Parameters of a Demand and Price Based Strategy for Efficient Urban Water Resource Use

Jim Elston
Water Resource Economist

1. Introduction and Summary

Economic growth, urbanisation, and income and price relationships, have resulted in rapid growth in demand for water. This paper explains the economic principals underlying this phenomenon. Using Shijiazhuang as an example, it shows how demand responds to price and income, and how price and demand management can play a significant part in improving efficiency of water resource use and overcoming shortages.

China is addressing the need to improve water pricing. Most cities have been increasing charges in recent years with a view to achieving full cost recovery. Wastewater charges have also been included in tariffs in many cities over the last two or three years. Still the charges are not at full cost recovery levels and will have to be increased further.

Issues for the future

More needs to be done regarding management of groundwater resources and implementation of resource fees for groundwater use. Lack of effective groundwater management is a fundamental problem to be overcome.

The recent moves to improve water pricing need further determination and political will to continue to raise tariffs to achieve full cost recovery of urban water services. The process has started, it must not stop.

With continued economic development and further tariff increases, the finances of water supply companies will improve. As revenue approaches cost recovery level, it is likely that there will be some conspicuous refurbishment of water supply company accommodation and facilities. Questions will start to be asked about the use of water supply revenues. There will be a need for some transparency and regulatory control to ensure the public that charges are not excessive. More will have to be done toward institutionalisation and systemisation of water pricing and price setting. Hebei could be an appropriate pilot province for implementation of an independent pricing and regulatory authority such as exists in developed countries (for example OfWat in the UK, and IPART in NSW, Australia).

In the future there is likely to be greater private participation in the urban water supply and wastewater industries. Foreign investment will be a growing source of funds for construction of treatment plants and distribution systems. This will require conformity with international standards of accounting and reporting.

Summary of points.

1. Where incomes are low and economic growth is strong, the demand for urban water increases very rapidly.
2. Where the demand for water is increasing, the marginal cost of meeting the demand is increasing. In developing countries, where incomes are low but increasing, the cost of meeting water demand increases very rapidly.
3. At low tariffs (less than cost recovery levels) water use is inefficient, demand quickly outstrips supply, shortage becomes chronic.
4. For water supply to be efficient and sustainable, costs must be recovered.
5. Costs must be recovered for all water supply facilities - water source development, transmission, water treatment, distribution, sewers, and wastewater treatment.
6. Cost recovery must allow for water supply companies and wastewater companies to make a reasonable profit (without profit, no company is sustainable).
7. Wastewater charges should be billed and collected together with water supply charges.
8. Increasing tariffs to cost recovery levels requires significant percentage increase in tariff levels. (Cost recovery levels for water and wastewater in China cities is of the order of RMB 2.5/m3 and rising).
9. Where demand is increasing, maintaining tariffs at cost recovery levels requires they continue to increase faster than inflation.
10. Increasing tariffs will reduce the pressure on urban water demands without imposing any difficulties on consumers.
11. Where costs of water supply exceed revenues, increasing tariff reduces demand and reduces costs. The overall impact reduces inflationary pressures in the economy.
12. The reduction of benefits brought about by increasing tariffs is less than the reduction in costs, resulting in a net improvement to the economy.
13. Where tariffs are based on usage (volumetric tariff) cost recovery levels are affordable and users are able to adjust their consumption within the range of their willingness-to-pay. (Most consumers will pay less than 1% of income in water tariff)
14. Increasing volumetric tariffs to cost recovery levels will overcome water shortage (water usage will adjust to balance supply and demand).
15. To maximise water saving and demand management, tariffs should be wholly volumetric (part fixed and part volumetric tariff is appropriate where incomes are high and cost recovery levels are high, as in the developed countries. It is not yet appropriate for China)
16. Tariffs should be simple: a minimum number of categories, and a single rate for each category (stepped tariffs do not achieve what they are intended to achieve).
17. Water tariffs are not an appropriate vehicle for welfare assistance, and are not successful in this role.
18. There is a need for groundwater charges and improved management of groundwater.
19. Licensing, management, and resource use fees should be applied to all users exploiting surface and groundwater resources.
20. Resource use fees for groundwater and surface waters should be levied on a volumetric basis as far as possible, and reflect the long run marginal cost of the resource exploitation.

21. International standards of accounting and reporting should be required of Water Supply Companies and Wastewater Treatment Companies.
22. Cost recovery calculations would benefit from being brought into line with international procedures.
23. More will have to be done toward institutionalisation and systemisation of water pricing and price setting. There will be an increasing need for transparency and regulatory control to ensure the public that charges are not excessive.
24. Hebei could be an appropriate pilot province for implementation of an independent pricing and regulatory authority such as exists in developed countries (for example OfWat in the UK, and IPART in NSW, Australia).

