California’s continuing drought underscores the severity of the State’s water supply defects. While in one respect all water supply problems are local, the expanding role of water transfers and development of new sources of supply create a common thread linking all water purveyors, and highlights the growing need for recycled water supplies and expanded water reuse systems. Among the challenges of an expanding role for recycled water is how to appropriately price it, particularly in light of on-going court decisions that have raised questions about new restrictions on pricing alternatives.
This paper is intended to provide a brief discussion and general guidance on pricing principles and mechanisms that water agencies may want to consider when establishing rates for recycled water customers.
Recycled rate structures and pricing approaches that other California agencies are currently using.
An overview of pricing methodologies and practices.
Industry Practices: Rate Structures and Pricing Methodologies
Understanding the recycled water pricing methodologies and approaches used by other agencies can provide a useful background and guidance on current industry standards and approaches to rate structures. These results are grouped into Southern and Northern California agencies. While this data is always being updated, it still provides an overview of market pricing.
Figure 1 and Tables 1 and 2 summarize some of the key recycled water characteristics of California agencies. Rates are organized by wholesale vs. retail agencies and by Northern vs. Southern state. The following are general observations about this data:
- Retail vs. Wholesale Rates – Retail rates are typically higher than wholesale rates, primarily because of the more extensive transmission and distribution costs and level of service that retail customers receive.
- Northern vs. Southern California – Recycled water rates for retail agencies are fairly similar in both Northern and Southern California.
- Range of Costs – Wholesale rates vary significantly, ranging from Metropolitan Water District’s (MWD) almost free rate to Upper San Gabriel Water District’s highest tier rate of more than $1,551 / acre foot, but are generally in the $300 to $500/acre foot range.
- Tiered Recycled Rates – Southern California retail recycled rates generally include more tiered rate structures (e.g., Irvine Ranch Water District (IRWD) has a wholesale base rate of $449/AF compared to retail rates that exceed $3,700/AF for a fifth tier).
This data illustrates the wide variety of pricing mechanisms and methodologies currently used today in California. We have also highlighted a few cases of interest with respect to advanced treatment and outside customer rates. General pricing concepts are discussed below.
Overview of Pricing Approaches
Discussions with various water and wastewater agencies that provide recycled water indicate there is no consistent approach with regard to the rate philosophy, methodology, or actual pricing mechanisms used in California. The following discussion provides a brief overview of general concepts, historical pricing practices, American Water Works Association (AWWA) and other pricing methodologies, followed by a discussion of alternative recycled water rate structures.
Although public utilities are not allowed to “make a profit”, recycled water rates should, at minimum, cover the costs for any new recycled water facilities. Ideally, this means recovering all fixed costs, thereby guaranteeing that non-recycled water customers will not be subsidizing recycled water customers. Additionally, all variable recycled water costs should be recovered through variable rates (i.e., volumetric charges). In other words, the recycled water agency should hypothetically be indifferent to how much recycled water it sells because (1) they will not lose money and (2) the fixed and variable recycled water prices are fully recovered. Ideally, the resulting recycled water rates are also agreeable to recycled water customers.
As a matter of policy, an agency should give priority to customers within its service area. Any new recycled water project, particularly those serving outside customers, should not only be financially feasible, but should also provide long – term benefits to customers inside their service area, such as lower potable and/or recycled rates. Recycled water customers that are outside the service area can, and probably should be charged based on their willingness to pay and/or on a contractual basis, rather than strict cost-of-service principles.
Historical Pricing Practices
Many agencies initially developed recycled water systems as a means to either reduce wastewater disposal costs, particularly in light of increasing discharge standards and costs, or because they provide non-potable supplies for landscaping where potable supplies were limited. Other reasons for developing recycled water facilities include (1) meeting additional and/or seasonal water demand with lower-cost, non-potable supplies, and (2) delaying or eliminating additional costs of potable treatment, storage, and/or delivery costs.
Recycled water has also been used to offset the loss of potable supplies. For example, the City of Ripon lost several potable groundwater wells due to contamination. Rather than adding wellhead treatment or constructing new potable wells, they constructed new distribution lines from these contaminated wells so they could be used to irrigate landscape area, thereby reducing their potable needs and offsetting the loss of these potable water wells.
Recycled water rates have historically supported the initial capital cost of developing “backbone” transmission and pumping facilities, and this usually required an agreement, memorandum of understanding, or some form of contracting with larger customers such as golf courses or industrial and commercial users that required larger volumes, but did not require potable quality water. As a result, water and wastewater agencies have typically offered “discounts” to make recycled water more attractive as a long-term source.
