Introduction
Water utilities and management authorities use price elasticity of demand for water to predict the effects of rate changes on water demand. Price elasticity of water demand provides information about how changes to the price of water motivate an increase or decrease in water consumption and how these changes in demand can impact water utility revenues. Accuracy in predicting revenues is necessary to finance, operate and maintain water storage, treatment and delivery infrastructure.
This special publication is intended for utility commissions, water utilities, municipal governments and other individuals interested in understanding water demand and consumer responses to changes in water pricing. This work focuses on factors that cause elasticity measurements to vary and the implications of inadvertently applying an elasticity from one context to another.
Price elasticity of demand is defined as a measure of the percentage change in the quantity demanded resulting from a 1 percent change in the price of a good. Elasticity is a measure of consumers’ abilities to respond to price changes and is generally not constant over all levels of consumption (i.e., parts of a demand curve). At low levels of consumption for many goods, consumers facing a price increase may have few alternatives other than to consume the same amount of the necessary good and consume less of other goods. However, at higher levels of consumption of the same goods, water included, a portion tends to be for uses over which a consumer has greater discretion – outdoor water use, for example – and a price increase can more easily be met with a reduction in the amount of water purchased.
“An important benchmark in price elasticity estimates is the value -1.0. Elasticity estimates are elastic when less than -1.0 (greater than 1.0 in absolute value). Elastic demand means that a 1 percent increase in price causes a more than 1 percent decrease in quantity demanded. When demand for a good is elastic, an increase in price will cause the firm supplying that good to lose revenue. Elasticity estimates are inelastic when between zero and -1.0. Inelastic demand means that a one percent increase in price causes a less than 1 percent decrease in quantity demanded. When demand is inelastic a price increase leads to an increase in revenue” (Las Vegas Valley Water District (LVVWD), 2016).
Elasticity of demand is calculated from the coefficients of estimated demand models where quantity demanded is predicted as a function of prices and income, conditional on other factors. We use a large set of data from municipal water utilities in northern and southern Nevada that exhibits substantial variation in seasonality, weather, landscape features, size of household and type of commercial sector, to demonstrate how elasticities are influenced by these characteristics. In particular, this special publication summarizes elasticity estimates from previous studies that are based on five to 10 years of monthly client billing data, along with additional information from various sources including National Oceanic and Atmospheric Administration (NOAA) for daily weather, property and building characteristics from county tax assessors, and business and employment features from the Nevada Department of Employment, Training and Rehabilitation. While many studies use aggregated data to calculate elasticities over all of the client base, the studies we summarize here estimate multiple demand models for portions of the data in order to generate elasticities for individual components, such as single-and multi-family residential clients, commercial clients and by season. Details regarding these data are found in Rollins, Lott, and Tchigriaeva, (2014); Lott, Tchigriaeva, Rollins, and Stoddard (2014); and LVVWD (2016).
Price elasticity estimates for water across the United States generally are observed as inelastic. An analysis of 64 residential water studies shows an average price elasticity of -0.41 (Dalhuisen et al., 2003). Additionally, elasticity estimates for single-family residences range between zero and -0.5 in the short run and zero to 1.0 in the long run (Worthington and Hoffman, 2008). We discuss in this publication why such ranges in price elasticity of demand for water exist using, as examples, estimates from disaggregated data from southern and northern Nevada.
Price elasticity can be visualized by using a demand curve. Figure 1 illustrates how an identical price change can be associated with two very different changes in the quantity of water demanded. The difference between prices P1 -P2 is the same as the difference between prices P3 -P4. However, these prices correspond with very different initial levels of consumption and changes in the quantity of water demanded. That is, the difference between quantities demanded Q3 -Q4 is much greater than the difference between Q1 -Q2. Water consumption at lower levels, indicated by Q2, often tends to be for uses over which consumers have little discretion, such as for drinking, cooking and bathing. On the other hand, water consumption at a higher level, Q4, is more likely to be used for purposes over which consumers have greater discretion, such as landscape irrigation, which can be reduced as a response to a price increase and thus warrants a more elastic response. Consumers simply have fewer ways that they can reduce water use when they already are at a lower level of consumption.
