Economist Urges Pricing As Guide To Waukesha Water Issues

Fascinating letter to Waukesha and state regulators about how to better use existing water supples rather than diverting a Great Lakes supply:

Bolton Hall 868D

P.O. Box 413

Milwaukee, WI 53201

(414) 229-6493 phone
(414) 229-2860 fax
Bolton Hall 868D
P.O. Box 413
Milwaukee, WI 53201
(414) 229-6493 phone
(414) 229-2860 fax

College of Letter and Science
Department of Economics

26 June 2013                                                                                 

  

Kenneth Johnson, Water Division Administrator
Eric Ebersberger, Water Use Section Chief  
Wisconsin Department of Natural Resources
101 S. Webster Street
P.O. Box 7921
Madison, WI  53707-7921 

Re:  Economic Analysis in the Environmental Impact Statement

Dear Mr. Johnson and Mr. Ebersberger:

I am an Emeritus Professor of Economics, recently retired from the Department of Economics at the University of Wisconsin – Milwaukee after forty years, nine and a half as its chair. I was the economist on the founding executive committee of our new School of Freshwater Sciences, a school that will produce scientific and policy research and academic degrees in several areas related to fresh water.  

I am writing to comment on  the City of Waukesha’s proposed Water Diversion Application under the Great Lakes Compact.  I offer these remarks to the Wisconsin Department of Natural Resources and other state officials and regional stakeholders to suggest how economics is an appropriate and important tool for evaluating some key elements of the diversion application. The views expressed here are my own and are independent of any held by the department of economics or the university. 

An important threshold requirement in any request for a diversion under the Great Lakes Compact is whether such large amounts of water from any of the Great Lakes are actually needed, and whether current water supplies are insufficient and that alternative measures, including conservation measures, will not serve the same purpose. 

I believe economic analysis should be central to this determination. 

In particular, to determine whether residential and commercial demand for water will be as projected, we have to examine the potential impact of price as well as “command and control” measures on current and future water use such as lawn irrigation regulations and/or programs such as appliance buyouts. The quantity of water demanded is not fixed, but instead is significantly related to the price per unit as well as other non-price conservation measures. 

The City of Waukesha’s early experience with pricing and non-price conservation measures indicates some real progress in using such measures to effect water use reductions. This positive result should prompt more rigorous analysis and research to determine how much additional reduction in water use could be expected from additional efforts to conserve. Such analysis and research would help determine whether the proposed water diversion from Lake Michigan is really needed now or in the foreseeable future.

Although early efforts to employ different price-based conservation methods have resulted in a substantial decrease in water usage, pricing strategies alone may not provide sufficient reductions in quantity of water use so that local supplies can satisfy demand. Combinations of pricing and non-price means of reducing quantity demanded may be required. 

We need further sound research on the best way to refine these early results, and to combine them to solve the problem in a manner that would be less expensive for the City and its taxpayers and to ensure that the provisions and requirements of the Great Lakes Compact are being effectively followed and implemented.  

PRICE ELASTICITY OF DEMAND FOR WATER 

To convey the relationship between price and the quantity of water demanded, economists use the concept of elasticity of demand. Elasticity measures are numerical estimates of the changes people make in their usage of water in response to changes in incentives such as price; command and control regulations such as limits on showerhead flow rates; and moral suasion such as public service announcements urging conservation.  Econometric studies of the elasticity of demand for water show price to be a particularly strong motivator for reductions in quantity demanded.  

Economists categorize demand elasticity into “long run” and “short run.” In the “short-run” people respond to changes in price by changing the amount of water they use but without changing their  previously-installed equipment.  That is, they respond to higher prices not by making large investments in changing the equipment -- appliances and fixtures – that enable them to use water but rather by using that equipment less intensively, e.g., by taking shorter showers,  washing the car less frequently, or watering the lawn less frequently and at night. In the “long-run” people not only change the way they use their water delivery equipment, but they can invest in changes in that equipment.   

Examples of long-run responses to higher prices include       investment in the latest in water conserving equipment, choosing  smaller lot sizes, forgoing water-intensive features like hot tubs,  planting less thirsty ground cover instead of grass, installing rain gardens, and building condominiums instead of single-family homes. Because longer time periods permit people to plan and implement more changes in the way they use water, long-run elasticity tends to be greater than short run elasticity.

As a numerical measure, elasticity is expressed as a ratio of the percentage change in the quantity of water people use in response to a price change divided by the percentage change in the price.  Indeed, the consensus among economists who make empirical measurements of the elasticity of demand for water is that it is substantially less than 1.

In fact, the consensus average of long-run demand elasticity is measured at .6: buyers consume 6 percent less water in response to a 10 percent increase in expected price.  As expected, short-run elasticity is less than long-run elasticity; the consensus is that short-run elasticity is .3.   

Relevance to the Diversion Application 

All elements of this or any diversion application will depend on the quantity of water to be diverted.  The Compact requires demonstration that “there is no reasonable water supply alternative in the basin in which [Waukesha] is located, including conservation of existing supplies” and the further requirement that “the need for the proposed diversion cannot be reasonably avoided through efficient use and conservation of existing water supplies.”  This is precisely the kind of “reasonable” estimate of quantity demanded that elasticity provides.

To economists the reasonableness of any diversion amount cannot be determined without estimating the amount that will be
demanded at alternative prices per unit.   

Block Pricing

The difficulty in imposing pricing to regulate water usage is that some uses of water are essential for life’s basic requirements while other uses are more optional and some much more optional.  In such circumstances economists recommend “non-linear pricing.”   With non-linear pricing, often called “increasing block pricing (IBP),” the price for the first quantum of daily water use -- say, forty gallons for personal hygiene, cooking, sanitary waste disposal -- would be at a low price whereas higher quantities would be at higher prices.     

