A proposal for the analysis of price escalation within water tariffs: The impact of the Water Framework Directive in Spain

Abstract

During the last few decades, numerous international organizations have emphasized the role of pricing policy as a tool to achieve objectives of efficiency, environmental sustainability, and cost-recovery in the management of water resources. Incorporating a certain level of price escalation within water tariffs by adopting increasing block rates is commonly advocated as a key element for controlling water demand and fulfilling these objectives. However, despite its widespread use, there exists no established procedure to measure the levels of price escalation embodied in water tariffs. We propose a measure of price escalation within water tariffs at the level of the water supply management unit (the municipality, in our study). In order to illustrate the usefulness of our measure, we analyse the evolution of price escalation in residential water tariffs between 2000 and 2014 in a sample of 952 Spanish municipalities and examine the factors influencing this evolution.

Keywords

Water pricing water industry European Water Framework Directive residential water use increasing block water rates price escalation

Introduction

Water scarcity is expected to be one of the most critical challenges for humankind in the near future (UN-Water, 2006: 4). According to the World Economic Forum (WEF, 2015), water crises are the 8th global risk in likelihood of occurrence and the one ranked highest in terms of potential impact. Consequently, the efficient and sustainable use of water resources will become paramount in the agenda of global leaders and international organizations in the forthcoming decades. Policy development in this area aims at the formulation of pricing schemes that can simultaneously accommodate several objectives, which can be synthesized as the generation of enough revenue to achieve cost recovery, while pursuing equity, efficiency, and sustainability goals (Rogers et al., 2002). First, water is considered a basic need, so universal access to a certain level of consumption must be guaranteed (Bovis, 2005). Among other issues, that implies the need for adopting affordable prices (Martins et al., 2013a, 2016; Van de Walle, 2008). On the other hand, pricing policies are expected to play a more prominent role in helping achieve full recovery of the cost of the service and making a more efficient and sustainable use of the resource.

Reconciling multiple objectives in a single instrument represents a difficult challenge, particularly if only linear tariff structures are applied (Farolfi and Gallego-Ayala, 2014; Schoengold and Zilberman, 2014; Wichelns, 2013). For this reason, two-part tariffs that include a fixed fee – per connection – and a variable or volumetric fee – related to the level of consumption – have become widespread (Dinar et al., 2015; GWI, 2014; IWA, 2014; OECD, 2010). The fixed part of the fee is supposed to provide financial stability to the utilities by guaranteeing an amount of revenue sufficient to cover at least part of the cost of the service, while the variable component is expected to help meet the other objectives. Increasing block rates (IBRs henceforth) are usually recommended (European Commission, 2000) for the latter, as a better means to reconcile the objectives of affordability, efficiency, and sustainability. Although water demand is relatively inelastic to price, there is evidence to suggest that substantial water savings can be achieved with IBRs (Baerenklau et al., 2014; Olmstead et al., 2007). Grafton et al. (2011) conclude, for instance, that households that do not face increasing block prices use around a third more water than similar households in a volumetric pricing framework. Besides, water price elasticity has been found to increase with consumption, especially when it is intended for recreational purposes, such as gardening and maintaining swimming pools (European Environmental Agency, 2012).

In this article, we quantify the results of efforts to enhance price escalation within water tariffs. To this end, we define a measure that permits full comparability among jurisdictions regardless of the specific tariff structure they use (i.e. regardless of the number and size of price blocks, presence and size of fixed components, and price levels included in the tariff). We also illustrate this approach by analysing empirical evidence for the Spanish case, specifically examining the evolution between 2000 and 2014 in 952 Spanish municipalities of the two price escalation¹ indicators we propose. In addition, we discuss the environmental, political, and business factors that influence those changes in the degree of price escalation in the tariffs between 2000 and 2014. Our results allow to identify the scenarios most suitable for the implementation of changes in tariff policy, as well as typical scenarios in which regulators would be expected to face more resistance and require more effort to promote water tariff reforms. To the authors’ knowledge, this is the first work that proposes an evaluation of the change of the level of price escalation of the water tariffs for residential uses.

The article is organized as follows. While Section “Literature review” provides a review of the relevant literature on the influence of pricing schemes on demand, Section “Measuring price escalation in water tariffs” outlines the construction of the proposed measure. In Section “The analysis of price escalation in water tariffs: An empirical implementation for Spain”, an empirical implementation of the indicators is conducted. Finally, Section “The impact on the WFD on water tariffs and price escalation” reports and discusses our results, before our concluding in Section “Results”.

