Demand Side Management of Residential Water Usage in Fort Collins, Colorado: An Econometric

Approach

Shu Guan Chuah

Submitted to the Department of Economics

Wichita State University
In partial fulfillment of the requirements for the degree of Master of Arts

Spring 2011

1
Abstract
Demand Side Management requires utility managers to influence residential water consumption via
price policies and/or non-price policies. This paper uses regression analysis to study the effect of price
policies on residential water consumption amongst single, duplex, and multi-family households in the
City of Fort Collins, Colorado. The effects of income, rainfall, temperature and non-price policies are
also examined. The results are largely consistent with previous findings; the co-integrating regression
indicates that water is price inelastic.

2
Acknowledgements
Much gratitude is offered to Mr. Dennis Bode, Fort Collins Utilities Water Manager for providing
information and data on water usage, rate structures, and conservation programs. Much thanks as well
to Dr. Philip Hersch for his invaluable comments, which have greatly improved the quality of the paper.

3
INTRODUCTION
There are two approaches to handling water needs of a city. The first approach calls for
expansion of water supplies by increasing production capacity of currently owned water sources or
acquisition of new water supplies by constructing reservoirs, building water catchment areas, harvesting
water from aquifers, and desalination. These projects usually require large amount of financial
investment due to the scope of the project and potential expenditures resulting from feasibility and
sustainability studies prior to project implementation. As nearby water sources reach exhaustion, and
water is obtained from farther sources, the costs of transporting water increases as well. Even in the
case of aquifers, if these are not properly managed, the costs of pumping water will increase as
underground water levels decrease. Furthermore, the potential for environmental degradation needs to
be taken into account.

The second approach calls for planned and responsible management of water demand,
otherwise known as Demand Side Management. In contrast to the above approach that aims to
increase water supplies, Demand Side Management requires utility managers to engage consumers of
water via price policies and/or non-price policies. Water use is usually divided into three categories:
agricultural, industrial, and residential. We focus on residential water usage. Price policies, as the term
suggests, have to do with the amount charged for per unit consumption of water, and also per account
charges and fixed charges per month; non-price policies, on the other hand, are usually associated with
programs that encourage or mandate water conservation, and includes measures such as education
campaigns, adoption of water efficient technologies, and water use restrictions.

This paper investigates how price policies influence residential water consumption in Fort Collins,
Colorado, thus informing city and utility managers about the effects of an increase in the price of water
or implementation of water conservation programs. This is meant to demonstrate that price policies
(despite their unpopularity) should not be abandoned; neither should they be relied on too heavily, as
water is price inelastic. Relying too much on non-price policies is not a solution either, as there is lack of
empirical evidence for the effect of non-price policies on water consumption. What is called for here is
a balance between price and non-price policies.

We find that water is price inelastic for single, duplex and multi-family households. A 10%
increase in water prices respectively generate 3.85%, 3.44% and 8.74% decrease in water consumption

4
for single, duplex and multi-family households. Upon implementation of new price policies in January
2003, water consumption would decrease by an additional 2.56% for single households and 2.66% for
duplex households. We find no such effect for multi-family households.

In the following sections we first provide background information on the City of Fort Collins in
specific regards to its water supply and water demand situation, examining the scope and extent of
water demand management in Fort Collins. We then move to a discussion of various topics that are of
relevance of estimation of water demand, such as price elasticity of water demand, income elasticity of
water demand, and effect of price policies. We then present the data, and provide a description of the
econometric method that will be used to estimate water demand. Results are then presented and
discussed, followed by concluding remarks.

1. BACKGROUND
The City of Fort Collins, Colorado, has a population of 138,736 (US Census), and is located 57
miles north of Denver, Colorado. It is situated east of the Rocky Mountains, on the Northern Front
Range. July is the warmest month, with mean temperatures of 71°F, annual average precipitation is 15
inches (The Weather Channel); major natural waterways that run through Fort Collins are the Cache La
Poudre River and Spring Creek.

According to the Fort Collins Utilities website, water in Fort Collins comes from three major
sources: (1) The Colorado-Big Thompson (CBT) project, which includes Horsetooth Reservoir (2) The
Cache La Poudre River Basin and (3) portions of the Michigan river basin that flow to the Poudre River
via the Michigan Ditch and Joe Wright Reservoir system. Each year, the City typically delivers 28,000
acre-feet of treated water to customers. In 2009, 10,300 acre-feet of the above treated water was
delivered to households for residential consumption. The City of Fort Collins also owns water rights that
yield approximately 72,000 acre-feet per year. However, due to system capacity (e.g., Size of water
treatment facilities, infrastructure for transporting treated water) and legal constraints (e.g.,
conservation measures adopted by the City), not all of the 72,000 acre-feet is available to meet treated
water demand. Typically, after taking into account the above constraints, the City is able to meet an
average annual demand of 32,000 acre-feet.

5
 In accordance to the “Fort Collins Water Supply and Demand Management Policy” dated
September 13, 2003, it was determined that new storage capacity “in the range of 12,500 to 14,000
acre-feet shall be pursued.” This has culminated in the purchase of the Halligan Reservoir from the
North Poudre Irrigation Company in 2004 (North Forty News, 2005) and subsequently the authorization
to pursue expansion of the Halligan Reservoir from its current capacity of 6,400 acre-feet to 40,000 acre-
feet (Fort Collins Coloradoan, 2009). However, it is also stated that “enlarging Halligan Reservoir is a
costly and complicated process”, one of the reasons being “working through the NEPA (National
Environmental Policy Act) process to obtain a permit is expected to take 2-3 years and cost about $3.9
million.” (www.fcgov.com). Chandler Peter, project manager with the U.S. Army Corps of Engineers,
says that a draft Environmental Impact Statement on the proposal to expand Halligan Reservoir is
expected to be complete by early 2011 (Fort Collins Coloradoan, 2009). In light of the above, the
Halligan reservoir does not yet function as a major source of water for the City of Fort Collins.

