Collision Course: Proposition 218 and Conservation Water Rates in California

Over the past decade, urban water utilities in California have sought to adopt rate structures that combine, to the extent possible, the goals of financial stability and incentives for efficient water use. This is often accomplished through shifting a relatively larger proportion of costs from fixed service charges to variable commodity rates, dividing commodity rates into multiple tiers with each tier for higher use bearing a higher rate, and disincentivizing the use of urban water supplies for irrigation. A recent California Court of Appeal case, City of Palmdale v. Palmdale Water District, Case No. B224869, tested the intersection of such rates with the primary restriction on public agency water rates, Proposition 218. The result: a moderate collision, with potential for a future pile-up.

On August 25, 2011, the Second District Court of Appeal published its decision in the Palmdale case. While the decision had been rendered earlier in the month, the court decided to publish its opinion on the 25th, meaning that the decision now has precedential effect in the courts. Given the outcome described below, there is a good chance Palmdale Water District will appeal the decision to the California Supreme Court, with continued amicus support from the Association of California Water Agencies (ACWA).

The Palmdale Water District, located in the Antelope Valley area of Los Angeles County, sought to raise its revenue in 2008 due to rising expenses and decreased revenues from its then-current rates. The board of directors hired a financial consultant and considered several options for rate design, eventually deciding to proceed with a “Fixed/Variable Cost Allocation” (FV) method. The FV rate design was established to recover 60 percent of revenues through fixed monthly service charges and 40 percent through commodity rates. The commodity rates were divided into five tiers, with higher prices for each progressive tier, and the tiers defined by percentages of a water budget set for each customer. The budget was determined for residential customers based on indoor and outdoor use allocations, commercial customers based on a three-year previous use average, and irrigation customers based on an outdoor allocation only. In addition, the speed at which each customer type moved up the tiers was different, as shown in the figure below. As is apparent, the FV method increased rates for irrigation customers more rapidly than for residential or commercial customers.
The district’s financial consultant also provided the board of directors with a second rate design option, ominously called “Cost of Service,” which collected a lower proportion of the district’s costs through fixed service fees. That option was expected to further incentivize efficient use of water based on higher commodity rates, but would have caused greater volatility in district revenues. This dilemma has been faced by many water utilities over the past few years, as there has been a push to drive water efficiency through customer incentives rather than specific directives (which approach, in my opinion, is well justified in a liberal society). I have written about the dilemma of conservation and utility revenues in a prior post.

The City of Palmdale challenged the district’s FV rate design based on the different commodity rate tiers imposed on irrigation customers, as opposed to residential or commercial customers. The city is an irrigation customer based on its maintenance of parks, playing fields and playgrounds. According to the city’s argument, the district violated Proposition 218 by treating irrigation customers differently without a cost-of-service justification, i.e., because it costs the district no more to provide irrigation water than it does residential or commercial water. In addition, the city argued that the fixed service fee for each water meter, the commodity rate tiers and the water budget allocation to each customer were not proportional to the cost of providing service.

Proposition 218, also known as the Right to Vote on Taxes Act, was adopted by California voters in November 1996. Codified at Articles XIIIC and XIIID of the California Constitution, Proposition 218 places both procedural and substantive limitations on property-related fees or charges, including water utility rates. Procedurally, a government-owned utility must adopt rates through a public hearing process and give voters the opportunity to protest. Substantively, utility rates must be set so that revenues do not exceed the funds required to provide the service, and the fee or charge imposed on any ratepayer must not exceed the proportional cost of the service attributable to that ratepayer.

The district first defended its rates by claiming the establishment of commodity rate tiers is not subject to the requirements of Proposition 218. The court rejected this argument, citing Bighorn-Desert View Water Agency v. Verjil, 39 Cal.4th 205 (2006), the seminal case holding that water rates are property-related fees subject to Proposition 218. In Bighorn, the California Supreme Court held that “all charges for water delivery are charges for a property-related service, whether the charge is calculated on the basis of consumption or is imposed as a fixed monthly fee,” and the Palmdale court concluded that such language applies not only to water rates as a whole but also to each constituent part.

