Financial Sustainability: The Case for Full Cost Pricing

400_2913679smSustainability is the buzz word of the industry.  Common topics include sustainable water supplies, sustainable construction methods, sustainable infrastructure, and sustainable financial management, to name a few. Sustainability is achieved when we are able to meet our needs today without compromising the opportunity for future generations to meet their needs.

“Sustainability means providing an adequate and reliable water supply of desired quality – now and for future generations — in a manner that integrates economic growth, environmental protection and social development” (American Water Works Association (AWWA), 2010).

The US Environmental Protection Agency (EPA) has developed a Sustainable Infrastructure Initiative to help utilities address the task of maintaining high quality water and wastewater services in the face of challenges such as aging infrastructure, limited funding assistance, diminishing water supplies (in some areas), increasing water quality standards, and others.  The Sustainable Infrastructure Initiative places focus on four areas: Better Management, Efficient Water Use, Watershed Approaches to Protection, and Full-Cost Pricing, the latter of which is the focus of this article.

Full-Cost Pricing Defined
A utility’s cost of service is defined as a system’s total cost of providing service to its customers.  This generally includes operation and maintenance (O&M), administrative/billing, reserves, and capital costs.  Capital costs can be represented by rate-funded capital, debt service principal, depreciation, rate of return on the system’s asset base, or some combination thereof. Full-cost pricing is the direct application of the calculated cost of service to the development of rates, fees, charges, and other revenue mechanisms associated with providing service.  The goal of full-cost pricing is a revenue stream that adequately covers ongoing O&M requirements and reinvestment in the system.

Full-cost pricing is generally the standard in private regulated utilities.  Unfortunately, rates charged by public systems are often viewed as taxes rather than fees for service. In many communities, this has created a reluctance to maintain rates consistent with rising costs and has resulted in deferral of capital investment.

Why Implement Full-Cost Pricing?
The most obvious benefit of full-cost pricing is the ability of the system to consistently meet all on-going operational, maintenance, and capital costs, providing a high level of service. It is important that utilities do not operate at a loss or continually deplete cash reserves so that degradation of the system does not result, thereby compromising the quality of service provided.

Some communities routinely make transfers from other accounts to cover utility costs.  Though this is a local policy decision and is not necessarily unfair, it is not in line with full-cost pricing strategy.  Such practices may be taking funds away from another area that is then unable to meet ongoing maintenance needs. Subsidizing the utility is simply not considered a sustainable practice unless the transferred funds are somehow legally obligated to the utility.

By recovering all utility costs through designated fee schedules, users will better understand the value of the service provided. This transparency encourages conservation of resources by providing an accurate indication to your users of the real cost of operating and maintaining the utility and sending an accurate price signal to customers.

Recognize that It’s Not as Easy as It Sounds
sustainabilitygraphicThe development of a full-cost pricing structure sounds like a straight-forward task.  Add up the O&M costs, reserve requirements, capital costs, etc., and divide by the number of users or amount of water sold or wastewater collected.  Unfortunately, it’s not that easy.  First of all, there are several opinions on what represents the “full cost”.   Sustainability is most often described as the triple bottom line – economic, social, and environmental. The successful overlap of these aspects is where sustainability is achieved. So there are questions that come up in full-cost pricing related to the triple bottom line, such as: Should you consider impacts to the environment, such as potential loss of recreation or the impact of sewage flows?  Are social costs, such as those associated with electricity generation included?  What about return on capital? There are a number of unaccounted costs that could be argued into the equation, potentially making it very complex.  For the most part, O&M and administrative costs, reserve requirements, and a representation of capital cost (a combination of depreciation and a return on investment or debt service principal and rate-funded capital) will give you a good place to start.