Having understood the context of how “costly and complicated” it is to expand the water supply,
we see why Fort Collins has adopted a two-pronged approach – tackling water supply and water
demand. In terms of water demand management, the City has outlined the following: (1) Water use
goals (2) Educational programs (3) Rate structures (4) Incentive programs (5) Regulatory measures and
(6) Operational measures (Fort Collins City Council, 2003). Based on data made available by Fort Collins
Water Utilities, we find that there has been much progress in terms of implementation of water
conservations measures to enhance demand side management (DSM) of water resources in the City of
Fort Collins.1 This is in contrast to the slower progress of water supply management in regards to the
expansion of Halligan Reservoir. The following programs were implemented in 2003: (1) Increasing
block rate structure (for single-family and duplex accounts); (2) Seasonal rate structure (for multi-family
accounts); (3) Residential clothes washer rebates; (4) Backwash recycling at water treatment facility; (5)
Restrictive covenants ordinance; and (6) Soil amendment ordinance. In 2007, the City began
implementing a program for dishwasher rebates.

Residential water consumption in Fort Collins is billed based on type of dwelling unit: single-
family accounts, duplex accounts, and multi-family accounts. Single-family accounts are defined as
residential customers with one dwelling unit, duplex being residential customers with two dwelling units,
and multi-family being residential customers with more than two dwelling units. According to Chapter

1
A detailed summary of water conservation programs is provided in Appendix 2.

6
26 of the Fort Collins Municipal Code and Charter, dwelling unit is defined as “one or more rooms and a
single kitchen designed for or occupied as a unit by one family for living and cooking purposes located in
a single-family or multi-family dwelling”. Each account type is billed differently.2

The City of Fort Collins has undergone several changes in terms of how monthly water
consumption is billed. The following is a brief description of how single and duplex accounts have been
billed for monthly water consumption. From January 1990 to December 1999, households were billed a
minimum charge for the first 2,000 gallons consumed, and a uniform rate structure for gallons
consumed beyond 2,000; this is in addition to flat rate charges per account and flat rate charges per 100
square feet. From January 2000 to December 2002, instead of being billed a minimum charge for the
first 2,000 gallons consumed, households were billed a “per account charge.” The uniform rate
structure therefore applied for all gallons consumed (The flat rate charges per account and flat rate
charges per 100 square feet still remained in force). From January 2003 onwards, Fort Collins
introduced a 5-tier increasing block rate price structure for single and duplex residential accounts, doing
away with the uniform rate structure. From May 2004 onwards, the flat rate charges per account and
flat rate charges per 100 square feet were removed; the increasing block rate price structure was
reduced to a 4- tier system. In May 2006, the increasing block rate price structure was reduced to a 3-
tier system.

The billing structure for multi-family accounts is slightly simpler in comparison to single-family
and duplex accounts. From January 1990 to December 1999, there were no charges for consumption of
the first 2,000 gallons. In other words, there was a free allowance of 2,000 gallons per month per
account. Customers were therefore billed a uniform rate structure for gallons consumed beyond the
minimum 2,000; this is in addition to monthly charges per account and monthly charges per additional
unit which have continued to remain in force (recall that multi-family accounts consist of residential
customers with more than two dwelling units). From January 2000 to December 2002, the free
allowance was removed, resulting in residential customers being charged uniform rates for all gallons
consumed. In January 2003, the seasonal rate structure was implemented for multi-family accounts,
resulting in higher tariffs during the summer, and lower tariffs during the winter. According to Chapter
26 of the Fort Collins Municipal Code and Charter, summer is defined as months from May to October,

2
A detailed description of the billing structure is provided in Appendix 1.

7
and winter is defined as months from November to April. Spring and fall are not given separate
treatment in terms of billing structure.

2. LITERARURE REVIEW

Worthington and Hoffman (2006) in their state-of-the-art review of residential water modelling,
point out that “population growth, coupled with the reduction in freshwater supplies, and the increasing
cost of infrastructure, has prompted suppliers to place renewed emphasis on demand management
through pricing structures and other strategies to control consumption.”

Much empirical research on residential water consumption has concluded that water is price
inelastic , carrying values of 0.25 to 0.75 (Worthington and Hoffman 2006) – meaning that a 10%
increase in the price of water will result in a less than 10% reduction in water consumption. This does
not mean that price policies are ineffective in managing water demand, but it does mean that non-price
policies may be desirable to supplement increases in the price of water. As highlighted by Renwick and
Archibald (1998), economists do generally advocate higher residential water prices as a means of
reducing demand, but there are others who argue that non-price policies, which do not affect the price
of water but place direct controls on water use such as rationing, constitute the only viable means to
reduce residential demand. This conclusion relies, in part, on the low price elasticity findings noted
above.

