Innovation in the U.S. water industry is incremental and fragmented. In the second half of this policy brief, Ajami, Thompson, and Victor propose increasing innovation in the water sector by addressing the challenges presented by inadequate water pricing, obstructive regulations, and the lack of public-sector financing to raise capital for new projects. Addressing these challenges would unlock new funding sources and opportunities for the water industry, while also establishing a regulatory environment more conducive to innovation, prerequisites for addressing the nation’s water needs.
WATER PRICING
To strengthen innovation in the water sector, the authors call for three targeted reforms. First, they advocate pricing schemes that capture the full price of delivering water to better support the financial health of water suppliers. In particular, they argue that rates should recover all the costs of utilities’ services, including the costs of replacing infrastructure over time as well as needed research and development. Full-cost water pricing would help utilities recover the fixed costs of their infrastructures, granting them greater stability in funding innovative projects.
Second, they call for consumers to face the full marginal cost of each unit of water consumed, including costs to society in the form of environmental damages. For example, water utilities that charge flat fees for water, under which all users pay the same price no matter how much water they use, would move to a metered pricing structure; utilities that charge a uniform unit rate to all consumers would move to a pricing structure that charges more per unit as consumption rises. These pricing reforms would encourage greater conservation by end users and incentivize them to adopt water-conserving technologies.
Third, the authors propose decoupling utility revenue from the quantity of water sold by setting fixed revenue targets that do not vary with sales. Decoupling can be achieved by allowing utilities to issue a surcharge or a refund if the quantity of water sold lands below or above the target quantity, respectively. For example, the California Public Utility Commission ordered investor-owned utilities to decouple prices in 2006, using a water rate adjustment mechanism—the ability to issue a surcharge or refund—to lower utilities’ risk of falling revenue resulting from increased conservation, unexpected weather conditions, or an economic recession. Decoupling would remove the incentive from water utilities to maximize the amount of water sold, instead giving them a stake in the development of more-efficient technologies.
REGULATIONS
Regulation in the water sector can both promote and inhibit innovation. To ease the negative impact of regulations, Ajami, Thompson, and Victor propose a two-pronged approach to regulatory reform. First, they propose that state legislators and regulators undertake a review of regulatory practices along several key criteria, such as minimizing variation across geographic jurisdictions and across related sectors (e.g., water and wastewater, water and energy) and providing sufficient flexibility to avoid blocking the timely adoption of new technologies. Second, they propose that certain states create water innovation offices to better coordinate and support innovation efforts across the industry and to recommend regulatory reforms to the respective state’s water sector.
The regulatory review would seek to:

  • Reconcile regulations that are inconsistent between state and local government and among local governments, with state regulations always taking precedence.
  • Coordinate regulations across sectors (e.g., water and wastewater, water and energy) to ensure consistent treatment of new technologies and to reduce obstacles to the development and adoption of new technologies.
  • Shape regulations to encourage utilities to meet performance standards, rather than force them to adopt fixed technology mandates.
  • Enact regulations that drive, rather than inhibit, the development of new technologies.