The district then argued that its commodity rate tiers were set appropriately to incentivize the efficient use of water pursuant to the California Constitution, Article X, § 2. The district specifically cited Water Code § 372, which authorizes water utilities to adopt conservation rates that rely on allocation budgets. The court sidestepped the issue of potential conflicts between Proposition 218 and Article X, § 2, holding that conservation rates are not at odds with Proposition 218 as long as such rates are set in a proportional manner. The court noted that § 372 provides only general authority for conservation rates and does not mention inequality of tiers between different types of customers. As stated in § 372(a)(4):

A conservation charge shall be imposed on all increments of water use in excess of the basic use allocation. The increments may be fixed or may be determined on a percentage or any other basis, without limitation on the number of increments, or any requirement that the increments or conservation charges be sized, or ascend uniformly, or in a specified relationship. The volumetric prices for the lowest through the highest priced increments shall be established in an ascending relationship that is economically structured to encourage conservation and reduce the inefficient use of water, consistent with Section 2 of Article X of the California Constitution.

The court held that the district’s rates violated Proposition 218 because they treated irrigation customers differently than residential and commercial customers with no cost-of-service justification. Although the district argued that the rates were designed to disincentivize use of urban water for irrigation, the court noted that both residential and commercial customers may use water for irrigation, but it was only those customers in the “irrigation only” category that paid higher rates. In addition, the record was clear that the Cost of Service rate design provided greater incentives for water efficiency than the FV design, and the district seemed to choose the latter over the former based solely on concerns about its own revenue stability.

Although the city argued that the fixed service fee, commodity rate tiers and water budget allocations of the FV rate design also violated Proposition 218, the court did not reach those issues. Thus, the court did not resolve many of the difficult questions that exist at the intersection of conservation rates and Proposition 218. While conservation water rates are commonly seen as good public policy, and there is express statutory authority for their adoption, there are serious questions about their viability in light of the California constitution. It seems likely that future cases will force the courts to address the issues head-on.

One approach that may satisfy the twin goals of promoting water efficiency and complying with Proposition 218 is the adoption of water rates based on the marginal cost of supplies. Under this approach, a water utility would create commodity rate tiers based on each of its water supplies, with the lowest-cost supply for the first tier, and higher-cost supplies for the following tiers. Some water professionals have suggested setting the highest rate tier at the cost of developing new, currently undeveloped supplies, and that fits well with a marginal cost approach. This would appear to be defensible under Proposition 218 because it expressly connects each rate tier to the cost of service, and good policy because it effectively communicates the cost of developing new water supplies to ratepayers. Such an approach might be difficult to implement because water supply costs are often fixed regardless of utilization and could not be entirely dependent on customer usage. Very few, if any, public agencies have sought to adopt rates based on a marginal cost approach.

While we wait for the Palmdale case to be resolved by the California Supreme Court and for a future court to address the issues left unanswered by the Court of Appeal’s decision, water utilities will need to proceed with caution, knowing there is a fog of uncertainty about what lies ahead. If the courts were to resolve future disputes about the intersection between conservation water rates and Proposition 218 without a clear understanding of the significant policy questions implicated, there is the possibility of a major collision that will snarl progress on water resources management for many years to come.

14 Comments on “Collision Course: Proposition 218 and Conservation Water Rates in California

  1. After Salton Sea are Community Service Districts subject to 218 rate voing on rate increases or new rates?

    • I will assume that the rates you are asking about are water service rates, which have been determined by the courts to be property-related fees. If so, then yes, a community services district is a local government pursuant to the definitions in Prop 218 at Cal. Const., Art. XIIIC, § 1(b) and (c), and any new water rate or rate increase by a CSD must meet the procedural and substantive requirements of Prop 218.