While it is generally agreed that water is price inelastic, the reasons behind the price elasticity
are varied – some bearing valid economic reasoning, and some not. One of the more questionable
reasons is that water is considered a necessity to life, meaning consumers cannot do without it. Berk et
al (1980) states that “the use of price as an allocation mechanism is constrained by the fact that water is
generally regarded as a basic necessity, even a right, not an economic good.” If this is the case, then no
economic policy can change the weak sensitivity of water consumption to price. It is important to note,
however, with specific regards to residential water consumption, not all of it is out of necessity – e.g.
washing the car, watering the plants, outdoor swimming pools, etc. Consumers can do with less
frequent carwashes, or cut down on watering activities by planting less flowers/shrubs. This is in
contrast to the argument and misguided view that water is a necessity. (Baumann and Boland, 1997).
The key is that, although part of water usage is a necessity of life, at the margin it isn’t. The main

8
reasons demand is still likely to be inelastic, even at the margin, is the lack of good substitutes (i.e.,
there are no alternative liquids for drinking or washing), water bills constituting a small portion of
consumer budgets, and the broad definition of the good (i.e., demand for water is inelastic compared to
demand for bottled spring water).

Thus, when water managers and/or city managers consider price measures to enhance
conservation, they should not be afraid to do so in the misguided assumption that residents’ right to
necessary water use is being violated. What they should bear in mind is that the increase in water rates
will generate less than proportionate reductions in water usage due to water bills constituting a small
part of consumers’ budgets, and lack of good substitutes of water. Based on recently calculated data, in
2009, 0.44% of average household income in Fort Collins was spent on water. Contrast this with 1990,
whereby 1.68% of average household income in Fort Collins was spent on water. This is due partly to a
noticeable reduction in water billing amount, which in turn is caused by Fort Collins removing the flat
rate charges per account and flat rate charges per 100 square feet for monthly water bills in May 2004.

The absence of price information on water bills has been suggested as an explanation for the
low price elasticity of water. According to the law of demand, people decrease consumption when price
increases, as demonstrated by the negative price elasticities for water. However, the law of demand
also implicitly assumes that consumers know prices – an unrealistic assumption in markets with ex post
billing. Gaudin (2006) reasons that when prices are not transparent, elasticity estimates are potentially
lower than their full information potential. He therefore hypothesizes that resident’s sluggish response
to price is partly due to the absence of price information on water bills. On the basis of a sample bills
collected from 383 utilities across the USA, he finds evidence that when price-related information is
given on the water bill, price elasticity increases by 30% or more.

At large, there is no question about the low price elasticity of water. However, when we come to
the issue of which water pricing structure is the most effective in reducing water consumption, the
conclusions are varied and mixed, i.e. there is no general consensus among economists as to which
pricing structure is more conservation oriented. This is an important issue to highlight as many utility
managers have moved away from a uniform rate structure to an increasing block tariff in the belief that
the latter results in water conservation. In the year 2000, approximately one-third of U.S. urban

9
residential water customers faced increasing block tariffs, up from 4% in 1982 (OECD 1999; Raftelis
1999).

Young, Kinsley and Sharpe (1983) have proposed that an increasing rate is more effective in
reducing water consumption than a uniform or a decreasing rate structure. Dandy, Nguyen and Davies
(1997) however offers a counter-argument: Economic efficiency requires that the marginal benefit of
water to consumers be equal to the marginal cost of supplying water. They expect marginal cost to be
about the same for consumers consuming different amounts of water, therefore a uniform rate identical
for all consumers appears to be preferable on the grounds of economic efficiency to either an increasing
or decreasing block rate. However, they do allow an exception for the increasing block rate structure,
explaining that this can be justified on the grounds of system expansion costs, whereby water supply
exhibits increasing Long Run Marginal Costs (LRMC) instead of constant LRMC. Finally, Nauges and
Thomas (2000) state that the increasing tariff is sometimes advocated in that it better protects water
resources.

Nieswiadomy and Cobb (1993) shed more light on the topic as their research compared the
price elasticities of increasing and decreasing block structures. They also explain that utility managers
commonly adopt increasing block structures in the belief that they are conservation-oriented. This is in
due in part to Wilchelns’ (1991) non-econometric analysis of marginal pricing’s impact in irrigated
agriculture, which associates increasing blocks with reduction in water use per acre. The findings of
Nieswiadomy and Cobb find that increasing block structures are apparently conservation-oriented. The
authors warn of a selection bias in this finding – whereby in cities where people are more interested in
conservation, utility managers may be more likely to select a rate structure that they believe is
conservation oriented – that belief being an increasing block structure.

Olmstead et al (2007) investigate whether price elasticity may depend on price structures. The
sample of households surveyed consisted of either increasing block households or uniform rate
households. While the paper is not explicitly focused on whether increasing block structures are
conservation oriented, the estimated price elasticity of respective household types does throw light on
whether residential consumers under increasing block structures are more sensitive to price changes.
The findings of the paper indicate greater price elasticity for increasing block households. However, the
authors also state, “... given our remaining selection concerns, we cannot definitely say IBPs [increasing

10
block prices] tend to increase elasticity. We cannot dismiss the hypothesis that underlying city-level
heterogeneity in characteristics such as aridity and conservation programs, which may be correlated
with both consumers’ price elasticity and utilities’ price schedule choice, explains part of the observed
pattern in the literature of higher price elasticity under IBPs.”

