An Incentive Water Pricing Policy for Sustainable Water Use

By adopting the Water Framework Directive (WFD), the European Commission and the Council made recommendations for water pricing policies in EU Member States with a view to enhancing the sustainability of water resources. Clearly, the Directive integrates economic instruments in environmental policies to provide incentives for the sustainable use of water resources. Our analysis will focus on public water utilities, required to be financially self-sufficient, facing demand and capacity shocks. The paper deals with the simultaneous determination of incentive pricing policies and investment rules under an ex ante maximum demand charge. We will characterize the welfare-optimal capacity selection rule and the welfare-optimal maximum demand pricing rule. Heterogeneous consumers demands are considered when tariffs are set ex ante, before demands are known. Our results are state-contingent nonlinear pricing that responds to demand fluctuations and capacity constraints.