A relatively elastic response represents consumers who have greater discretion over their water use, perhaps by using water for nonessential outdoor purposes. In contrast, an inelastic response may be characteristic of consumers who have already responded to conservation messages or use water primarily for essential indoor purposes.
Water Pricing and Regulation
Water utilities are characterized by large capital expenditures and the inability or inefficiency of having multiple competitors. The term “natural monopoly” is used to describe this situation. As water is a basic need, most communities choose to either own the utility outright or to create a quasi-municipal organization, such as the Las Vegas Valley Water District (LVVWD) and Truckee Meadows Water Authority (TMWA), which answer directly to elected officials.
Utilities require revenue to meet current operating costs, maintain current capital stock, protect water quality, expand the system as the community grows, and secure adequate supplies for the future.
Because competitive market prices do not exist, rates are set and adjusted through a public hearing process. For a public utility, requesting a rate increase is a major undertaking. It usually requires credible growth forecasts, demand analysis and the application of a financial model. Public Utility Commissions are charged with judging the need for rate adjustments through their own analysis.
Analyses, models and scenarios of rate changes are meaningless if they cannot predict precisely how people will respond to proposed rate changes. The estimate of price elasticity is a critical input required to make financial models and scenarios useful to evaluate the effect of a proposed rate change. It is often not feasible to estimate elasticity of water demand given time, data needs and budget constraints. Therefore, utilities, public utility commissions and other analysts often use elasticity estimates from published studies. These, however, may not be representative of their own customers due to differences in characteristics that determine specific elasticities. This special publication explores why and how variations in elasticity estimates occur, thereby assisting more-informed decision-making about which estimates to use and why.
Water Conservation and Elasticity
“Demand hardening is the reduction in the ability of a customer (or customers collectively) to achieve further water reductions after relatively easy and inexpensive water reductions have been implemented” (Tabors Caramanis and Associates (TCA), 1994 as cited in Howe and Goemans, 2007). With demand hardening, demand for water becomes even more inelastic. This induced tendency toward increasingly inelastic demand for water during drought can result in a severe impact on utilities’ revenues after the drought has passed.
Residential, Commercial and Composite Price Elasticities
Research conducted in southern (Las Vegas Valley) and northern (Reno) Nevada (LVVWD, 2016; Rollins, Lott, and Tchigriaeva, 2014) demonstrates how several factors can influence the price elasticity of water demand specific to residential and commercial sectors. Residential refers to single-family (individual residences) and multi-family (apartment buildings, condominiums and manufactured home parks) water users. Commercial refers to manufacturing, retail and other commerce-based water users.
Single-Family Residential Price Elasticity
For single-family residences in arid areas such as Nevada, outdoor water use is the largest and most variable component of water consumption. Outdoor water consumption varies across residences depending on a number of characteristics, including size of turfed area, size of treed area and presence of a swimming pool.
Single-Family Residences in Reno Area.
The Reno area climate is classified as high desert with less than 8 inches of rain per year and an annual average temperature of 54.4 F. Reno has an average annual high of 81 F and low of 26 F. The Truckee River Basin supplies water to this area and depends nearly exclusively on annual Sierra Nevada snowpack accumulation and snowmelt runoff (National Weather Service Forecast Office, 2012). The TMWA services the Reno area. Single-family residences in Reno consume, on average, 12.3 thousand gallons of water per month.
Irrigation for landscaping is the primary water use for residential and commercial water users in the Reno area. The irrigation season is from early spring through late fall, during which time water use is four to five times greater than winter use, which represents primarily indoor consumption. Table 1 illustrates how fluctuation in seasonal temperatures and wind speed can influence demand for outdoor water use in the Reno area.
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