Similarly, in terms of price specification, there has been a lot of debate in the water demand
literature as to which specification should be employed in estimating the price elasticity for water.
Hoffman, Worthington and Higgs (2005) provides a brief list of the various approaches in price modelling:
(1) Marginal Prices [Nieswiadomy (1992), Garcia and Reynaud (2003)]
(2) Marginal Price less Nordin’s difference3 [Barkatullah (1996), Renwick et al (1998)]
(3) Average Price [Gaudin et al (2001)]
(4) Marginal Price in highest tariff block [Pashardes and Hajispyrou (2002)]
(5) Average Marginal Price [Martinez-Espineira (2003)]

However, despite the five different price specifications listed above, the main methodological
issue usually relates to the choice of marginal or average prices. The variants provided above are merely
extensions or variations upon average and marginal prices. Although economic theory suggests the use
of marginal price (the price of the last cubic meter), average price (computed as total bill divided by total
consumption) has often been preferred. Authors who opt for average price argue that households are
rarely well informed about tariff structures and thus more likely to react to average price rather than
marginal price (Nauges & Whittington 2010). Furthermore, several studies have shown that consumers
tend to respond to average prices of water rather than marginal prices (Foster and Beattie 1981; Griffin
and Chang 1990). It has also been pointed out that using a marginal price specification with
heterogeneous price structures would create estimation and interpretation problems (Gaudin 2006).
There are others who have found that neither an average price nor marginal price specification can be
rejected in favour of the other (Williams and Suh 1986). Admittedly, a few studies have shown that in
some circumstances, marginal prices are more appropriate (Nieswiadomy and Molina 1991; Taylor et al.
2004).

3
Nordin (1976) introduced a difference variable referred to as the ‘rate structure premium’, which is defined as
the difference between the total bill less what the bill would have been if the water quantity was consumed at
marginal price. The ‘rate structure premium’, referred to as Nordin’s difference by subsequent researchers, should
be able to capture the income effects of changes in intramarginal prices, the fixed price and quantity breakpoints.

11
 Research concerning estimation of water demand is usually accompanied with information on
income elasticity. The inclusion of income variables in estimation of water demand is motivated by basic
economic theory which suggests that income is a key determinant of demand. Water consumption, as a
normal good, should then be positively related to income. This can be explained by the fact that income
is also positively related to many other water-using goods, such as swimming pools, dishwashing
machines, and gardening activities. Furthermore, higher income levels are also correlated with larger
house size, which increases water consumption as well. This would tie in well with conventional
economic theory which suggests a positive relationship between income and water consumption.
However, it has also been suggested that there may be a negative income effect for water consumption
– income through its positive relationship with education may be reflective of water conservation
measures taken by the household through the purchase of water-conserving appliances and planting of
drought-tolerant garden vegetation (Worthington, Hoffman and Higgs 2005). Despite this alternative
explanation, empirical research has indicated that income elasticity of demand is positive, but inelastic
(Nieswiadomy and Cobb 1993; Dandy, Nguyen and Davis 1997; Renwick and Archibald 1998; Nauges and
Thomas 2003).

In regards to estimation techniques, numerous econometric methods have been employed to

study water demand. For cross-sectional data, techniques employed include ordinary least squares
(OLS), generalized least squares (GLS), two and three-stage least squares (2SLS and 3SLS), logit and
instrumental variables (IV). In terms of time-series data, two common techniques are Vector
Autoregression (VAR) and co-integration methods (Worthington and Hoffmann 2006). However, we are
unaware of any published work that has utilized VAR for estimation of water consumption. This is
because VARs are a-theoretic, its emphasis on forecasting makes it less suited for policy analysis, and
individual coefficients from estimated VAR models are often difficult to interpret (Gujarati 2003). On a
related note, Martinez-Espineira is the only paper to date that has employed co-integration techniques
and Error Corrections Mechanisms (ECMs) to in the estimation of water demand. OLS is a very common
and basic econometric technique used to examine the relationship between dependant and explanatory
variables. However it is important to note that OLS (especially in the case of increasing/decreasing block
rate pricing) may produce biased and inconsistent estimates due to simultaneity issues between water
consumption and price. Researchers have proposed GLS or 2SLS to resolve the problem.

12
3. DATA & METHODOLOGY

Data Sources
In this paper, we will use co-integration methods with ECMs to estimate the monthly demand
for water in Fort Collins using a sample of monthly observations for the period January 1990 to
December 2009. The dependent variable is consumption per account measured by thousand gallons
consumed per household account. The explanatory variables are average price, income per capita, total
monthly precipitation, average monthly maximum temperature, and increasing block/seasonal rate
structure. The variables are discussed below. The variables are discussed below.

Consumption per account (Q)

Data on monthly water consumption and number of accounts served by Fort Collins Utilities
were organized according to account types: single-family, duplex, and multi-family accounts. This was
instrumental in calculating monthly consumption per account for the different types of customer
accounts. Consumption per account was chosen as the dependent variable of choice (instead of
consumption per capita) as we are interested in looking at how the independent variables influence
water consumption at the household level. Furthermore, Fort Collins Water Utilities does not serve the
entire population of Fort Collins, making the number of customers served (i.e. number of accounts) a
more accurate measure of household level behavior. However, it is important to highlight that the
household size for each of these account types will be different as we have pointed out that single-
family, duplex, and multi-family accounts are respectively defined as residential customers with one,
two, or more dwelling units. Thus, estimation procedures will be conducted separately for the different
types of accounts, i.e. monthly consumption per account for single-family accounts will be regressed
against relevant variables discussed below; the same principal applies for duplex and multi-family
accounts. Data for water consumption and number of household accounts were obtained from
“Residential accounts and water usage”4

Average Price5 (AP)

The choice of average price specification is driven by several factors. Economic theory suggests
that marginal price should be the variable of choice. However, in our previous discussion, several studies

4
Data for water consumption and number of household accounts is available upon request
5
The background literature in support of average price is drawn largely from Gaudin (2006).