Literature review

Price variable

The way block pricing affects water demand is not straightforward. The modelling of water demand under block pricing has generated a long-standing debate during the last few decades. Consumer theory predicts that, under perfect information and faced with the piecewise budget constraint that corresponds to a block pricing structure, consumers optimise their consumption by responding to the actual marginal price structure of the tariff they confront. However, since under block pricing consumers do not face a single price but a complete tariff scheme, Taylor (1975) first suggested that the sole marginal price could not be enough to capture their demand decisions. Instead, he proposed using both a marginal and an average price. Building on Taylor’s work, Nordin (1976) introduced what is known as Nordin’s difference variable,² in an attempt to account for the income (or intramarginal) effect resulting from consumers moving from one block to another.

However, consumption decisions are most often made in the absence of perfect information. In fact, empirical evidence has shown that consumers are not always perfectly informed about the tariff structure (Nataraj and Hanemann, 2011; Nieswiadomy and Molina, 1989; Pérez-Urdiales et al., 2015) and that the cognitive effort to understand complex pricing and non-linear structures is usually substantial (De Bartolome, 1995; Nieswiadomy and Molina, 1989). Random shocks to consumers’ demand (Borenstein, 2009) or income (Saez, 2010) may be another source of suboptimizing consumption behaviour.³ Consequently, economic theory has long attempted to provide guidance on how best to identify or proxy the price perceived by consumers under imperfect information. For instance, Saez (1999, 2010) and Borenstein (2009) relax the assumption of perfect information by allowing the existence of random shocks to income and demand, respectively. They predict that consumers will respond to the expected marginal price or even less precise information about marginal price (Borenstein, 2009). In turn, Liebman and Zeckhauser (2004) introduce in their model the assumption that consumers are not perfect optimisers (since they do not fully understand the nature of block tariffs) and find that the price they perceive corresponds to the average price at their consumption level.

Our objective with this paper is to work with a price escalation metric that reflects the suitability of a tariff to promote water conservation. While reacting to marginal prices requires that consumers be perfectly informed about the price structure they face, reacting to average prices requires much less information. In the latter case, only information about the total bill and quantity consumed, readily accessible from any standard bill, is needed. Since in practice most consumers usually admit to not knowing their tariffs (Pérez-Urdiales et al., 2015), we choose to use average price as the price variable of reference with which to construct our proposed index of price escalation. Moreover, this theoretical prediction about the average price being the price perceived by consumers has been confirmed by numerous empirical (Ito, 2014; Liebman and Zeckhauser, 2004; Shin, 1985) and experimental studies (De Bartolome, 1995).

Two additional considerations

Before further considering the analysis of price escalation, two more concerns must be addressed: the effects of a fixed component and the choice of the importance that should be attached to each of the price averages considered under the nonlinear tariffs.

Treatment of the tariff’s fixed component

The adoption of two-part tariffs, including both a fixed fee and a variable or volumetric fee, is increasingly common (Dinar et al., 2015; GWI, 2014; IWA, 2014; OECD, 2010). However, although necessary for the utilities’ financial stability, the fixed component introduces a regressive element in the tariff. With a fixed fee, the effective average price per cubic metre will be relatively high and decreasing for the lowest levels of consumption, until the counterbalancing effect of the escalation embedded in the block prices makes it rise again (Figure 1). The overall degree of price escalation in the tariff effectively involves the combined effect of both tariff components, fixed and variable, so it is important to account for the fixed component in the proposed analysis.⁴

Figure 1.

Fixed charge, variable (marginal) price and average price per cubic metre in an increasing block pricing scheme.

Considering proportions of users per block when dealing with IBRs

When using aggregate data (usually collected at the municipality level), as it is the case in our study, water demand functions must be estimated by regressing average consumption against a measure of the price faced by the consumers in each jurisdiction. However, since most often water tariffs are non-linear, it is not obvious what the relevant price should be.⁵ Under these conditions, using an average of the different marginal prices in the tariff weighted by the proportions of users consuming in each corresponding block has been acknowledged as the most theoretically correct specification for the analysis of the effects of IBRs on demand when only aggregate data is available (Martínez-Espiñeira, 2003; Schefter and David, 1985).⁶

As explained in Section “Price variable”, in our analysis the average price is more relevant. However, as our proposed measure of price escalation is intended as an aggregate indicator of the level of price escalation in water tariffs, we do follow a strategy analogous to the one described above, namely weighing the degree of escalation built into the different ranges of consumption by the proportion of users that consume within each particular range. This way, the degree of escalation embedded in each of the intervals is given an importance in accordance with its frequency of occurrence.

Measuring price escalation in water tariffs

The comparative analysis of the degree of price escalation in water tariffs requires the development of synthetic indices that provide a common metric to help those in charge of designing and assessing water pricing policies. However, to our knowledge, no such indices have been developed. The recent contribution by Suárez-Varela et al. (2015) is the only attempt in this regard. We build on their work, proposing a new variant of their suggested measure that incorporates in its calculation widely available additional relevant elements. For the purposes of this paper, we define price escalation as the increase in the average price per cubic metre as consumption increases. Hence, in order to measure price escalation, we must measure the average price that the tariff in use in each jurisdiction yields at different levels of consumption.