Economists point out four advantages when they prescribe IBP pricing to regulate water use. First, while water is essential, not all uses of water are essential. Second, essential uses tend to be low volume while more optional uses are typically high volume uses.  Third, although the essential uses of water are very unresponsive to price changes, i.e., demand is very inelastic, more optional uses are much more responsive to price changes, i.e., more elastic.    Fourth, because IBP is a price system and not a command and control regulation, IBP leaves the rate of usage up to the user and not a direct government intervention into private decision-making, as with sprinkling bans. 

However, coupling pricing mechanisms with direct government action such as sprinkling bans is likely to achieve even greater water conservation.

Evidence on Pricing from Waukesha Conservation Report 

On March 1, 2011 Waukesha issued its “Water Utility Conservation Report” to the Wisconsin Public Service Commission. The report reveals a number of opportunities for efficiencies and savings of both money and water.  

First, the report shows reductions in quantity of water demanded in response to a block pricing program with just over 15,000 participating families. Although there have been just a few years of experience with block pricing there is initial evidence of considerable demand elasticity. 

The results are spread over numerous tables beginning on page 2 of the report, showing the results for various building sizes and types. For illustrative purposes, consider the charges imposed on single family houses. At first, during the period June 2007 to June 2009, the first block was very large, 30,000 gallons per month for a single family. The large size of that first block reduced the incentive effect of block pricing. That is, with the first block so large, the customer was so unlikely to get to block two (e.g. the higher pricing block) that there was little reason to try hard to avoid it.  

But in 2009 the size of the first block was cut back to just 10,000 gallons/month and its price raised to $2.05 per thousand, the second block was the next 20,000 gallons and its price was $2.65, and quantities beyond 30,000 gallons were charged $3.40 per thousand.  Once again, the first and second blocks together are so large that the third block is largely irrelevant for many users. Still, the incentive to avoid the second block was greatly strengthened since the first block was cut by two-thirds. 

Waukesha’s early experiences with the block pricing is optimistic, with a 6% reduction in usage despite a nearly 4% increase in residential customers served (page 21). Moreover, while the data reported in the report is not sufficient to determine elasticities within the three blocks, we expect that there is greater elasticity in the third block than in the second, and in turn more elasticity in the second than in the first. 

These promising early results show the potential to save a lot of money. I hope the City would experiment to make the pricing even more effective. As more is learned about how people are responding to the price blocks, many variables could be adjusted such as creating more blocks, and making them smaller.

This would have the effect of increasing price more quickly on more optional uses while keeping the price lower for more essential uses of water. 

A major cost savings could be gained if it can be shown that the city can provide water without the expense of the currently proposed pipeline to convey diverted Lake Michigan water.  The capacity requirements are reduced when peak-time usage is reduced. If there are several blocks, the higher blocks can be raised during the peak months without penalizing those who use much less water. This would create an incentive for people to stay off the peak, reducing the ratio of peak to average usage.  

The overall lesson from the block pricing experience is clear: this strategy for conserving water is working and should be applauded, and frankly, expanded from the residential sector to other sectors such as the commercial and industrial users which are not included in the City’s current increased block pricing structure.  In addition, experiences from other cities that have employed pricing mechanisms successfully should be thoroughly researched for lessons learned.

 Low-flow Toilet Program   

The conservation report also shows success in swapping low-flow toilets for 65 toilets in the city. While the number of participants is small  -- 65 – demonstrating  that this program is just getting started, the results so far are promising. By participating in this program, plus other measures the City has apparently undertaken to heighten awareness of the need to conserve, the residential participants in the low-flow toilet program reduced their water use from roughly 19,000 gallons per month to 16,000 gallons per month. 

Only three years are reported, so it would take a more complete statistical analysis to separate out all of the causes taking place at the same time.  But, these participants reduced their total water usage by 15.37% (page 19) from this one conservation measure. 

Given this experience, the City should significantly expand this program and provide even greater incentives/subsidies for the installation of these water conserving appliances and techniques. The cost saving with reduction in water treatment, less pumping, less infrastructure maintenance, could be reinvested to support these incentive programs.

CONCLUSION

In conclusion, the “Water Utility Conservation Report” shows promising results for reductions in water usage, and water usage is substantially down, not up (page 21).

It seems reasonable to expect that the way to optimize water conservation is to go beyond what has been started to an aggressive push forward to coordinate and integrate a combination of approaches including not only the usual command and control practices, such as limiting lawn sprinkling and appliance swaps and buyouts or assisting residents and businesses to switch to “native” grasses and rain gardens, but more use of pricing strategies. 

The effect of doing so over time will not only save water, but save the City and its residents money for reduced pumping, treatment, distribution and maintenance.  

The other significant point is that pricing should be part of any  overall strategy of meeting the City’s long term water needs with existing water supplies.  In addition, the City of Waukesha would be able employ these practices to maintain control over its destiny rather than pursue an expensive diversion that must comply with stringent requirements under the Great Lakes Compact that is administered by Wisconsin, seven other states and two Canadian provinces.

I hope these remarks are helpful. 

Sincerely,

William L. Holahan

Professor Emeritus

Economics Department 

Cc: Mayor Jeff Scrima, City of Waukesha

Ed Henschel, Administrator, City of Waukesha

Joe Pieper, President, Waukesha Common Council 

Dan Duchniak, Director, Waukesha Water Utility

Dan Warren, President, Waukesha Water Utility Commission

Jeff Ripp, Public Service Commission