The authors propose that select states establish offices of water resources innovation and development (called innovation offices) to develop a vision of water sector innovation. In some cases the legislature or governor would first create a commission or task force comprising policymakers, academic experts, and stakeholders to examine specific water challenges and opportunities in the state. The legislature or governor would then decide if an independent innovation office is necessary to carry out the vision, or if an existing office within the principal water agency can implement the plan.
Statewide water innovation offices would be well-positioned to support regulatory, as well as pricing and financial, reforms. Potential first adopters of water innovation offices include California, Florida, and Texas, which have the existing administrative capacity and most-pressing water supply challenges. These states may wish to employ their innovation offices to carry out or assist in the systematic review of water regulations. The innovation offices would also be positioned to support water pricing and utility financing reform and to promote research and development to a level seen in the energy industry.
The authors also suggest that the federal government play a supportive role to the first innovation offices, especially for states that lack the expertise or funding to promote innovation on their own. Utilizing the resources of the U.S. Environmental Protection Agency, the federal government would supply expertise and enable information sharing of best practices among the states. It could reward best practices with race-to-the- top funds and a periodic innovation report card. It would also engage organizations such as the National Association of Regulatory Utility Commissioners to promote adoption of innovation-driving regulations.
PUBLIC-SECTOR FINANCING
Finally, Ajami, Thompson, and Victor propose that authorities— either local water utilities or a statewide entity such as a water innovation office—institute a surcharge on water usage, called a public benefit charge (PBC), to create a stable and sustainable source of funding to finance innovative projects. The surcharge would create a pool of monies that could be used to invest in research and development, to pay for adoption of new technologies, and to attract private capital. The authors also suggest that the federal government act as a catalyst to investment by continuing to provide low-interest loans and grants to pilot and implement innovative projects.
Experience already shows how the administration of the PBC can be tailored effectively to state and local circumstances. One example is the water stewardship rate levied by the Metropolitan Water District of Southern California, which added a fixed charge to water bills to fund conservation programs and support research. Another successful illustration of how PBCs can promote innovation includes the California Solar Initiative, which used the funds levied from California’s PBC on electricity usage to promote renewable clean energy, successfully bringing down the prohibitive cost of rooftop solar power through the use of subsidies. Implemented in stages, the subsidies started at a high level and then declined—broadly in line with improvements in technology.
The primary benefit of instituting a PBC is that it would confront the water sector’s fundamental public-sector challenge to raise sufficient capital to support innovation. For the 80 percent of the water market that is supplied through state-owned enterprises, a public surcharge on water users is perhaps the most economically efficient mechanism for raising new capital while tying the costs to users. The PBC would help reverse the long-standing trend of exceptionally low public investment in water innovation.
PREPARING FOR THE FUTURE
In order to prepare for nation’s anticipated increased vulnerability to water scarcity, the water sector must confront its historic lack of support for innovation. The authors stipulate that three factors in particular present barriers to greater innovation, and that these could be addressed with smart policy reforms. First, water is typically underpriced, meaning that consumers do not face the full cost of their consumption, and water systems struggle to fund infrastructure renewal projects, let alone research and development of new technologies. Water systems are also subject to regulations that vary by jurisdiction and often emphasize implementation and use of status quo— rather than next-generation—water technologies. Furthermore, water systems lack access to the capital needed for innovation due to a dearth of public funding and difficulty obtaining low-yield bonds. Taken together, these factors limit the innovation in an industry predisposed to utilizing existing technologies over pioneering, but possibly riskier, alternatives.
The policy reforms called for by Ajami, Thompson, and Victor can help to break down some of these barriers to innovation. Price reforms would incentivize both utilities and consumers to conserve water and increase funding for innovation. Conducting systematic reviews of water regulations at the state and local levels would make regulations consistent and help drive the water industry to reach new performance standards through innovation and adoption of new technologies. Finally, instituting a PBC would provide utilities with a dedicated revenue stream and increase their access to capital to fund research for new technologies.
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QUESTIONS AND CONCERNS
1. Would states need to build additional capacity or provide additional funding for these reforms?
Most of the reforms presented in this paper, including reforms to pricing, regulations, and public financing, do not require significant new capacity or funding from state governments. The only reform that could require additional capacity or funding is the establishment of an innovation office. A task force or commission in each state would initially evaluate the steps needed to promote innovation, including the potential value of an innovation office. As part of this evaluation, the task force would examine the capacity needs of such an office and how the office might be financed. The exact needs of an office would depend on its mandate and activities. In some cases, a state might be able to create the office without a significant investment of new resources by reallocating resources within an existing state agency.
If the innovation office would need new resources, the state may be able to fund the office and its activities either by allocating a portion of the funds collected from the public benefit charge or through contributions from the local water agencies who would benefit from the office. States could require local agencies to fund the office, or they could institute a membership model in which local agencies could voluntarily decide whether to provide funding. In the energy sector, the Electric Power Research Institute (EPRI) successfully relies on voluntary subscriptions to support its activities. Like the Institute, a state innovation office could open its membership not only to local water agencies, but also to businesses and other governmental agencies interested in promoting innovative water technologies. EPRI estimates that, by pooling the resources of its members, it provides them with ten dollars in research and development for every one dollar received in contributions. Under this model, members would presumably receive benefits, such as the ability to formulate research goals and access research results, that are not available to nonmembers. However, other activities, such as regulatory reform, would benefit all water agencies.
2. Should there be a mandate for these pricing reforms?
In many cases, state or federal mandates may not be necessary. Water suppliers will often want to develop larger and more-reliable revenue streams in order to respond to the multiple water challenges facing them. Moreover, some reforms, such as decoupling revenue from the quantity of water sales, may not increase water consumers’ rates and therefore not engender significant political opposition. Other reforms, such as full-cost pricing and tiered pricing schemes, may threaten consumers’ budgets and therefore attract political opposition. Many water suppliers, nonetheless, have successfully raised rates or reformed their pricing structures. Education of customers has often been the key to success in these cases. Consumers are much more likely to accept higher rates if they understand the necessity of the rate increase or the benefits of reform.
Both the federal government and state governments, moreover, can help encourage pricing reforms without resorting to mandates. First, these governments can provide information and programs designed to help water suppliers explain the necessity of the reforms to their customers. Second, where state governments require water suppliers to adopt efficiency or conservation policies, the states can make pricing reforms such as those recommended above meet those requirements. The pricing reforms not only would help promote innovation, but would also encourage conservation and more-efficient water use.
Where pricing reforms prove impossible, water suppliers or states might be able to adopt other policies that mimic the effect of the reforms but with less political opposition. For example, if a water supplier is unable to raise its rates because of consumer opposition, the supplier might use a shadow price (i.e., a price equal to the full cost of the supplier’s water, including environmental and other costs) to determine what investments to make in new technology. Innovation opportunities that may be cost-ineffective when based on actual water rates could actually be cost-effective when shadow prices are used instead.
This policy brief is based on the Hamilton Project discussion paper, “The Path to Water Innovation,” which was authored by Newsha K. Ajami, Stanford Woods Institute for the Environment; Barton H. Thompson Jr., Stanford Woods Institute for the Environment and Stanford Law School; and David G. Victor, University of California, San Diego. To learn more about this proposal, read the full paper at www.hamiltonproject.org.

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MODERN PUMPING TODAY, June 2015
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