Water is consumed to satisfy different types of needs and wants, so it can be viewed differently from an equity perspective, all the way from being seen as a basic good to a luxury good, depending on the amount consumed. In order to account for the different uses of water (basic, intermediate, and luxury), we work out from each tariff the average price of water for a number of different levels of consumption and attach different weights to each, before incorporating them into our measure of price escalation. Following Martínez-Espiñeira et al. (2012), we consider the average variable price per cubic metre (excluding fixed costs) corresponding to a hypothetical bill of 3, 5, 10, 15, 20, 25, and 50 cubic metres (which we denote bill_c). Then, as formally explained below, we calculate the differences between the average prices in subsequent levels of consumption. We then weight these differences by the proportion of users within the range of consumption included between the two relevant consumption levels and finally we sum them up. By weighting the elements of the summation, our objective is that the resulting variable reflect the real effect of the price escalation embedded in the tariff in containing demand. For instance, a sharp escalation might be embedded in the price difference between two blocks, but if no consumers fell within that range, the impact of that price escalation on water conservation would indeed be effectively much weaker, if not null. The value yielded by the previous computations is also normalized employing the average price per cubic metre at 25 m³ (that is, the middle point of the range considered). This normalization corrects the effect of a higher average level of prices in a municipality, which would systematically lead to higher values of the outcome variable, unduly distorting the comparison of price escalation across jurisdictions.

In summary, the suggested measure is obtained as follows:

ESC = \frac{\sum_{c = 5}^{50} (\frac{{bill}_{c}}{c} - \frac{{bill}_{c - 1}}{c - 1}) w_{\frac{c}{c - 1}}}{\frac{{bill}_{25}}{25}}

(1)

forc = 3 m^{3}, 5 m^{3}, 10 m^{3}, 15 m^{3}, 20 m^{3}, 25 m^{3}, 50 m^{3}

{andw}_{c / (c - 1)} beingtheproportionofusersconsumingbetweenc - 1 andc

Finally, a thorough analysis of the level of price escalation in the tariffs must also include the influence of the size of the fixed component. Therefore, a parallel measure of price escalation, analogous to the previous one, is proposed. In this case, average unit prices are computed including also the fixed component in the total estimated bill (totbill).

ESC fix = \frac{\sum_{c = 5}^{50} (\frac{{totbill}_{c}}{c} - \frac{{totbill}_{c - 1}}{c - 1}) w_{\frac{c}{c - 1}}}{\frac{{totbill}_{25}}{25}}

(2)

forc = 3 m^{3}, 5 m^{3}, 10 m^{3}, 15 m^{3}, 20 m^{3}, 25 m^{3}, 50 m^{3}

{andw}_{c / (c - 1)} beingtheproportionofusersconsumingbetweenc - 1 andc

The previously depicted measures are intended to be complementary. As explained above, in a two-part tariff scheme, the variable component targets efficiency, sustainability, and equity goals. However, the fixed part is expected to ensure the financial stability of the utility, contributing to cost recovery goals. Given that the fixed component introduces a regressive element within the first levels of consumption, its inclusion attenuates the value of the measure.⁷ Therefore, the escalation measure that includes only the variable component (ESC) is expected to reflect the efforts made to promote water conservation habits and to meet the objectives related to the variable component, while ESCfix illustrates the effective overall degree of price escalation embedded in the tariff after the specific goals of this component⁸ are accomplished.

Finally, it should be noted that the two measures proposed yield different values depending on the nature of the pricing scheme that underlies the tariff. In the case of tariffs based on decreasing block rates or flat rates, average price is decreasing in consumption. Therefore, differences between average prices at subsequent levels of consumption are negative, leading to negative values for both measures and indicating that those tariffs are in fact regressive on consumption. For volumetric proportional rates, a constant average price makes differences between subsequent ranges of consumption null, thus leading to a null value for the measure as well. And finally, those in IBRs present a positive value for the indexes and its size will increase with the degree of price escalation embedded in the tariff.

The analysis of price escalation in water tariffs: An empirical implementation for Spain

Spain is a Southern European country subject to water stress⁹ or severe water stress throughout most of its territory. In fact, it is the third country of the European Union with the highest water exploitation index¹⁰ and the incidence of droughts is expected to increase in the near future (OECD, 2011). Regarding domestic supply, Spain is also one of the countries with the highest per capita consumption (Eurostat), although significant efforts have been made to reduce it during the last decade (Instituto Nacional de Estadística, 2014).

