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.