Pricing for scarcity? An efficiency analysis of increasing block tariffs

Abstract

Water pricing schedules often contain significant nonlinearities, such as the increasing block tariff (IBT) structure that is abundantly applied for residential users. The IBT is frequently supported as a good tool for achieving the goals of equity, water conservation, and revenue neutrality but seldom has been grounded on efficiency justifications. In particular, existing literature on water pricing establishes that although efficient schedules will depend on demand and supply characteristics, IBT cannot usually be recommended. In this paper, we consider whether the explicit inclusion of scarcity considerations can strengthen the appeal of IBT. Results show that when both demand and costs react to climate factors, increasing marginal prices may come about as a response to a combination of water scarcity and customer heterogeneity. We derive testable conditions and then illustrate their application through an estimation of Portuguese residential water demand. We show that the recommended tariff schedule hinges crucially on the choice of functional form for demand.