In Spain, water prices are set at the municipal level, since each municipality has jurisdiction over the management of its water service. There does not exist a legal framework or regulatory body that establish common guidelines for the determination of water tariffs, so municipalities are left with the decision about how to design their own price schedules. Therefore, tariff systems are fairly diverse (González-Gómez et al., 2012). In the absence of a formal regulatory body, the Spanish Association of Water Supply and Wastewater (AEAS), which is financed by both private and public utilities and public institutions and is the Spanish representative member of the International Water Association (IWA) and the main advisory body in the Spanish water sector, elaborates the main statistics and indicators related to the performance of the water sector, as well as some recommendations for the design of water tariffs (e.g. AEAS, 2014).

Regarding the regulatory framework, the Water Framework Directive (WFD henceforth) that came into effect in 2000 places special emphasis on the maintenance and improvement of the quality of water bodies and the sustainable use of water resources, which confers a marked ecological and environmental character to this regulation (Petersen et al., 2009). More specifically, the use of economic instruments is highlighted as the main tool for the attainment of these objectives (Unnerstall, 2007). According to Article 9 of the WFD, pricing policies should be granted a more prominent role in national policies addressed at covering the cost of the service and making a more efficient and sustainable use of the resource. In response, a volumetric tariff with a certain degree of escalation is usually recommended, justified mainly because it helps promote economic efficiency and sustainability goals (AEAS, 2014; European Commission, 2000). Nevertheless, according to the European Environmental Agency the efforts made by Member States in terms of pricing policy reform have been limited in practice to meeting the requirement of recovering supply costs, but “generally speaking, the WFD did not result in a change in water pricing policy” (European Environmental Agency, 2013: 9). Only in recent years have some countries, such as the Netherlands and Spain, implemented some changes in response to the WFD (European Environmental Agency, 2013).

In Spain, according to AEAS, between 2002 and 2012 water supply tariffs experienced an increase of 7% (AEAS, 2013).¹¹ Nevertheless, there is no information available about the changes made to the structure of the tariffs and its potential contribution to moderating consumption. In this context, we wonder whether the necessary changes in the structure of water pricing schemes have followed the rise in average water prices and whether price escalation has increased.

We will use the synthetic indexes proposed in Section “Measuring price escalation in water tariffs” to evaluate the degree of price escalation in water supply tariffs in the years 2000 (when the WFD came into effect) and 2014, as well as the main factors affecting changes in price escalation during that period. That will allow us to assess the degree of implementation of the guidelines proposed by the WFD and identify the common characteristics of those municipalities that embedded a higher degree of escalation into their water tariffs.

Data and sample

This study uses data from the 2000 and 2014 water tariffs applied in 952 Spanish municipalities. This sample includes 11.91% of Spain’s municipalities and covers around half (48.58%) of its total population. Together with this information on water tariffs, information on other variables that affect the degree of price escalation within each tariff and its evolution was added to the database. Table 1 in the Appendix contains a comprehensive description of the variables and data sources. All the variables refer to 2000 and 2014, except for those about water stress, as they reflect averages for longer periods. The prices that refer to 2014 have been deflated to their 2000 equivalents.

We expected water stress to be a main driver of price escalation in water tariffs, so we gathered information on the percentage of occupancy of reservoirs in the relevant river basin (Occup), August temperatures (Temp) and annual rainfall per square metre (Pluv), all expressed in averages for the periods 1990–1999 and 2010–2013. We also include a proxy for the level of economic activity (Econ) in the form of the index of municipal economic activity calculated by La Caixa (2014). Likewise, tourist activity was deemed to be a relevant factor for two reasons. First, because it increases the seasonality of demand, so to meet peak demands it is necessary to maintain excess capacity at other times. Second, because tourism in Spain is highly linked to water use, for example to fill pools or water golf courses. To proxy for it, we use the Tourist Activity Index (Tourism), also calculated in the 2014 edition of La Caixa’s Yearbook (La Caixa, 2014).

The literature on public local services also points out that ideological and political factors can interfere with the management of those services, so they must be considered (Picazo-Tadeo et al., 2012). Left-wing parties are expected to be more committed to social and environmental causes, and therefore more likely to adopt a higher degree of escalation in their tariffs. In Spain, the centre-right is occupied by Partido Popular (PP), while the Partido Socialista Obrero Español (PSOE) represents the centre-left, and Izquierda Unida (IU) is a party located further to the left than PSOE in the political spectrum. Moreover, these national parties coexist with some other smaller parties with a more regional character. To test for the influence of ideological factors, we include binary indicators for the main parties in Spain (variables PP, PSOE and IU), taking value 1 if the party dominated the local government during the last three four-year ruling periods.¹² Also included as factors related to political determinants, we include the degree of public support garnered by the ruling party (variable Majority) in each municipality is considered. This binary indicator equals 1 if during the previous three ruling periods the most voted party obtained over 50% of votes.