  2. MY SITIUATION IS, IN THE CITY OF WHITTIER WHERE I LIVE. STARTING JUNE 2011 THE CITY COUNCLE ON THE RECOMENDATION OF THE DIRECTOR OF PUPLIC WORKS (DAVID A. PELNSER) AND CITY MANAGER (S. W. COLLIER) AND CHIEF ASS ISTANT CITY MANAGER (JEFFREY COLLIER) BEGAN A YEARLY FEE INCREASE IN WATER SERVICE FEE, SEWER AND SOLID WASTE FEE INCREASES. WATER SERVICE FEE WERE LOW AT $ 2.00 PER MONTH WITH A $2. 35 CHARGE PER UNIT. AT PRESENT THE WATER SERVICE FEE $ 14.93 PER MONTH AND $1.76 CHARGE PER UNIT. THIS JUNE 11 2013 IT IS PROPOSED TO RAISE THE SERVICE CHARGE TO BE $44.34 PER MONTH. THAT IS A RATE OF $ 2.00 VERSE $44.34 INTHREE YEARS. NOW THE INCREASE WILL IN 40YEARS IN THE 2011 AND ONLY 30 YEARS IN THIS NEWEST INCREASE WILL PAY FOR THE REPLALCEMENT OF THE CITYS AGED WATER DELIERY SYSTEM. ARE THESE INCREASES IN VIOLATION OF PROP 218 NOT TO MENTION THE ADDED STRAIN TO ITS CITIZENS. I HAVE MUCH MORE INFORMATION, BUT THAT IS THE JIST. THANKYOU FOPR ANY HELP IN ADVANCE B. W. AHERN

    • Prop 218 has two components related to water and sewer rates, a required protest process, and a substantive requirement that rates be directly related to the cost of providing the service. In order to show latter, a water or sewer utility will generally commission a rate study that calculates the cost of providing the service, and the proportional share of costs to be borne by each type of customer. Utilities fail that test most regularly when they attempt to transfer money received from utility customers to another governmental function, like the city general fund.

      Prop 218 does not necessarily govern the magnitude of a rate increase, only the magnitude of overall revenues and the relationship of those revenues to costs. Of course, that does not mean Prop 218 is the only restriction on utility rates, nor that dramatic rate increases are a good practice. Significant, sudden rate increases, known as “rate shock,” are generally disfavored as a matter of public policy.

  3. I would argue that the provisions of Article X are general provisions governing the use of water and Proposition 218 is a specific provision governmening charges for water. As a specific provision, Prop 218 would prevail over Article X to the extent there is a conflict. I would also argue that prop 218 is a later provision that supresedes Article X to the extent of any conflict.

    There are other ways to promote water conservation than to make those who can afford the rates substantially immune while imposing the burden on the less fortunate and those with more people living under the same roof.

    • I would largely agree with your legal argument. Regarding ways to promote water conservation, I would actually flip your argument the other way around. The past five years have shown that increasing water rates has enormous potential to incentivize water conservation. Contrary to the common (older) statement that water prices are relatively inelastic, i.e., changes in water prices do not affect demands, we have learned that water prices are quite elastic above a certain threshold. I believe that using price signals to drive proper levels of water use is vital. Rather than keeping prices low for everyone in order to help the poorest 20 percent of citizens, we should target financial assistance to the truly needy. The wealthiest 80 percent should not be incentivized to waste water in the name of helping the poor.

  4. Wes, I’ve been reading your articles for some time now and appreciate your comments and insight on water issues in California. Just a couple of thoughts on comments made above that I hope will lend some clarification to the nebulous intersection of Prop 218 and water rates in the state.

    Regarding transfers from utility enterprise funds and the general fund, as you are fully aware, agencies run a greater risk of a successful legal challenge if such transfers are made without a reasonable basis for doing so. We’ve seen this happen with a number of agencies over the past 5 or 6 years. My suggestion is that agencies develop this basis through an indirect cost allocation plan or similar mechanism. Transfers to the general fund are okay as long as there is a documented basis and it is reasonable.

    Regarding conservation incentives, customer awareness of resource scarcity and effective pricing signals are the best means to reduce wasteful water use. With respect to pricing signals, we must always keep in mind that our main pricing signal is an inclining tier commodity water rate structure. However, we have to keep in mind that Prop 218 requires us to meet the proportional cost of service requirement, meaning that each tier price (and any marginal cost differences in the next unit of water) must have a documented “nexus”. It is likely that there are CA water agencies basing higher tier rates on arbitrary factors (usually policy-driven) despite legislation (AB 2882) chaptered several years ago that require higher tiers be based on costs related to conservation programs, alternate source of supply efforts and facilities, and the like.

