Investigating the Affordability of Utility Services – from the Ratio Measure to the Residual Income Approach

Erik Gawel (Helmholtz Centre for Environmental Research)
Wolfgang Bretschneider (University of Leipzig)

Abstract: Economists argue that prices for environment-related services should reflect full-cost recovery and therefore provide incentives for sustainable use. Efficient pricing, however, is likely to conflict with other competing objectives, amongst others ensuring affordable access to services for all sections of the population, including the poorest (affordability). Welfare economics literature suggests to neglect affordability aspects by separating allocative from distributive impacts of pricing. In practice, this approach runs the risk of rendering impossible any sustainability-oriented price reform. An Institutional Economics approach takes competing objectives into account. Hence, the question arises how can water prices be so arranged that they provide the desired incentives and at the same time are socially acceptable, especially affordable? The research on affordability features a tendency from the traditional ratio measure to a residual income approach. In our paper we first analyze affordability measures in the framework of the microeconomic household theory. With this approach we consider three objections against the ratio measure. We find that (only) two of them appear reasonable. But these two build a double step argument to the residual income approach. We conclude that the ratio measure appears hardly to be an appropriate foundation for political interventions with respect to service pricing.

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