13
have shown that consumers tend to respond to average prices of water rather than marginal prices, and
the average price specification is preferred when there are heterogeneous price structures. In the case
of Fort Collins, we have seen how price structures have changed over the examined 20 year period,
resulting in heterogeneous price structures, hence discouraging the use of marginal price. The average
price has been adjusted based on changes in the consumer price index in order to reflect real prices.
Average price is expected to display a negative coefficient. Data for average price were obtained from
“Rate History for Residential Accounts”6

Increasing Block/Seasonal rate structure (POLICY)

In January 2003, a new price structure was introduced in the City of Fort Collins. Increasing
block rate structures were introduced for single family and duplex residential accounts; seasonal rate
structures were introduced for multi-family residential accounts. In light of this significant policy shift in
water rate structures, we have introduced a policy dummy to measure the effect of the introduction of
this change. Prior to January 2003, when the City of Fort Collins implemented a uniform rate structure,
the policy dummy carries the value “0”; from January 2003 onwards, when the policy changes were
introduced, the policy dummy carries the value “1”. We will interact this binary variable with AP – the
value of AP prior to January 2003 will be “0”, the value of AP from January 2003 onwards will carry the
original AP values. This will allow us to examine if policy implementation has an added effect on price
elasticity.
Understandably, interaction of the average price specification with a policy dummy that
introduces marginal price specification raises some questions as to the choice of using AP to measure
how water prices affect the consumption of water. The choice of AP is not meant to convey that MP is
less important. Rather, the choice of AP is driven by several other factors that have been previously
discussed, one of those factors being the fact that Fort Collins faces heterogeneous price structures in
the 20 year period examined. Data for policy implementation of increasing block/seasonal rate
structures were obtained from “Conservation Programs Summary”.7

Real Income per Capita (INC)

Since we are examining household level water consumption, the corresponding variable of
choice to examine income elasticity of demand would be income per household. However, due to

6
See Appendix 1 for rate structures
7
See Appendix 2 for implementation of water conservation programs

14
limited data availability, we use annual income per capita of Fort Collins-Loveland as a proxy for income
per household. There were no quarterly or monthly income per capita data available at the city, county
or state level. We then deflate Income per Capita with the consumer price index in order to obtain Real
Income per Capita. Real Income per Capita is expected to display a positive coefficient. Data for income
per capita and consumer price index were obtained from Federal Reserve Economic Database (FRED) via
the Federal Reserve Bank of St. Louis online database (Annual data were s used)

Total Monthly Precipitation, Seasonally Adjusted (RAIN)

Monthly precipitation plays an important role in water consumption. This can be attributed to
the fact that outdoor water use is a large subset of total water consumption. Some examples of outdoor
water use are watering activities for the lawn and garden, and carwash activities. The variable is
included here under the assumption that significant amount of rainfall will result in decreased outdoor
water use. Since outdoor water use does not occur much or at all during winter months, we interact
this variable with a non-winter seasonal dummy8; upon interaction, precipitation in the months of
December, January and February carry the value “0”, whereas the remainder months retain their
respective precipitation values. Total Monthly Precipitation is expected to display a negative coefficient.
Data for total monthly precipitation were obtained from the Colorado Climate Center;

Average Monthly Maximum Temperature (TEMP)

Previous studies have shown temperature to influence water consumption, with higher
consumption resulting from higher temperatures. The average monthly maximum temperature was
preferred as we can reasonably assume water usage to be influenced by maximum temperatures which
occur during the day, instead of average monthly temperatures which factor in cooler temperatures at
night. Average monthly maximum temperature is expected to display a positive coefficient. Data for
average monthly maximum temperature were obtained from the Colorado Climate Center;

Methodology9

8
Non-winter months are defined as months from March to November; the seasonal dummy will carry the value “1”
for these months.
9
The methodology here is largely drawn from Martinez-Espineira (2005), the only published work known to utilize
co-integration and ECM for time-series analysis of water consumption. Please refer to the above for more detailed
explanations of the different tests and econometric methods.

15
 Co-integration techniques and error correction mechanism (ECM)10 are used to investigate the
effects of the above explanatory variables on household water consumption. These will also allow us to
measure the short run and long run price elasticity of water. However, before we can conduct a co-
integrating regression, we first need to test for the order of integration of the different time-series data,
i.e. we must find out if they share the same unit root. To do this, we will conduct a series of unit root
tests to investigate order of integration of the time-series data. The following will be used to test for
unit roots: Augmented Dickey Fuller (ADF) test (Dickey and Fuller 1981), Dickey-Fuller Generalized Least
Squares (DFGLS) approach (Elliot et al 1996), and KPSS test (Kwiatskowski et all 1992).

Developed back in 1981, the ADF test is one of the earliestst and traditional tests for non-
stationarity. Maddala and Kim have advocated that the traditional ADF tests should be discarded
(Gujarati 2003). This is due to limitations of the ADF test and modifications done to the ADF test by
Perron and Ng, Elliot, Rotheberg and Stock, Fuller, and Leybourne (Maddala and Kim 1998).
Nevertheless the ADF test will still be used here as a starting point for testing unit roots. In testing for
unit roots using ADF, if the null of non-stationarity cannot be rejected, a second test is conducted to
check whether the integration order of the series. In the second test, the series is differenced once. If
the null is rejected during the second test, we say that the series is integrated of order one.

However, it is noted that in small samples, an ADF test can suffer from a lack of power to reject
the null hypothesis of non-stationarity (Eguia and Echevarria 2004). We therefore employ the DFGLS
test which is likely to be more robust than the ADF test (Baum 2001). The KPSS test is applied for two
reasons: It tests for a null hypothesis of stationarity, and in applying this with the ADF and DFGLS tests,
we can examine the consistency of the test results.