    Likewise, the use of frugal discounts for low-income, senior and efficient users subsidized by higher ratepayers also likely still continues despite Prop 218 requirements to the contrary. My suggestion in this case would be to fund “frugal” use discount prorgrams through revenue sources other than utility rates and fees and/or develop a base tier that is tied to the lowest cost of water source/supply and let that represent the “efficient user” tier, again making sure we have a documented rationale for basing the price of each and every tier.

  5. Non lawyer here:

    The City of San Diego is proposing a flat 15% increase in irrigation rates, while at the same time proposing a new highly progressive tiered system for residential users, with the top tier being a 75% increase over current rates. From what I gather that would be illegal as it treats irrigation customers different than residential customers not related to their actual cost of service. In short, this would be a violation of Prop. 218? Can I as a residential customer (with a large yard with fruit trees) bring a class action lawsuit? Would I have standing? As an aside, my monthly water rates will go up $100 per month if this rate increase goes thru.

    Who were the lawyers that did the Palmdale case?

    Here is your out:

    I understand anything you say is not legal advice from a lawyer and won’t be used as such. I waive my right to hold you financially accountable in any way for any opinion you give.

    Thanks

    DR

    P.S. If you have any question on quantum mechanics, I’m your guy.

    • Thanks for any information on quantum mechanics, that’s way over my head. I have a hard time helping my junior high daughter with her science homework.

      Regarding irrigation versus residential water rates, the utility needs to do a rate study regarding the cost of providing each type of service and set rates that are roughly proportional. The rates for irrigation and residential water do not need to be the same, for example, irrigation water may be untreated or may be interruptible, which would make a significant difference in terms of cost of service. So I couldn’t say whether the rates in that case would comply with Prop 218.

      On rate design, increasing block rates (sometimes called conservation rates) are still trending, even though a few utilities have started to move back toward increasing the contribution of fixed rates due to the volatility of block rates, especially during the transition and shortage periods. There is a small but dedicated group that favor conservation rates based on a water budget, and while such rates are authorized by California law, there are few utilities that have adopted them yet.

      As a ratepayer you would likely have standing, although there are strict procedural and timing requirements to meet. You would not likely need to seek class status, since any remedy in this type of write action would affect all ratepayers by its nature. Most litigation like this is brought by local taxpayer associations, since they often have relationships with attorneys who are like minded and will accept the case on a contingent or reduced fee basis.

    • Thank you, and quantum mechanics is easy to understand if you have it explained.

      I’ve been reading on this water rate subject, and talking to Palmdale. My understanding is that the conservation rate structure has to be proportional to cost of the service per parcel owner. In the case of San Diego, they just pasted a one-size-fits-all tiered rated structure which prices water use the same for folks living in cool, moist La Jolla as those living inland in hotter, drier Rancho Bernardo. A one acre lot in La Jolla uses far less water than a one acre lot 20 miles inland in Rancho Bernardo. In essence, Ranch Bernardo is now subsidizing the water for La Jolla. Moreover, all the inland single family homes have had their property devalued by have a redistributive tax disguised as a conservation water rate scheme. This is in violation of Prop. 218.

      I am ready to move forward with a lawsuit. Can you suggest where I can start to find a good lawyer.

      Quantum mechanics:

      In the old days you could turn your radio dial to any volume you desired. Now, the volume knob has clicks and digits associated with the volume settings. You can have a volume of any whole number, but not a fractional number. For example, you can have a volume of 24 or 25, but not 24.5, or 24.6, etc. In other words, there are only certain allowable levels of energy, each one separated by a specific energy level or quanta. Nature is the same way. It only comes in certain allowable energy levels, never in fractions. The reason you never notice these levels is because they are so closely spaced that it appears continuous. This is similar to your light bulb which flashes 60 times per second. The question of why the world is spaced in quanta is a longer discussion. For now, just realize nature is digital, spaced in quanta.

    • The issue of varying climate zones within a water utility’s service area is interesting, but not one that any court has addressed. Conservation pricing based on individual lot water budgets is allowed by statute, but not required. I am sceptical that a utility will be required to set rates by zone.

      Regarding an attorney, I do think the local taxpayer association is the best place to start for any issue related to local governmental finances.

  6. Is an appeal going to be heard at the Supreme Court or has that window now passed?

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