Additionally,¹³ the type of ownership of the water service supplier may be a cause of heterogeneity among local utilities and, more precisely, in the water supply sector (Renzetti and Dupont, 2009). Spanish law stipulates that the municipality is responsible for the management of water supply services but the local government has the authority to outsource the management to private companies and public-private enterprises. Therefore, we included a binary indicator of the type of ownership of the water utility serving the municipality (Private), with value of 1 if the utility is privately managed.

We also include several socioeconomic characteristics that serve both as controls and to test several of our hypotheses. These include indicators of population (Population), population density (Density), average household size (HouseholdSize) and unemployment rates (Unemp). Finally, and in order to account for the rest of components of the tariff, we gathered information on the number of blocks (Blocks) and the size of the fixed component of the tariff (Fixed).

Table 2 in the Appendix contains selected descriptive statistics.

The impact on the WFD on water tariffs and price escalation

In this section, the two proposed indexes are used to conduct an analysis of the degree of price escalation in Spanish water tariffs in 2000 and 2014, as well as to assess the evolution showed by these indicators between those two reference points.

First, we calculated the total variable cost and the total bill (that is including the fixed component of the tariff) corresponding to the hypothetical monthly bills for consumption levels of 3, 5, 10, 15, 20, 25, and 50 cubic metres.¹⁴ Table 3 shows the main descriptive statistics related to these variables, as well as Fixed and Blocks for the two years considered, together with the percentage change in their mean values between 2000 and 2014.

Then, as explained in Section “Measuring price escalation in water tariffs”, average prices at each level of consumption were computed based on both the total variable cost (Bill) and the total bill (Totbill) before the differences between subsequent thresholds were summed, weighted by the proportion of consumers falling within each consumption range. These weights rely on information about the number of users consuming water within each range. Ideally, these proportions should be obtained at the municipal level. Municipal civil servants and statistical agencies interested in implementing these measures should request information to utilities so that they reflect real proportions in the municipality or management unit being analysed. Unfortunately, in Spain this information is rarely available to researchers and we could not obtain it. Therefore, to illustrate the use of the measure, we use a rough approximation. In Spain, the Encuesta de Presupuestos Familiares (Consumer Budgets Survey)¹⁵ conducted by the Spanish National Statistical Service (Instituto Nacional de Estadística 2006–2012) gathers information about the number of cubic metres consumed by each household. This can, therefore, be used to obtain the distribution of users per range of consumption. We can introduce added variability in these proportions, since households can be classified in 570 groups¹⁶ or clusters according to the characteristics of their place of residence; including population density, range of total population, region (which one of Spanish Autonomous Communities), and whether the municipality is a capital of a province or not. That allows us to simulate the proportions of consumers per consumption range and impute them to the municipalities in our database, based on those aforementioned characteristics that are included in both databases. The proportions of users within each range of consumption in our sample are shown in Table 4. Finally, the normalization explained in Section “Measuring price escalation in water tariffs” is applied to both ESC and ESCfix. Table 5 shows descriptive statistics for the two indicators of price escalation in the two considered periods. The absolute differences in the indicators are also shown in the table (Diffprog and Diffprogfix, respectively).

With respect to the impact of the WFD, Table 3 allows us to analyse the impact on the water tariffs themselves. Our figures show that, after the implementation of the WFD and following the guidelines of the main advisory bodies,¹⁷ the municipalities have significantly increased the fixed component, as well as the number of blocks (13.76% and 4.96%, respectively) in their tariffs. We also find that the variable price of water has increased, on average, for every consumption level considered in our study. Moreover, the consumption levels that have experienced a greater price increase are those above 20 m³, and the higher the consumption level, the higher the percentage increase, being 50 m³ the one that has experienced the sharpest price increase. It should also be noted that, contrary to expectations, the prices at 3 m³ have also increased substantially, as opposed to subsequent consumption levels. After the implementation of the WFD and under the recommendation of the main advisory body in Spain,¹⁸ many municipalities decided to eliminate free allowances, as they were regarded as counterproductive in promoting an efficient and sustainable consumption of the resource. In our sample, the number of municipalities including these free allowances actually decreased from 196 in 2000 to 139 in 2014. Thus, our results seem to suggest that local governments have made a substantial effort after the enforcement of the WFD to increase price escalation by increasing prices more sharply in the higher levels of consumption, while some regressivity was introduced as a consequence of the elimination of the free allowances.

Nevertheless, despite the formal efforts made to increase price escalation in the tariff schedules, as shown by Table 4, the main increments in water tariffs took place in those ranges of consumption with lower proportions of consumers. Thus, when the actual distribution of consumption is considered, the picture we obtain is rather different.