Once the time series are determined to be stationary at the same order of integration, a co-
integration regression analysis is conducted. The log-linear specification allows us to directly obtain
elasticity estimates. The co-integrating regression will carry the following expression:

logQt = β0 + β1logAPt + β2 logAP*POLICYt + β3logRAINt + β4logTEMPt + β5logINCt + ut (1)

10
Introductory explanations for these can be found in Gujarati, Chap.21 (2003).

16
 To test for stationarity of residuals (ut) of the co-integrating regression, the Augmented Engle-
Granger (AEG) test is conducted. This test is almost identical to the ADF test except that critical values
have been calculated by Engle and Granger (1987) as the critical significance values from the ADF test
are not quite appropriate.

We also subject the variables to the Levin, Lin & Chu Test, and the Breitung test, to test for unit
roots; these tests assume that the variables share a common unit root process. The temperature
variable employed in Martinez-Espineira (2005) was found to be possibly non-stationary, therefore
coefficients for the climate variables should be treated with caution; we expect temperature variable in
our unit root tests to display non-stationarity. The presence of non-stationary series (or stationary of
different order) could mean that there exists more than one cointegrating relationship in the above
regression, which will influence the stationarity of residuals.

Once the series of variables have been determined to be cointegrated (residuals demonstrated
to be stationary), we would introduce these residuals as an error correction term in the ECM, which
carries the following expression:

∆logQt = α0 + α1∆logAPt + α2∆logAP*POLICYt + α3∆RAINt + α4∆TEMPt + α5∆logINCt + α6ut-1 + εt (2)

β1 to β5 from equation (1) represent the effect of the various explanatory variables on logQ;
β1 ,β2 and β5 respectively represent the price elasticity, income elasticity for water, and the effect of price
policy on price elasticity.

4. ESTIMATION AND RESULTS

Unit Root Tests

The results of the ADF test (Appendix 3, Table 4) indicate that logQ, logAP and logAP*POLICY are
integrated of order one for single, duplex and multi-family accounts. The test statistics for logINC
indicate an order of integration higher than one, since the series is not stationary upon 1st
differentiation. The climate variables (logRAIN and logTEMP) are stationary at levels, indicating the
presence of an I(0) series.

17
 The results of the DFGLS test (Appendix 3, Table 5) present a slightly different picture with
regards to the stationarity of logQ, logAP and logAP*POLICY. In the case of single-family households,
logQ, logAP and logAP*POLICY are all I(1) series. In the case of duplex households, only logAP*POLICY is
an I(1) series. In the case of multi-family accounts, logAP and logAP*POLICY are I(1) series. The test
statistics for logINC are mostly consistent with the results from the ADF test, indicating that logINC has
an order of integration higher than one. The test statistics for logRAIN differ greatly from the ADF test,
indicating that logRAIN might have an order of integration higher than one. The test statistics for
logTEMP are different from the previous ADF test, indicating that the series has an order of integration
higher than one.

We conclude unit root testing with results from the KPSS test (Appendix 3, Table 6). It is
important to note that the null hypothesis for the KPSS test is stationarity of the series being examined.
We find that logQ, logAP and logAP*POLICY are not stationary at levels. Upon first differencing, they are
stationary of order one for all single, duplex and multi-family accounts. According to the KPSS test then,
these variables have an I(1) process. Looking at the results for logINC, we find that the series is not
stationary at levels, and still remains non-stationary upon conducting a first difference. According to the
KPSS test, logINC is an I(2) series. Turning our attention to the climate variables, we find that RAIN and
TEMP are stationary at levels.

One of the requirements for conducting a co-integrating regression is that the variables are
integrated of the same order. In our case, we would have liked to see all the variables demonstrate an
I(1) process. For the most part, logQ, logAP and logAP*POLICY from single, duplex and multi-family
accounts demonstrate an I(1) process. logINC is found to be an I(2) process based on the results of the
ADF, DFGLS, and KPSS tests. However, the same cannot be said of the climate variables. logRAIN is
found to have an I(0) process. The unit root process of logTEMP is hard to determine – the ADF and
KPSS tests indicate the presence of an I(0) process; the DFGLS test indicate perhaps an I(2) process.
Since we cannot make a definite claim about the degree of integration of the climate variables, the
coefficients generated for logTEMP and logRAIN should be interpreted with caution.

Having shown that the series used in the demand model is non-stationary, except for the
climate variables and INC, we present the results of the co-integrating regression.

18
Co-integrating Regression
Table 1: Results of Co-integrating Regression
Single Duplex Multi+
Variables Coefficient Coefficient Coefficient
logAP -0.129 -0.078 -1.135***
(0.080) (0.076) (0.165)
logAP*policy -0.256*** -0.266*** 0.261
(0.060) (0.056) (0.163)
logINC -0.731*** -0.838** N/A
(0.266) (0.264)
logRAIN -0.071*** -0.064*** -0.020**
(0.024) (0.024) (0.009)
logTEMP 2.053*** 1.453*** 0.895***
(0.176) (0.150) (0.052)
Intercept 1.455 5.134* 0.355*
(2.676) (2.726) (0.210)
2
Adjusted R 0.7984 0.6725 0.7992
DW statistic 1.4779 1.2847 1.1735
Number of observations = 238
*** denotes 1% significance level; ** 5%; *10%. Standard errors are in parentheses.
+
logINC was removed from the co-integrating regression for multi-family accounts as the inclusion of
the variable resulted in failure to reject the AEG test; coefficient diagnostics revealed that logINC had a
VIF of 22346.23

The results indicate that water is price inelastic for all single, duplex and multi-family households,
with values ranging between -0.344 to -0.874. This means that given a 10% increase in the price of water,
consumption per account will decrease by 3.44% to 8.74%. It is important to note that the coefficients
for logAP for single and duplex households are not statistically significant. However, upon conducting a
general F test, we find that the sum of the coefficients for logAP and logAP*POLICY is different than zero
for single, duplex, and multi-family households.11

Water demand is income inelastic as well, but displays a negative coefficient of -0.731 for
single household accounts and -0.838 for duplex accounts. This means that as per capita income
increases, consumption per account decreases. In other words, there is a negative income effect on the
consumption of water. This is in contrast to most research findings that indicate a positive income
effect for water consumption. 12

11
See Appendix 4 for results of General F-test
12
It is possible that the co-integrating regression may be misspecified and thus the income elasticity should be
interpreted with caution. More research needs to be conducted to resolve this issue of negative income elasticity.

