Designing Better Policies for Water Pricing

Water pricing policies are designed to encourage conservation while ensuring that utilities can recover their costs and consumers afford their bills. In many Latin American countries, including Brazil, utilities use increasing block rates (IBRs), a tariff structure where the price of each unit of water rises as consumption passes certain thresholds  and enters into a new block of greater consumption.

This design, in theory, nudges consumers to conserve because the marginal cost of the next unit of water is higher. Yet, new research reveals consumers do not seem to respond to marginal prices, but respond to the average price of their bills.

Using millions of household water bills from a private provider in Brazil, the study examined how consumers reacted to two types of price variation. First, it looked for bunching behavior. In theory, if consumers responded to marginal prices, we would expect to see many households using a volume of water just below that triggering the higher rates in a new consumption block. However, the data showed a smooth distribution of water usage, with no evidence of such bunching behavior.

Second, the study focused on households whose marginal price remained unchanged at zero but whose fixed fees increased over time, raising the average price of their water bills. The results show that households reduced their consumption when their average price went up, even though the marginal cost of an extra cubic meter of water was unchanged. Together, these findings provide evindece that households base their decisions on the average price rather than the marginal cost of the last unit consumed. This behavior aligns with a broader body of evidence from electricity and gas markets showing that consumers simplify complex pricing schemes. They don’t separate fixed and variable charges in their minds. Rather, they react to what is most salient: the total they pay, not the incremental cost.

Getting Water Tariffs Right

Most tariff structures, conservation policies, and welfare analyses are built on the assumption that consumers optimize based on marginal prices. If this assumption is wrong, policymakers may overestimate the conservation impact of increasing block rates. Moreover, welfare analyses that assume marginal price responsiveness might miscalculate both consumer surplus and the distributional effects of pricing reforms.

This insight forces us to rethink a fundamental premise of utility regulation: if consumers behave according to average prices, how should tariffs be designed to achieve conservation, cost recovery, and equity?

The first takeaway is clear: simpler and more transparent pricing schemes could improve policy effectiveness. But the research suggests deeper policy lessons as well:

1. Design tariffs aligned with average-price behavior. Rather than relying solely on marginal price hikes for conservation, regulators could adjust fixed charges and the overall average price of water to influence behavior.
2. Pair pricing with behavioral nudges. Utilities could adopt approaches tested in electricity markets, such as comparative feedback (“you use 20% more than similar households”) or consumption alerts sent mid-cycle. These reinforce price awareness and provide real-time prompts to reduce use.
3. Reassess subsidy design. Many social policies rely on fixed credits (like a lump-sum rebate for water bills) under the assumption they don’t distort consumption. But if consumers don’t distinguish fixed from variable costs, fixed credits might unintentionally lower perceived average prices and reduce conservation incentives. Policymakers need to consider this behavioral effect when designing subsidies.
4. Improve demand modeling for policy forecasts. Demand models should incorporate average-price elasticities instead of marginal-price elasticities. This would provide more accurate predictions of revenue, consumption, and welfare outcomes under different tariff structures.

In short, recognizing that households make decisions based on average prices opens the door to more realistic, equitable, and effective pricing strategies that better serve both consumers and utilities.

Broader Lessons for Other Sectors

While this study focuses on water, the implications extend to other public utilities like electricity, heating, and gas, where two-part or tiered tariffs are common. Similar behavioral patterns have been documented in China’s heating demand and in U.S. electricity markets: consumers respond to what they see on their bill. That is, they respond to the total amount, rather than complex price schedules.

A Call for Policy Innovation

Policymakers aiming to achieve conservation goals must align tariff designs with real-world consumer behavior. Relying on marginal price changes alone may not be sufficient. Instead, future water policies should:

• Prioritize clarity regarding price schedules in tariff reforms.
• Integrate behavioral tools like social comparisons and targeted communication.
• Consider alternative regulatory approaches, such as rewarding households for reductions relative to their past consumption rather than imposing complex tiered pricing.

In short, recognizing that households make decisions based on average prices opens the door to more realistic, equitable, and effective pricing strategies that better serve both consumers and utilities.