Our proposed measures provide a synthetic index of the degree of price escalation with which to study the level of price escalation in each period, as well as the evolution between different periods. The figures in Table 5 lead us to highlight two facts. First, if we only take into account the variable component and once the distribution of consumers is accounted for,¹⁹ tariffs have on average a positive degree of escalation embedded, both before and after the implementation of the WFD (the values of ESC are positive). However, if we include the effect of the fixed component, tariffs are regressive in consumption on average (as revealed by the negative mean value of ESCfix). Interestingly, we can also see that, accounting for both the fixed and variable components, some progress has been made to increase price escalation (the differences in ESCfix are positive on average), while there has actually been a decrease in the degree of price escalation in the variable component of the tariffs between 2000 and 2014. This would be the opposite of what would have been expected from the implementation of the WFD.

Determinants of the evolution of price escalation in water tariffs

The second purpose of our empirical analysis is twofold. First, we analyse the determinants of the evolution of price escalation in water tariffs from 2000 to 2014. Second, we try to identify the characteristics of the municipalities that have more successfully increased, in line with the guidelines set by the WFD, the degree of price escalation. We, therefore, focus on the changes in price escalation levels brought about the coming to effect of the WFD.

Moreover, several of the variables introduced in Section “Data and sample” as relevant explanatory factors of price escalation are expressed in terms of differences between the two periods considered (before and after the implementation of the WFD). That is the case of DFixed DBlocks, DOccup, DPluv, DTemp, DDensity, DPopulation, DTourism, DUnemp, DEcon, DHsize, Privthroughout, Continuity and Dpubpriv. Tables 6 and 7 in the Appendix include further details about the definition and summary statistics of these variables.

Methodology

After calculating the degrees of price escalation before (that is, in 2000) and after (2014) the water pricing policy reforms introduced by the WFD, a variable measuring the differences for each municipality between those two time periods was constructed.

A difference between two continuous variables, the resulting variables was itself continuous too, so the simplest way to analyse it would be to use an ordinary least squares (OLS) estimator. However, a simplified version of the original dependent variable (DiffESC) was constructed by turning it into a trichotomous categorical variable (policychoice) that reflects the three possible general choices available to the municipalities. That is, each jurisdiction could have increased the level of price escalation, maintained it at the same level or even decreased it during the period considered. This variable was, therefore, obtained at the expense of sacrificing some of the information contained in the data but allowed us to uncover more significant relationships between the explanatory factors and the three resulting ordinal values of policychoice (indicators of a decrease, no change, and an increase in price escalation). Table 8 in the Appendix shows the frequency distribution of this variable.

We note that DiffESC was simplified into policychoice after substituting by zero those values of the DiffESC that were smaller than 0.001 in absolute value. Otherwise, only one municipality would have the value zero, suggesting, spuriously, that only that municipality had experienced no changes in price escalation between 2000 and 2014. This adjustment was needed because, during the considered period, a key change occurred in the European Union. From 2002, the euro became the official currency in several European countries. Therefore, when we were constructing the price variable, we had to perform a currency conversion to homogenize the water bill amounts from 2000’s pesetas (the former Spanish currency) to euros. To this end, we used the official exchange rate set by the monetary authorities at the beginning of the euro era: 166.386 pesetas/euro. However, many municipalities, when revising their tariffs, simplified instead the resulting amounts by rounding the result of the conversion to either the second or third place after the decimal point. By applying the correction mentioned above, we make sure that we offset the spurious effect of that rounding in those municipalities that have not suffered an actual increase in tariffs during the period.

The immediately obvious way to model variable policychoice would be to use an ordered logit or ordered probit estimator. Ordered regression models rely on the assumption that, although the effect of a given explanatory variable on the probability of any given outcome is not constant (depending instead on the values of all explanatory variables), there is an overall direction of the effect of the explanatory variables and proportionality in the odds of choosing among different categories. This parallel regression assumption,²⁰ more specifically, implies that the relationship between each pair of outcome groups is the same.²¹ In other words, the ordered regression models assume that the coefficients that explain the choice between decreasing price escalation versus not changing it are the same as those that explain the choice between the latter and the choice to increase the degree of price escalation. Under these conditions, only one set of coefficients needs to be estimated to explain the probabilities of all outcomes. Otherwise, two different models would be needed to describe the relationship between the three possible outcomes.

The assumption makes it possible to exploit a very elegant and parsimonious model from which a generic interpretation of coefficients is straightforward. However, the assumption is often violated in practice. In fact, a Likelihood-Ratio test of proportionality of odds across response categories showed that the parallel regression assumption could be rejected at a 1% level, so less restrictive (and thus less parsimonious) models had to be considered. Generalized ordered models, such as the generalized ordered logit model obtained by Stata’s gologit routine (Kang Fu, 1997) or the “partial proportional odds” model (Peterson and Harrell, 1990) are possible options but they can lead to interpretation issues and, if the notion of ordinality in the explained variable is preserved, problems of nonsensical predicted probabilities.²² Moreover, generalized ordered logit estimations of our model did not show convergence to a unique solution.