19
 The interaction of AP with policy implementation produces values of -0.256 for single
households and -0.266 for duplex households. A coefficient of 0.261 was obtained for multi-family
households but this result is statistically insignificant. In regards to single and duplex households, this
implies that during the years of policy implementation (from January 2003 to December 2009), there is
an additional decrease in water consumption per account when the price of water increases. In other
words, implementation of the increasing block tariff has increased the responsiveness of change in
water consumption to change in the price of water. This finding conveys that marginal pricing is
important in promoting water conservation. For single households, there is an additional 2.56%
decrease in water consumption given a 10% increase in the price of water; for duplex households, there
is an additional 2.61% decrease in water consumption given a 10% increase in the price of water.

RAIN displays the expected negative coefficient, and TEMP displays the positive coefficient.
RAIN is very inelastic: a 10% rise in rainfall reduces water consumption by 0.71% for single households,
0.64% for duplex households, and 0.2% for multi-family households. In contrast, TEMP is an important
variable, whereby a 10% rise in temperature increases water consumption by 20.53% for single
households, 14.53% for duplex households, and 8.95% for multi-family households. However, as
previously discussed, due to the climate variables being integrated of a different order, the coefficients
should be interpreted with care.

Table 2: Results of Augmented Engle Granger Test

H0: Series are not co-integrated
Tau-statistic Prob.
Single -9.124 0.0000
Duplex -8.440 0.0000
Multi -2.677 0.7481

Table 3: Results of Group Unit Root Tests

H0: Unit root (assume common unit root process)
Levin, Lin & Chu Test Breitung t-stat test
Statistic Prob. Statistic Prob.
Single 10.215 1.0000 0.814 0.7922
Duplex 7.434 1.0000 0.793 0.7861
Multi 15.402 1.0000 -0.881 0.1893

20
 Based on the results of the AEG test, we reject the null hypothesis of the series not being co-
integrated for single and duplex accounts. In the group unit root tests, consisting of Levin, Lin & Chu
Test, and Breitung t-stat test, we fail to reject the null hypothesis of the presence of unit root (assuming
common unit root process). From these tests, we infer the series for all account types to be co-
integrated of the same order of integration. This also means that the residual term ut is stationary (in
spite of climate and income variables demonstrating a different order of integration). This allows us to
proceed with the ECM.

Error Correction Mechanism

Upon investigation of the error term from the ECM, we find that the error terms are not random
white noise. The results from the Breusch-Godfrey LM Test demonstrate that the error terms are
serially correlated at 2% for single households, 10% for duplex households and 4% multi-family
households. Our ECM is thus plagued with problems of heteroskedasticity and autocorrelation of error
terms.

Implications for policymaking

We focus our discussion on the co-integrating regression and the relevance of its coefficients to
policymakers. The findings reveal that price of water is statistically insignificant in regards to influencing
the demand for water. In 2003, implementation of the increasing block tariff and seasonal rate
structures (which are both price policies) have brought about decreased water consumption of 2.56%
for single-family accounts and 2.66% for duplex accounts when water prices are increased by 10%. This
means that, given the continued implementation of increasing block tariffs/seasonal rate structures,
utility managers can expect water consumption for single and duplex households to further decrease,
provided there is an increase in water prices. This finding is in support of the view that increasing block
tariffs encourage water conservation, as it has done so in Fort Collins.

In view of how the above results demonstrate that water remain price inelastic despite the
introduction of additional price policies (in the form of increasing block tariffs and seasonal rate
structures), policymakers should not rely merely on price policies alone to reduce water consumption.
This is demonstrated via the implementation of other conservation programs (or non-price policies) in
conjunction with the implementation of increasing block tariffs and seasonal rate structures in January
2003. The other conservation programs launched include: (1) Residential clothes washer rebates; (2)

21
Backwash recycling at water treatment facility; (3) Restrictive covenants ordinance; and (4) Soil
amendment ordinance. In 2007, Fort Collins also began implementing a program for dishwasher rebates.

It is possible that the above conservation programs had a role to play in encouraging water
conservation. However, we are not able to confirm that from the existing co-integrating regression. We
attempted to model the effect of the non-price policies listed above by introducing another dummy
variable to the existing co-integrating regression, and obtained questionable results.13 Several
explanations for the questionable results are possible. Firstly, the introduction of these non-price
policies coincided with the introduction of the increasing block tariffs and seasonal rate structures; both
were introduced in January 2003. Secondly, some non-price policies will not generate immediate impact
on water consumption, i.e. time is needed for these policies to have had an impact (e.g. washer rebates,
dishwasher rebates). To overcome these issues, monthly frequencies of the different water programs
would be required to isolate their individual impacts on reducing water consumption. The frequency of
the different water programs were recorded annually, therefore having the records in a monthly format
would enable quantification of the impact of the different water conservation programs. This would be
a recommended area for further research, pending data availability.