There has also been increasing efforts to add “green” attributes into new residential projects in order to gain approval from city councils, planning commissions, and the public in general. As an example, a large residential development in El Dorado Hills (in the service area of El Dorado Irrigation District) constructed a recycled water system to provide landscape irrigation water for 3,900 dual-plumbed homes. This system, along with 165 commercial and recreational turf recycled customers, resulted in reduced wastewater disposal costs and avoided capital costs for additional potable water treatment capacity.
However, reduced and avoided potable water system costs are not always easy to incorporate into recycled water rates if agencies take a strict “cost-of-service” approach. Additionally, recycled water, has become a valuable source of “new” water supply in recent years. Due to drought issues and higher marginal cost of new potable supplies, one agency notes that recycled water is “the lowest cost of new water supply in California.”
Recycled Water Pricing Methodologies
Since there is no over-arching recycled water pricing methodology used by California agencies, in many cases recycled water pricing is market-based, similar to many wholesale potable contracts. That is, two parties agree to a certain price tied to predetermined stipulations (i.e. capacity, limits/guarantees on delivery, or quality). However, the increasing scarcity of potable supplies has encouraged a general trend towards using a tiered pricing approach as well as developing a better cost basis and rationale for how recycled water is priced.
The following is a summary of pricing principles from (1) the AWWA regarding standards in water and wastewater rate setting, and (2) pricing concepts recommended by the Economic Regulation Authority in Western Australia, where a long-term drought has resulted in the accelerated development of recycled water as a major component in water supply portfolios.
AWWA Manual M1 and other AWWA publications are typically well accepted as some of the most definitive and reliable sources for cost-of-service rate analysis. Unfortunately, they have minimal information about recycled water rates other than providing a solid foundation for cost-of-service rate practices in general. This can be attributed to the relatively new field of pricing recycled water.
Most water and wastewater utilities consider the overall cost-benefit when they decided to develop recycled water supply systems. The primary concern typically is covering short-term costs. However, recycled water facilities can also be justified by their avoided costs of wastewater effluent disposal. For example, the City of Santa Rosa, which has severe restrictions on summertime “in-river” disposal of wastewater effluent, developed an extensive effluent conveyance system in order to inject recycled water into the geothermal energy fields at The Geysers Project. The City also evaluated other approaches such as reducing collection-system infiltration and inflows, re-injection wells, seasonal storage, and percolation ponds. Two of the City’s more cost-effective alternatives included using recycled water for landscaping and irrigation of some excellent vineyards. The City has continued to expand these over time.
In light of the lack of AWWA standards, most California utilities are still searching for rational policies and approaches to pricing their recycled water. As discussed below, the Australian government has developed recommendations for this purpose.
An Australian Approach
The Economic Regulation Authority in Western Australia (ERAWA) prepared a report that evaluated a number of recycled water principles in an attempt to establish a consistent approach to the development and pricing of recycled water supplies.
Among other purposes for this report, the ERAWA wanted to promote conditions in which (1) resources for recycled water are distributed to those who value them the most, (2) there is “robust competition” between alternative providers, and (3) there are strong incentives to achieve least-cost provision of wastewater activities. This report recommended the inclusion of three cost components in pricing recycled water, as follows:
- Incremental Delivery Costs – There should be a charge associated with the cost of delivering recycled water to a customer, including incremental costs for achieving specific levels of treatment required by individual customers.
- Avoided Cost Discounts – There should be a “negative adjustment” in the price to account for avoided costs that result from selling wastewater rather than disposing of it. However, this discount should not exceed the direct cost of the recycled project.
- Scarcity Premium – If the amount of wastewater available for recycling is less than total demand, a premium should be added to reflect its relative scarcity. This premium should be determined by a neutral third party.
Another important concept included in this report’s final recommendations is that recycled water pricing should not include contributions towards “joint costs” of wastewater treatment. In other words, to the extent that recycled customers are willing to pay, wastewater entities typically seek to recover at least some wastewater facility costs. The basis for this recommendation is that recycled water customers should not have to pay for wastewater facilities which they did not cause to be constructed.
“Inside” vs. “Outside” Customers
While the “cost-of-service” provides the basis for setting recycled water rates for customers inside the agency’s service area, it should be considered the floor of recycled water prices for outside customers.
That is, outside customers should never be charged less than the full cost-of-service. Additionally, inside customers should not incur financial risks for providing services to outside customers, at least not without a corresponding benefit, such as lower long-term rates for inside customers, whether they are potable, recycled, or wastewater customers. In providing facilities and services to customers outside the service area, an agency should consider using a pricing philosophy more typical of a contract, and could include the three principles identified in the Australian approach noted above (covering incremental delivery costs, avoided-cost discounts, and incorporating a premium based on the relative scarcity of recycled water).