In light of these difficulties, we chose to use a multinomial logit model, entirely giving up on the ordinal nature of the information and instead considering the three categories in the dependent variable as nominal outcomes. The multinomial logit model relies on the assumption of independence of irrelevant alternatives, which we also tested.²³

The multinomial logit model allowed us also to conduct a test of the hypothesis that any two categories out of the three available (decreased price escalation, kept it unchanged, and increased it) could be combined. Both these tests suggested that it would be more efficient in our case to merge the categories indicating decreased and unchanged price escalation and model the dependent variable in its simplest form, namely as a binary variable. We, therefore, used a logit model to explain whether the municipalities’ decision to increase price escalation (rather than decreasing it or leaving it unchanged).

Results

Table 9 displays the average marginal effect for all the variables included in the Logit model whose dependent variable is an indicator of whether the municipality increased price escalation instead of decreasing it or keeping it at the same level between 2000 and 2014. Unlike linear regression models, the coefficients from non-linear outcome models (such as logit) are not directly interpretable as marginal effects. Traditionally, marginal effects are reported at the mean values of the variables included in the model, that is, for the “average individual” in the sample. Although computationally more demanding, the interpretation of average marginal effects (the average of partial changes over all observations) is preferred by many authors (Bartus, 2005). With the development of new statistical packages and increasing computational capacity, average marginal effects have become increasingly used and the most common form to report and interpret discrete choice models. It is this second type of marginal effects that we report in Table 9. A Likelihood-Ratio test of the hypothesis that all coefficients except the intercept are zero is rejected at 1%, implying that the model is globally significant.

The results of the logit model show that those municipalities that have experienced a larger growth in population along the period are more likely to have increased the degree of price escalation. It is reasonable that those municipalities whose population has increased more also have stronger incentives to promote water demand contention, as a means to avoid network overload or the need for further investments to meet the increasing demand. Municipalities under more water stress would be expected to respond to an increased pressure on their current and future availability of resources by increasing price escalation to adjust their demand to an expected reduction in supply. Our results suggest that municipalities that face higher temperatures or a higher reduction in the level of reservoir occupancy during the studied period have increased the price escalation embedded in their tariffs. However, it seems that those municipalities with less abundant rain have not been so inclined to maintaining or decreasing the degree of price escalation instead.

Regarding political and ideological issues, those municipalities in which PP (the main right-wing party in Spain) has been ruling with a majority show a significantly higher probability of experiencing increases in price escalation. Although left wing parties might be expected to be more committed to social and environmental goals, and thus more prone to increasing the level of price escalation in the tariffs, it is not the first time that a result of this type is found. In fact, previous research has found that, although left-wing parties usually increase public expenditures, it is right-wing parties that tend to set more progressive taxes and benefits (Bucciol et al., 2013; Padovano and Turati, 2012). Finally, those municipalities that have increased price escalation also tend to present an increase in the number of blocks and the fixed component of the tariff.

Conversely, we find that continuity in the type of ownership of the management during the period or a change from public to private management can decrease the probability of increasing price escalation in a 38.7% and 48.1% respectively. This is not surprising, as private managers should not be expected to be as committed to the environmental and equity benefits derived from an increased escalation in prices. Likewise, the continuity in the type of ownership provides companies with fewer incentives to improve management and efficiency in the use of water resources. Furthermore, a higher level of tourist activity is also related to lower probabilities of increasing price escalation. It should be noted that tourist activity in Spain is highly linked to the use of water, for filling pools or watering gardens and golf courses, for example. These uses for water could be regarded as a type of “luxury good” that would rely on the highest levels of consumption. Thus, it is to be expected that towns with a higher influx of tourists, local authorities try not to penalize this type of consumption by embedding a sharper level of escalation in the prices, as it could potentially harm the tourism industry. Finally, we find that municipalities with a higher average household size are less likely to have raised the degree of price escalation. This constitutes a positive fact, as otherwise price escalation would be penalizing larger families instead of promoting an efficient allocation of resources.

Conclusions

Water scarcity is expected to be one of the main challenges humanity will face in the coming years. Thus, the efficient and sustainable use of water resources is becoming increasingly relevant. Furthermore, water is a basic need, so universal access to at least a certain amount of water must be guaranteed at affordable prices. In the last decades, the use of economic tools has been fostered as the main tool for the achievement of these goals. In this line, a volumetric tariff with some degree of price escalation is usually recommended. The more the degree of price escalation in the tariff the more substantial its expected contribution to a better allocation of resources.