2. Economic Efficiency

The concepts of supply and demand (marginal cost and marginal benefit) underlie the principle of economic efficiency. They form the foundation of project evaluation, comparing costs and benefits to maximise efficiency. They also form the parameters of a demand and price based strategy for efficient urban water resources management.

Net benefit is at a maximum when the marginal cost and marginal benefit are equal. For a given quantity, the net benefit is the area under the demand curve less the area under the supply curve. In Figure 1 the net benefit is indicated by the area under the demand curve and above the supply curve. The optimum price, P, is where the demand curve (marginal benefit) and supply curve (marginal cost) cross over (are equal). That is to say, the optimum price is where the sale price equals the cost of supply.

Prices above or below P throw supply and demand out of balance and reduce efficiency. Marginal cost increases as the quantity supplied increases. If demand is excessive the marginal cost exceeds the marginal benefit. When costs exceed benefits it is not good news for any economy. It is inefficient, inflationary, and generally inequitable. When marginal costs exceed water revenues, cost recovery is impossible and more and more subsidy is required.

It is suggested that demand and price management should be used to bring marginal benefit and marginal cost more into balance, and thus achieve economic efficiency of urban water resource use. When marginal cost (the cost of supply) exceeds marginal benefit (the sale price) there is no harm, and a lot of good, in setting the marginal benefit (the sale price) at a higher level. This is something that price bureaus should bear in mind. If marginal benefit is set at a higher level, users take more care, waste and inefficiency are reduced, demand becomes more reasonable, marginal costs are reduced, supply is generally more equitable, and cost recovery improves. When incomes are increasing, all this is achieved with hardly any disadvantage to the users.

3. Water Demand and Income

The demand per capita for water is determined primarily by price and income. As household incomes increase the quantity of urban water demanded increases. A poor household with one small tap and limited buckets, tubs and vessels to handle water, cannot use as much per capita per day as a wealthy household. A wealthy household may have showers, flush toilets, washing machines, dishwashers, garden sprinkler systems, fountains, swimming pool, (the list gets bigger as people get richer). The wealthy tend to wash body and clothes more often, and wash cars and paths and floors. Consumption per capita per day can be very high.

As income increases, the demand curve moves to the right. This is illustrated in Figure 2. As income increases, the quantity demanded at a given price also increases. The marginal cost of meeting this increased demand (indicated by the supply curve) also increases. If the sale price is not increased, the marginal cost (the cost of supply) of meeting the increased demand would far exceed the marginal benefit (revenue). For the water supply to be sustainable, the price must increase.

As income increases, demand increases. As demand increases, marginal cost increases. As marginal cost increases, price must increase to balance marginal cost and marginal benefit. When real incomes are increasing, that is income increasing faster than price inflation, the price of water must increase faster than price inflation to manage sustainable resource use.

In addition to income effects influencing per capita consumption, there is the population effect. As urban population increases, total demand for water increases, thus placing further pressure on the marginal costs of supply.

4. Price and Income Elasticity of Demand

Knowing that demand reduces if price increases, and that demand increases if income increases, is all very well. But, for demand management, we want some idea of how much demand will change with a change in price, and how much demand will change with a change in income. This leads us to the concept of elasticity. The term "elasticity" refers to the extent that demand responds to changes in price or income.

4.1 Responsiveness of Demand to Price Change

The price elasticity of demand is the responsiveness of the quantity demanded to a change in price. Price elasticity is measured by the percentage change in quantity demanded divided by the percentage change in price. It can be expressed by the formula

The price elasticity of demand for water tends to increase as price increases. At very low prices, the responsiveness to price change is relatively small. At very low prices, demand is relatively inelastic. A 10% increase in price might only reduce demand by, say, 1%. At high prices, the demand for water is quite responsive to a change in price. At high prices, a 10% increase in price might reduce demand by 8% (this is unusual as very high prices are rarely charged for urban water supply). Commonly, where appropriate prices are being charged for urban water supply, the price elasticity is around -0.5.

An indicative demand curve for domestic water supply is illustrated in Figure 3. The indicative demand curve suggests that the price elasticity of demand between 0.5 yuan/m3 and 0.75 yuan/m3 is about -0.2. The price elasticity of demand between 5 yuan/m3 and 6 yuan/m3 is about -0.65.

I use a model that has proven remarkably reliable in forecasting impacts of price and income changes on urban water demand in developing countries. Price elasticities indicated by the model, and applicable to China, at 1999 constant prices, are shown in Table 1. The price elasticities given refer to the elasticity for each 0.25 yuan/m3 increment in price.

Table 1. Price elasticity of demand (1999 comparable prices)

The parameters of price elasticity for non-residential water are the same as the price elasticities for residential water. Generally the prices charged for non-residential urban water supply are higher than for residential water supply, and the responsiveness to price changes therefore tends to be higher.

