Policy Study

Water Utility Regulation

Rates and Cost Recovery

Executive Summary

Water utilities are under significant financial pressure as a result of increasing urbanization, deteriorating infrastructure, and increasingly stringent drinking water-quality regulations. In addition, recurring droughts and the difficulty of developing new sources of supply indicate that, relative to demand, water is becoming more scarce. The present ability of water utilities to address these problems is partially constrained by regulation.

Designed to prevent monopoly pricing, price regulation of water utilities has generated several forms of inefficiency. First, poorly designed rates misallocate water among different consumers and may result in insufficient revenues to cover costs. Second, the lack of incentives to minimize water-provision costs creates cost inefficiency. And third, scarce regulatory resources are wasted when the costs of regulation exceed the benefits.

Five costing, financing and rate initiatives, if implemented, could reduce the inefficiencies inherent in traditional rate regulation. These include:

  • integrating marginal or incremental costing into the rate-design process;
  • implementing where feasible, seasonal pricing, zonal pricing, conservation surcharges, availability charges, and system development charges;
  • installing incentive regulation mechanisms, including price caps, cost indexing, incentive rates of return, and incentives for demand-side or conservation capital investment;
  • implementing selective state deregulation of investor-owned water utilities, weighing consumer benefits against regulatory costs; and
  • implementing selective state regulation of publicly owned water utilities, weighing consumer benefits against regulatory costs.

The water industry has been historically slow to adopt water pricing and costing changes. Thus, any progress towards introducing these initiatives will require regulatory officials to offer both public and privately owned water utilities greater incentives to develop more-efficient water-supply practices.