However, despite the widespread use of price escalation in water tariffs, no established procedure exists to measure its degree. In this paper, we propose a measure of the level of price escalation in water tariffs and demonstrate its usefulness by analysing the evolution of price escalation between 2000 and 2014 in residential water tariffs using a sample of 952 Spanish municipalities. We examine the factors influencing this evolution in the context of the guidelines included in the European WFD, the main legislative body of reference in Spain.

We find that, when only the variable component is considered, the tariffs exhibit, on average, a positive degree of price escalation both before and after the implementation of the WFD. However, when the fixed component is also considered in the analysis, tariffs are found to be regressive, on average, in both periods. Moreover, our results suggest that, despite the formal efforts made by local governments to increase price escalation after the coming into effect of the WFD by increasing prices more sharply at higher levels of consumption, the main increments actually affected those ranges of consumption with smaller proportions of consumers. Thus, once the distribution of consumers is considered through the use of our proposed measures of price escalation, our results show that, accounting for both the fixed and variable components, some progress has been made in terms of price escalation, while there has actually been a decrease in the degree of price escalation in the variable component of the tariffs between 2000 and 2014, contrary to what should have been expected from the implementation of the WFD. Besides, we find that some factors related to water stress, ideological factors, socioeconomic characteristics, issues related to tourist activity, and the ownership of the management may be affecting the probability of adopting tariffs with a higher level of escalation.

The main policy recommendations that can be drawn from our results involves the need to improve the incorporation into national law and implementation of the WFD in Spain. As pointed out by Pinto and Marques (2015), the decentralization of price-setting decisions to the municipalities may be hindering the implementation of the WFD, as it leaves the determination of price structures to retail utilities that may lack the necessary technical capability to design tariffs that simultaneously fulfil the multiple objectives of cost recovery, efficiency, sustainability, and equity expected from water tariffs. Moreover, the decentralization of the design of water tariffs may lead to political interference in those price-setting strategies (Pinto and Marques, 2015). Therefore, the creation of a regulatory body with the empowerment to standardize the design of pricing policies as well as establishing clear guidelines is highly encouraged. The reader should refer, for example, to the cases of the OFWAT in UK (Ofwat, 2013), the ERSAR in Portugal (Martins et al., 2013b) or the CER in Ireland (CER, 2014) for case studies in this respect.

In summary, our contribution with this paper is twofold. First, we suggest two synthetic indexes of the degree of the price escalation within water tariffs. Our intention is that these summary metrics assist policy makers in conducting sound policy analysis, when assessing efforts made by countries and/or municipalities to enhance the price escalation of tariffs or performing comparative analysis between jurisdictions. Additionally, our empirical application should help public administrators identify favourable scenarios for the implementation of the due improvements in pricing policies, thus directing their efforts towards generating those propitious conditions. Similar analyses could be conducted in other regions with slight changes to adapt it to the specific problems and the legal framework in those regions.

Footnotes

Declaration of conflicting interests

The author(s) declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this article.

Funding

The author(s) disclosed receipt of the following financial support for the research, authorship, and/or publication of this article: We gratefully acknowledge the financial support of the Spanish Ministry of Economy and Competitiveness (project ECO2016-75237-R and PhD Grant BES-2013-062824). We also thank two anonymous referees for their useful comments.

Notes

Marta Suárez-Varela is currently a PhD candidate at the Department of Applied Economics II of the University of Valencia (Spain), where she is hired under the Project ECO2012-32189 of the Spanish Ministry of Economics and Competitiveness. Her research interests lie in the field of Environmental and Resource Economics. Particularly, she works on water management (particularly water demand estimation and pricing), as well as environmental taxes and efficiency and productivity measurement.

Roberto Martínez-Espiñeira is a professor of Economics at Memorial University of Newfoundland. He completed his undergraduate degree at the University of Santiago de Compostela in Spain, before moving in 1996 to the United Kingdom to obtain his MSc in Environmental Economics from the University of York's Environment Department, where he also completed in 2001 his DPhil thesis on the economics of water demand estimation and water pricing, under the supervision of Jack Pezzey and Charles Perrings. Before joining Memorial University in 2009, he worked, since 2001 at the Economics Department of St Francis Xavier University in Antigonish, Nova Scotia. Although he has taught courses in Microeconomics, Environmental Economics, Natural Resources Economics, Industrial Organization, while his current teaching interests focus on Econometrics and Cost Benefit Analysis. His research covers issues of water demand estimation and management, as well as nonmarket valuation of public goods, with particular emphasis on natural resources. His work has been published in journals such as Applied Economics, Environmental and Resources Economics, Ecological Economics, The Journal of Environmental Management, Utilities Policy, and Urban Studies.

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