5. CONCLUSION

The paper confirms prior empirical findings regarding the price inelasticity of water. However,
this is not to be interpreted as an abandonment of price policies. What this conveys is that price policies
by themselves carry a small effect in managing water demand, and should be complemented with non-
price policies. We have shown that in terms of price policies, the introduction of increasing block tariffs
for single-family and duplex accounts have resulted in decreased water consumption. However, we also
offer a note of caution as to how non-price policies might have a role to play in the decreased water
consumption. The effect of non-price policies on water consumption in Fort Collins currently remains
ambiguous. Further empirical research will shed light on the effect of non-price policies and is a
recommended area for further research.

13
Please see Appendix 5 for results of modified co-integrating regression.

22
APPENDIX 3. Estimation results of ADF, DFGLS, and KPSS Unit Root Tests

Table 4: t-stat values from ADF Test (I = Intercept; T&I = Trend & Intercept)
Single Duplex Multi
Variables I T&I I T&I I T&I
logQ -1.558 -3.771** -1.501 -2.813 -0.605 -2.599
∆logQ -12.821*** -12.795*** -6.639*** -6.621*** -13.186*** -13.164***
logAP -1.238 -1.541 -1.477 -2.412 -1.069 -2.167
∆logAP -11.861*** -11.848*** -11.137*** -11.135*** -3.816*** -3.809**
logAP*POLICY -2.669* -3.899** -2.027 -2.949 -0.874 -1.780
∆logAP*POLICY -12.935*** -12.909*** -14.205*** -14.176*** -10.077*** -10.050***
I T&I
logINC -2.076 -0.844
∆logINC -2.100 -2.720
logRAIN -3.887*** -4.043***
∆logRAIN -15.235*** -15.203***
logTEMP -4.526*** -5.086***
∆logTEMP -13.530*** -13.492***
*** denotes 1% significance level; ** 5%; *10%

Table 5: t-stat values from DFGLS Test (I = Intercept; T&I = Trend & Intercept)
Single Duplex Multi
Variables I T&I I T&I I T&I
logQ -2.076** -2.163 -1.902* -1.968 -1.293 -1.344
∆logQ -5.311*** -12.186*** -1.061 -2.284 -1.387 -2.539
logAP -0.067 -1.627 -0.056 -2.584 -0.238 -1.936
∆logAP -2.830*** -4.186*** -1.159 -2.212 -2.746*** -3.241**
logAP*POLICY -2.226** -3.695*** -1.622* -2.793* -0.344 -1.495
∆logAP*POLICY -12.951*** -12.935*** -14.223*** -14.215*** -10.032*** -9.960***
I T&I
logINC -0.523 -1.499
∆logINC -1.994** -2.052
logRAIN -0.519 -1.802
∆logRAIN -13.466*** -0.532
logTEMP -0.377 -1.363
∆logTEMP -0.661 -0.335
*** denotes 1% significance level; ** 5%; *10%

23
APPENDIX 3. Estimation results of ADF, DFGLS, and KPSS Unit Root Tests (cont’d)

Table 6: t-stat values from KPSS Test (I = Intercept; T&I = Trend & Intercept)
Single Duplex Multi
Variables I T&I I T&I I T&I
logQ 0.866*** 0.627*** 1.307*** 0.059 1.857*** 0.041
∆logQ 0.066 0.021 0.088 0.060 0.053 0.034
logAP 0.639** 0.294*** 1.077*** 0.295*** 1.811*** 0.207**
∆logAP 0.014 0.014 0.053 0.055 0.031 0.030
logAP*POLICY 1.315*** 0.163** 1.272*** 0.153** 1.532*** 0.259***
∆logAP*POLICY 0.049 0.042 0.037 0.034 0.048 0.047
I T&I
logINC 1.718*** 0.426***
∆logINC 0.424* 0.128*
logRAIN 0.127 0.035
∆logRAIN 0.272 0.137*
logTEMP 0.034 0.010
∆logTEMP 0.021 0.009
*** denotes 1% significance level; ** 5%; *10%

24
APPENDIX 4. Estimation results of General F-test

H0: β1 + β2 = 0

Test statistic: F = (R2ur – R2r)/m

(1- R2ur)/(n-k)

Number of observations (n) = 238

Number of coefficients (k) = 5
Number of regressors omitted from restricted model (m) = 2

Critical Value: F0.01 (2, 236) = 4.696

Single Duplex Multi

Adjusted R2 (unrestricted) 0.7984 0.6725 0.7992
Adjusted R2 (restricted) 0.7297 0.5743 0.4806
F-ratio 39.7001 34.9332 186.4318

25
APPENDIX 5. Results of Co-Integrating Regression with added dummy variable

Single Duplex Multi

Variables Coefficient Coefficient Coefficient
logAP -0.754*** -0.949*** -1.230***
(0.063) (0.053) (0.151)
logAP*policy+ 0.650*** 0.905*** 1.365***
(0.082) (0.070) (0.269)
policy_nonprice -1.268*** -1.646*** -0.488***
(0.109) (0.095) (0.098)
logINC -0.014 -0.357*** N/A
(0.182) (0.136)
logRAIN -0.056*** -0.042*** -0.026***
(0.015) (0.012) (0.008)
logTEMP 1.431*** 0.777*** 0.829***
(0.114) (0.077) (0.048)
Intercept -2.282 4.362*** 0.651***
(1.754) (1.350) (0.196)
Adjusted R2 0.9047 0.9169 0.8320
DW statistic 1.2651 0.9798 1.2232
Number of observations = 238
*** denotes 1% significance level; ** 5%; *10%. Standard errors are in parentheses.
+
This finding implies that the introduction of increasing block tariffs and seasonal rate structures has
increased water consumption, which means a failure to promote water conservation.

26
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