4.2 Responsiveness of Demand to Income Change

The income elasticity of demand is the responsiveness of the quantity demanded to a change in income. Income elasticity is measured by the percentage change in quantity demanded divided by the percentage change in income.

The income elasticity of demand for domestic water supply tends to diminish as household incomes increase. At very low household incomes the responsiveness of demand for water to a change in income is relatively high. A 10% increase in income might lead to an 8% increase in demand. At very high household incomes, demand is relatively income inelastic. A further 10% increase in income might increase demand by only 2%.

Parameters of income elasticity of demand that appear to fit the situation in China are indicated in Table 2.

Table 2. Income elasticity of demand (1999 comparable prices)

Response of non-residential demand to income is different. Industries, municipalities and commercial enterprises can consume very large amounts of water, and do consume large amounts when the price is very low. International comparisons suggest that, in large cities, where total non-residential water requirement exceeds total residential water requirement, non-residential demand is income inelastic. It does not respond to a change in income (but it does respond to price). Where total non-residential water requirements are less than total residential water requirements, there is a response to increased income and development..

5. The Dynamics of Demand in Developing Countries

In the developing countries, marginal costs of water supply have been low, and tariffs have traditionally been low. With successful economic growth, and economic restructuring leading to high urban population growth, the economic parameters underlying urban water demand have reacted, taking many developing countries by surprise. The demand for urban water has risen faster than expected, the costs of supplying urban water services have increased much faster than expected.

Where incomes are low, the income elasticity of demand for urban water is relatively high. As incomes start to increase from a low base, percentage increases in income can be substantial, and the percentage increase in the demand for water is high.

The easy options of shallow ground water and perennial streams to meet the water demands are no longer available. The costs of source development are increasing. Treatment is required for urban water supplies. Increasingly sophisticated approaches to sewage, drainage, and wastewater handling are required. The marginal costs of providing urban water services are rising fast. There is a reluctance to increase tariffs accordingly. The low price levels further encourage high demand.

At low price levels, the price elasticity of demand is low. Moderate price changes have little effect. Gradual increases in tariff are being swamped by the income effect, and by urban population growth. Demand is becoming excessive. Marginal costs exceed marginal benefits, and continue to escalate. The costs of meeting the increased demand are unsustainable.

In many developing countries the price of water must increase substantially to bring supply and demand back into balance. It is often stated that the price of urban water should be increased gradually. A political concern is expressed that water is a basic need, and that the low income populations cannot afford big increases in price, despite the fact that present demand may be far in excess of basic need, and the marginal benefit of water consumed may be near to zero. There are many instances where gradual adjustments in tariff may never catch up to the increasing costs. There are many instances where bold decisions are needed to bring marginal cost and marginal benefit into balance.

Price adjustments must not stop there. The dynamics of supply and demand, the underlying parameters of high income elasticity, high urbanisation rates, and increasing marginal cost, are such that prices must increase faster than inflation to keep marginal cost and marginal benefit in equilibrium. This is necessary, desirable and efficient. It does not create hardship, nor is it inflationary.

If the marginal benefit continues to be set too low, resource use becomes inefficient, services deteriorate, economic, social and environmental costs escalate, and provision of adequate urban water services is not sustainable. This creates hardship. It is invariably the poor who suffer most. The political concern that keeps tariffs low to protect the poor is often the cause of the poor not having access to urban water supplies and of their having to pay very heavily to meet their basic need. There are plenty of examples from developing countries to illustrate that increasing tariffs to raise revenues to provide improved urban water services is more equitable than attempting to subsidise inadequate services from which those with power and influence take excessive amounts of water, while the poor receive little or no benefit.

6. Demand and Price Management

The combination of low tariffs and increasing incomes has led to consumption much above the norms for urban demand. This appears to be the case for many of the cities in China. With appropriate price and demand management, consumption can be brought toward the norms for urban water consumption in other cities of the world.

How can this situation be achieved? International experience has shown that simply limiting supply to production capacity has undesirable repercussions. The level of service suffers, supply becomes unreliable, and a high level of subsidy is required. Added to this, as suggested already, it is the poor who suffer the most when supply is restricted.

Consumer awareness campaigns and water saving activities are alternative options, and are to be encouraged. However, international experience suggests that water saving activities on their own are rarely enough. Water saving activities are more effective when supported by appropriate price adjustments.

The demand curves and elasticity parameters indicate how per capita demands might respond to price adjustments. Demand curves, together with estimates of income growth and population increase, can be used to forecast production requirements and to examine the impacts of price adjustments.

