THE EFFICIENCY OF WATER PRICING: A RATE OF RETURN ANALYSIS FOR MUNICIPAL WATER DEPARTMENTS1

Abstract

ABSTRACT: The rate of return on invested capital can be used as a guide to resource allocation by municipal water departments (MWD's) in the same way it is used in the private sector. To achieve economic efficiency, the target rate of return for MWD's should be the market rate of return as an approximation to the opportunity cost of capital. The actual internal rate of return for a sample of 30 California MWD's for the period 1970‐1982 is calculated for this study. The operating internal rate of return varies across the sample MWD's from less than 2 percent to 14 percent. If 10 percent is taken as the opportunity cost of capital, 25 of the 30 MWD's were inefficient; i.e., earned less than 10 percent. Half the sample earned less than 5 percent. An examination of potential causes of low rates of return shows that low average water prices are the primary reason for the low rates of return. For efficient operation, MWD's should set a target rate of return equal to the opportunity cost of capital and adjust water prices so as to achieve that target.