Be aware that there may be social issues that make full-cost pricing difficult. Affordability is a reasonable concern, as the availability of basic services to all users is a primary goal for all utilities. Consider the makeup of the community and whether programs to assist low-income users with a subsidy would be appropriate.  By providing a subsidy for a subset of the users, you will be able to structure your rates at or slightly above the cost of service (if absorbing the subsidy within the utility), thereby achieving full-cost recovery while remaining sensitive to affordability issues.

In some areas, communities use sales tax revenues for utility repair and/or improvement costs. This practice is one that tends to be adopted by others in the area once neighboring communities demonstrate success. While not in line with full-cost pricing, this can be an effective solution for some systems if full-cost pricing of rates is not feasible.

For small and rural systems, sustainability may be a different objective initially due to limited population density and affordability issues. As a result, it is common in such systems to utilize grant or alternate funding sources initially and then strive for sustainability after initial construction.

Each community may have different objectives for its municipality.  Some may desire to promote economic development by offering attractive rates to industrial users.  This is another instance in which a subsidy may be an appropriate means for supporting a rate structure that is reflective of full-cost pricing but encourages economic growth. The message associated with under-pricing for economic development purposes should be considered, to avoid promoting inefficient water use by the industry. In many cases, the addition of industrial users frequently serves to improve the financial position and sustainability of utility systems.

In the end, a rate structure that does not rely on subsidies from outside of the utility is the most sustainable approach. Given constraints such as those discussed above, however, the ability of a utility to implement a purely cost of service-based rate structure will vary based on local policy and unique objectives of each municipality. Full-cost recovery still remains a worthy goal for every system.

Step Toward Financial Sustainability
How do we make this happen?  Experts agree that the move toward full-cost pricing must be taken in steps.  The process will require time and significant public education efforts. Consider the following tips to start easing your utility toward financial sustainability:

  • If not already in place, implement accounting and reporting practices that are specific enough to facilitate cost allocation to specific user classes.  Regulated private utilities, as well as some unregulated utilities, use the National Association of Regulatory Utility Commissioners (NARUC) uniform system of accounts.
  • Track usage patterns for each user class to provide data for evaluating future revenues.
  • Implement public outreach initiatives to educate consumers on the value of water.
  • If not already practiced, begin funding reserves to adequately provide resources to meet ongoing maintenance needs and to fund reinvestment. Reserves are an important component of the full-cost pricing rate configuration.  This only works, however, if reserves are funded at adequate levels and reserve funds are not diverted to other funds.
  • Complete mid- and long-range planning efforts to enable you to forecast revenue requirements into the future. As part of this, consider the degree to which you are willing to promote conservation through non-pricing means, such as rebates, consumer education programs, ordinances with usage restrictions, etc, and evaluate the potential revenue effects associated with such efforts.
  • Complete a cost of service analysis, allocating all costs to the appropriate customer classes. Set rates to send an accurate price signal, while taking care to consider affordability issues applicable to your service area. Observe the effects of changes to your rate structure and track usage patterns.
  • Optimize system operations. Look for means to enhance efficiencies and potentially reduce costs on the operations side. In addition, review metering and billing practices for potential ways to increase revenue collections.
  • Implement a comprehensive asset management program to allow you to plan and manage responsible reinvestment in the system.

The result of successful transition to full-cost pricing is a system that does not divert funding from other sources, sends an accurate price signal about the value of service to customers, and provides for financial sustainability.  In turn, financial sustainability is key to overall system sustainability.

For more information on sustainability initiatives and resources available through the AWWA, visit

American Water Works Association (AWWA) Government Affairs Office, AWWA and Water Utility. Sustainability, December 2010.

“Case Studies of Sustainable Water and Wastewater Pricing,” USEPA, December 2005.

“Full Cost Accounting for Water Supply and Sewage Treatment:A Case Study of the Niagara Region, Canada”  Steven Renzetti, Brock University, Catherines, Ontario, 2003.

“Full-Cost Pricing”, Janice A Beecher, Ph.D., Institute of Public Utilities, Michigan State, 2007.