Figure 4 shows the impact of different growth in production requirements. Where incomes are low, but growing rapidly, a growth rate of 10% per year in production requirement is a possibility for some time if tariff is not increased. A 10% per year growth in production would require much expenditure in capacity expansion. With an increase in tariff, growth in demand would be slowed. The need for expenditure on capacity expansion could be deferred.

Impacts of recent price increases on urban water demands, and expected impacts of future price increases, were examined for the City of Shijiazhuang. As an example of how price and demand management can calm down demand, the expected situation for Shijiazhuang with and without the price adjustments is shown in Figure 5. Price levels assumed are in Table 3.

Figure 5 Shijiazhuang WSC Demand and Capacity Forecast Demand and Without Price Increase

Table 3. Price levels assumed in Shijiazhuang analysis (RMB/m3 1999 constant prices)

7. Willingness to Pay and Affordability

Because of the traditional concern that water is a basic need, affordability and willingness-to-pay invariably come under examination in water supply projects. For the last several years there has been a tendency to incorporate willingness-to-pay surveys in water supply investigations. More recently, the value of willingness-to-pay surveys has come under question. Where water supply facilities are established, willingness-to-pay surveys are not necessary, and have proven to be not very conclusive. The demand curves, and parameters of elasticity, based on indirect methods of observing what people actually do pay, are more consistent and conclusive than contingent valuation methods that ask people directly to express how much they are willing to pay.

Demand curves, relating price to quantity demanded, illustrate the willingness-to-pay for an amount consumed. Examples of the demand curves generated by the urban water demand model are illustrated in Figure 6. These show that at a given price and income, consumption is adjusted to a level the consumer is willing to pay and can afford.

Observations of experience in most cities of Asia and the Pacific show that about 1%, or less, of household income is spent on urban water service tariffs. On average, throughout Asia and the Pacific countries, households spend about 3 to 4 times as much on electricity and gas as they spend on water supplies. These observations indicate expenditure levels on water supply that are readily affordable.

Concerns about how households might be disadvantaged by an increase in water tariffs are often overstated. The impact on household expenditure is very small. A 30% increase in water tariffs in Shijiazhuang is likely to increase household expenditure by one thousandth. Where incomes are increasing, as they are in China, the increase in income in 12 months is likely to be a hundred times the increase in expenditure on water supply. Where incomes are increasing, and water tariffs are low, households barely notice the financial impact of quite substantial increases in water tariff. (They do however notice the price signal, and take a little more care with water use.)

The work undertaken in Shijiazhuang suggests that tariffs could be raised over time to enable full cost recovery for urban water services and household expenditure on tariffs will not exceed 1%, even for the households in the lowest quartile of incomes.

8. The Cost of Meeting, Or Not Meeting, Demand

The supply curve, or marginal cost curve, indicates the cost of dealing with demand at different levels. From examination of cost recovery levels in many cities around the world, an indicative marginal cost curve is illustrated in Figure 6. From the national economy point of view, the cost is similar whether or not the demand is properly met. If the amount is supplied, the costs are primarily engineering costs of source development, diversion, transmission, treatment, distribution, sewerage and drainage, wastewater treatment, and disposal. If the amount is not supplied, the costs are shortage, social deprivation, industrial disruption, pollution, health, environmental deterioration, and over exploitation of other limited resources. When the costs are excessive it is better to reduce demand than to attempt to meet it.

Comparison of experience in countries around the world shows that costs of meeting water demands increase more rapidly when income are low, than when incomes are high. The same indicative costs as are shown in Figure 6 are graphed against income in Figure 7. Costs increase dramatically as household incomes increase from RMB 500/month to RMB 3,000/month. This is the situation in most cities in China at present.

Figure 6 Household Income and Water Demand (and Indicative Costs of Supply)

Figure 7 Cost of Water Services

9. Economic Impacts of Raising Tariffs

Raising tariffs reduces consumption. This has an economic impact. The extent benefits are reduced can be measured by the demand curve. The extent that costs are reduced can be measured by the supply curve.

If we look at the residential demand curve for average household income of RMB 2,000/month, raising tariff from RMB 1.0/m3 to RMB 2.0/m3 reduces consumption from an average 135 Lcd to 98 Lcd. The extent benefits are reduced is illustrated in Figure 8. It represents 13.5 m3/year at a value of RMB 1.5/m3, or an economic loss of about RMB 20/capita/year. The extent to which costs are reduced is shown in Figure 9. It represents 13.5 m3/year at a saving of RMB 4.4/m3, or an economic gain of about RMB 60/capita/year.

The situation is similar with non residential demand. The reduction of benefits brought about by increasing tariffs is less than the reduction in costs, resulting in a net improvement to the economy. While tariffs are below cost recovery levels, raising tariff will have a greater positive economic impact than negative economic impact. It will make water resource use more efficient.

Figure 8 Benefits Lost by Raising Tariff (Economic Cost)