who tend to focus on the average usage price rather than the marginal usage price, and therefore perceive that there are few benefits from saving water.

3.1.2 Wastewater

Wastewater volume charges are also becoming increasingly related to usage, with calculations based on actual water consumption, a percentage of water consumption, or actual measurement by special wastewater flow meters. Wastewater charges are normally billed together with charges for water supply, as it enables efficiency cost savings and facilitates consumer recognition of the link between water consumption and discharge.

Many wastewater enterprises faced with major industrial waste discharges incorporate a charging basis for the strength of wastes discharged. This reflects the additional loadings and costs imposed by stronger effluent on drainage systems (through damage to pipes and drains) and treatment plants (through the need for secondary treatment).

3.2 Choice of Tariff Structure

As mentioned above, there are many different types of water and wastewater tariff structures in place in urban centres around the world. However, the choice of tariff structure must take account of local factors, such as:
- tariff setting objectives, eg. financial sufficiency, demand management;
- implementation aspects, eg. metering and billing arrangements;
- customer base characteristics, eg. the distribution of residential water consumption, low income household size.

In evaluating the suitability of any particular design for use in a particular social and political context of China, criteria which can be used include:
- practical and easy to implement, administer and update
- easily understood by water supply company staff, government officials and customers
- provides stability of charges and revenue generated
- encourages efficient use of water and wastewater resources
- encourages equity or fairness between customer groups and between current and future generations

Generally, the simpler the tariff structure the better, as more complex structures can lead to customer relations difficulties, as they are more difficult to explain and justify. They can also distort or dilute the pricing signals given to customers. As noted in Section 3.1.1, customers tend to focus on the average usage price rather than the marginal usage price. Also, unless stepped or block tariffs are properly structured, they do not necessarily reflect the costs of providing services to consumers within each consumption step or block.

3.3 Appropriate Tariff Structure for Shijiazhuang

In the light of the above discussion, international trends and the national guideline for urban water tariffs, it is appropriate to evaluate two types of user pays tariff structure:
- a single system, where all costs are recovered through usage charges (current system in use in Shijiazhuang);
- a two-part system, where certain costs (related to the capital costs of the existing asset base) are recovered through an access charge and the remaining costs through a usage charge (similar to the methodology outlined in the national guideline).

The option of a fixed rate or stepped rates also considered within each system.

Each of the next four sub-sections presents the advantages and disadvantages of the following tariff structure options, particularly with respect to the current and likely future situation in Shijiazhuang:
1. single system, with fixed tariff
2. single system, with stepped tariff
3. two-part system, with fixed tariff
4. two-part system, with stepped tariff

In considering any move away from an existing water tariff structure, it is normal practice to undertake a quantitative evaluation of the impact of alternative structures on customers (commonly referred to as "incidence analysis"). However, this requires detailed analysis of the existing customer base, including a frequency analysis of consumption for each category of consumer - what percentage of billing occurs at each level of monthly billed water usage (cubic metres).

Proper assessment should also be made of the level of cross-subsidisation which occurs between the non-residential and residential sectors. This requires identification of the costs of services provided to the different consumer categories.

3.3.1 Single ystem, with fixed tariff

This structure meets all tariff revenue requirements by charging solely on the basis of water consumption or wastewater usage. Only one tariff is used for each category of consumer.

Advantages

Disadvantages Present system in Shijiazhuang Use of long run marginal/average incremental cost may result in deficit Amount paid varies in direct proportion to use Must be based on total costs otherwise insufficient revenue generated Easy for consumer to understand May lead to instability of revenue due to fluctuations in use Sends same price signal to all consumers

3.3.2 Single system, with stepped tariff

This structure again meets all revenue requirements by charging solely on the basis of water consumption or wastewater usage. However, for each category of consumer it uses different tariffs for different levels of consumption (measured in blocks or steps), with the tariffs increasing with the blocks or steps. Normally three or four blocks or steps are used, with the charge per cubic metre remaining constant within each block or step.

Increasing block or step structures have been very popular in urban areas throughout the world, for two reasons:
- they can assist low income consumers by making the first block or step a "lifeline" tariff;
- they can assist in discouraging overconsumption by charging higher prices in the higher blocks or steps.

However, in practice, low income consumers are often penalised by stepped tariff structures. This occurs because low income households are often high volume consumers due to the number of persons in the household - their water consumption exceeds the first block or step.

There is also the possibility that a block or step tariff structure would penalise low income and low volume users in Shijiazhuang, where the majority of households obtain their water via one main bulk meter which is read and the charge calculated on that reading. This is because the main meter would be charged at the high blocks or steps (due to the large number of consumers) where the highest marginal tariffs
operate. The most likely outcome is that the individual household faces an average tariff which is higher than if it had been charged directly by the water enterprise on the basis of an individual household meter. This would be the case irrespective of whether the individual household is metered by the owner of the main meter (this is quite an extensive practice) or is not metered at all.

Also, in many countries stepped tariff structures have not been as effective in discouraging overconsumption as originally anticipated. This has occurred where the first block or step accounts for a large proportion of water consumption - there is no incentive on these consumers to conserve water; however, in the higher blocks or steps, where the incentive exists, only small volumes of water consumption can be affected.

Advantages

Disadvantages High blocks or steps discourage over- consumption Only effective in reducing consumption where high volume consumers account for large % of total consumption With individual metering, can assist low volume consumers Requires individual metering, otherwise can adversely affect low volume consumers Can adversely affect low income/high volume households Sends different price signals to different consumers based on arbitrary boundaries

3.3.3 Two-part system, with fixed tariff

This system is proposed as a practicable alternative to marginal cost pricing, retaining a central role for marginal or usage charges but addressing the deficit problem associated with servicing past investments. It recovers certain costs (mainly related to capital costs) as a fixed component of the consumer‘s bill and the remaining costs from a variable charge applied to the volume consumed or used. It is generally felt that the fixed component should be low for water supply, but higher for wastewater services due to the higher capital intensity of treatment plants.

Advantages

Disadvantages Provides greater stability of revenue than full user pays Impacts adversely on low income consumers Approximates an economically efficient price system Discourages water conservation if fixed component too high

3.3.4 Two-part system, with stepped tariff

As discussed in Section 3.3.2, the use of a stepped tariff requires individual metering and billing otherwise low volume consumers can be adversely affected.

3.4 Conclusion

The choice of tariff structure requires detailed analysis of the impact on all customers of moving away from the present structure, requiring data on the existing customer base and the cost of service provision to each category of customer.

Any changes to the existing tariff structure must avoid complicated administrative arrangements. More complex structures can lead to customer relations difficulties, as they are more difficult to explain and justify.

It seems appropriate to continue with the present tariff structure in Shijiazhuang, given:
- the absence of detailed analysis of the existing customer base;
- the lack of formal cost allocation for identifying the costs of service provision to individual consumer categories; and
- the expected continuation of the current residential "bulk" billing system.

Continuation of the combined billing and collection of water and wastewater charges is also appropriate, as it enables efficiency cost savings and facilitates consumer recognition of the link between water consumption and discharge.

It is important that the tariff system incorporate a charging basis for wastewater strength which ensures that all discharges from industries to the drainage system meet the costs of conveyance and treatment. The wastewater enterprise should have responsibility for levying and collecting excess strength fees to reflect the additional loadings imposed by stronger effluents on drainage systems (through damage to pipes and drains) and treatment plants (through the need for secondary treatment).

Consolidated Report on Urban Water Tariff Reform in Municipality of Shijiazhuang[II]