Alternative Rate Structures
When developing a recycled water rate structure, in general an agency should consider a broader range of financial factors than just the direct cost of facilities and operations. They should also consider how recycled water fits into the agency’s broader mandates and objectives. The following rate structures options should be considered:
- Base Rates – This can refer to a single tier, or uniform rate, for volumetric charges, usually combined with some form of fixed charge. These fixed charges are often based on capacity requirements and therefore tied to meter sizes. Base rates can also be specific to customer classes (agriculture, commercial, landscape).
- Tiered Rates – This approach most logically goes hand-in-hand with some form of water budgets, which define the irrigation needs of large landscape customers (golf courses and parks), such as those used by IRWD. Other forms of tiered rates can be tied to meter sizes, such as those used by the Otay Water District.
- Surcharges for Outside Customers – Many agencies have a policy of adding a surcharge for service to potable and recycled water customers outside their service areas. This reflects the additional costs of serving customers farther from service centers, the lack of initial investment in capital facilities by outside customers, and the fact that outside customers do not carry the same liability and/or financial burden of debt service payments or other risks.
- Contracted Services – recycled water service to new customers, particularly those with larger volumetric demands, can be provided on a contractual basis whereby the agency and customer develop an agreement for the level of service, specified deliveries of recycled water, and payment of capital costs. This arrangement typically means that recycled water service is outside the normal constraints of the agency’s obligations to serve municipal customers within its service area. These agreements are not typically subject to Proposition 218 requirements, since the agreement is voluntarily entered into by both parties.
Proposition 218 and Rates
Although recycled systems are categorically different than potable systems, and recent court rulings have raised concerns over pricing methodologies and rate structures, to the best of our knowledge they are still subject to the same legal requirements as potable water rates, including Proposition 218. The San Juan Capistrano case has specifically allowed the City to spread the costs of their recycled water plant to all customers, although it did question whether costs could be equitably allocated to the lowest-use customers.
As shown in the tables above, many recycled water rate structures use either tiered rates or are tied to a tiered potable rate. As industry standards for recycled water rate methodologies advance over time, this is likely to be a much less common approach in the future.
Several current issues for recycled water pricing mechanisms that are as of yet unresolved include: (1) how to establish specific cost justification to support a tiered recycled water rate structure (as is required for potable tiered rates), (2) how will recycled water rates incorporate avoided costs that undoubtedly should be reflected in pricing mechanisms, and (3) will California consider and integrate at least some of the lessons from the Australian approach?
Honestly, bearing the full costs of recycled facilities and operations can be a significant difficulty for many recycled water systems. Recycled water system costs don’t always compare favorably with the costs of potable water, as evidenced by the discounts that are often offered in an effort to sell the available supply of recycled water. However, as the scarcity of potable supplies intensifies, more and more recycled water projects are likely to start “penciling out” in terms of true cost of service.
As California’s limited storage capacity and cyclical droughts continue to constrain water supplies, the growing need for recycled water will continue to offer new opportunities and new challenges for water and wastewater agencies providing recycled water.
In light of these challenges, determining the recycled water pricing mechanism and rate structure that best fits your utility is not an easy task. It will require a thorough understanding of the current and future role of both potable and recycled water, the future demands and types of customers they each serve, and a careful evaluation of your agency’s recycled water policies.
The key factors that will play important roles in shaping and defining recycled water pricing mechanisms will include:
- The feasibility of various pricing mechanisms.
- The limitations of those mechanisms.
- The relationship between the utility (supplier) and recycled customers.
- The political and legal forces affecting rate design and industry practices.
 This fifth tier represents “wasteful” landscape irrigation based on IRWD’s water budget rate structure.
 Recycled Water Status Report and Proposed Rate Increase, FY 2010/2011, Inland Empire Utilities Agency, February 2010.
 Principles of Water Rates, Fees, and Charges, Manual of Water Supply Practices (M1), AWWA, Sixth Edition.
 Inquiry into Pricing of Recycled Water in Western Australia, Final Report, Economic Regulation Authority of Western Australia, February 6, 2009.
 Ibid, pages iv and v.
 This is not intended to provide legal advice; each water agency should consult legal counsel.
 Capistrano Taxpayers Association v. City of San Juan Capistrano – Court of Appeal, 4th District, Division 3, April 20, 2015, and City of Palmdale v. Palmdale Water District, et. al., Los Angeles County Superior Court, August 9, 2011.