CA Appellate Court Holds That Tiered Pricing Must Reflect Cost-of-Service

On April 20, 2015, the Fourth Appellate District in the Court of Appeal of California rocked the world of water agencies by holding that increased tiered-pricing of water service must reflect the cost-of-service.   The court’s decision in Capistrano Taxpayers Association v. City of San Juan Capistrano created an immediate flurry in the water industry.  Press reports indicated that Governor Brown called the ruling a “straight-jacket” for conservation efforts.


The City of San Juan Capistrano established a four-tier rate structure for residential customers.  The City identified the categories based on historical water usage as low, reasonable, excessive use and very excessive.  For Tier 1, the low water budget was for exclusively indoor usage and used World Health Organization guidelines concerning “minimum quantity of water for survival” with adjustments for “low-flush toilets” and “other high-efficiency appliances.”  Tier 2, the reasonable budget, included an “outdoor allocation” based on “typical landscapes” and assumed “use of native plants and drought-tolerant plants.”  The final two tiers were based on water budgets that the City considered excessive uses of water or “overuse volumes.”

The City set its rate structure so that the anticipated revenues from the four tiers equal the City’s cost-of-service.  Therefore, taking the system as a whole, the City’s revenues equaled its cost-of-service.  See table below for the resulting residential rate structure.

Tier 1 Categorization Usage* Price
1 Low Up to 6 ccf $2.47/ccf
2 Reasonable 7 ccf to 17 ccf $3.29/ccf
3 Excessive 18 ccf to 34 ccf $4.94/ccf
4 very excessive Over 34 ccf $9.06/ccf

* ccf = hundred cubic feet = 748 gallons

The City did not calculate the incremental cost of providing water at the level of usage represented in each tier.  In oral argument, the City admitted that it was using revenues from the higher tiers to subsidize below-cost rates for the bottom tier. 


First, did the City’s tiered rate structure comply with the Constitutional requirements of Proposition 218?  The key provisions involve section b(1), where the revenues received from fee or charge shall not exceed the funds needed to provide the service and b(3) the amount of a fee or charge imposed on a parcel shall not exceed the proportional cost of service attributable to the parcel.  The Superior Court held that the City’s tiered rate structure violated Proposition 218.

Second, did the City properly charge ratepayers for the cost of recycled water to customers who do not use recycled water nor have recycled water immediately available to them?  Under Proposition 218, b(4), no fee or charge may be imposed  for a service unless that service is actually used by or immediately available.  The Superior Court held that the City violated this section as well. 


The Appellate Court affirmed the Superior Court decision regarding the unconstitutionality of the City’s tiered rate structure, but overturned the Superior Court decision regarding the inclusion of recycling costs in water rates and remanded for further factual investigation.

The Appellate Court reasoning kept to a key theme: is there a cost-of-service justification for the tiered water rates?  The City admitted that it did not address the issue.  The Appellate Court’s displeasure with the City is evidenced by a paragraph in the decision where the Appellate Court said it “pitched a batting practice fastball” to the City in oral argument that the City would “hit into the upper deck”—is there evidence in the Administrative Record that the prices in the various tiers corresponds to the actual cost of delivering water in those increments.

“What we got back was a rejection of the very idea behind the question.”  Instead, the City proposed that the cost-of-service requirements of Proposition 218 must be balanced against the reasonable and beneficial use standard in Article X, section 2 of the California Constitution.  The Appellate Court found no merit to the balancing test.  The Court concluded that Proposition 218 and the reasonable and beneficial use standard could work together.

Regarding the water recycling issue, the Appellate Court held that residential customers all receive City water service.  The creation of a recycled water supply can make additional potable water available to customers.  Therefore, the Appellate Court overturned the Superior Court who held that non-users of recycled water should not pay water rates that include the costs of recycled water.  However, the Appellate Court remanded the issue on recycled water and instructed that the Superior Court investigate whether the City’s cost of delivering water in the increments of the tiered rate structure require the City to develop recycled water to meet water demands. 


JOW does not find the Appellate Court decision as troubling as other commentators.  Instead, the Appellate Court provides the road map for constitutionally-permissible rate-making.  Define tiers based on the level of service.  Link the development and use of water supply sources to meet the increment of demands within the tiers.  By defining the operational policy of how water sources are used to meet “demand increments,” cost-of-service water rates can be established for services under the various tiers.

What must give way is the approach that water agencies can decide what water uses are reasonable and which are excessive.  Instead, for residential users, for example, one can justify only two tiers—one for inside use and another for outdoor use.  With these two tiers, a constitutionally-permissible rate structure can be fashioned.  A third tier would be added when increased outdoor use requires the uses of a block of higher cost water.

What happens when a water agency does not have the water supply to meet all customer demands at the tier price schedule?  This will require all water agencies to develop water allocation policies.  The specifics of designing such a system and providing incentives for water conservation is beyond the scope of a discussion of an Appellate Court decision.  Look for this discussion to occupy center stage of California’s response to a well-reasoned Appellate Court decision.

Written by Rodney T. Smith, Ph.D.