Recent policy discussions on public utility pricing have increasingly focused on the provision of free or fully subsidized utility services for low-consumption households as a mechanism to improve affordability, support vulnerable groups, and promote sustainable resource use. Such policies, particularly in electricity, gas, and water services, can be analyzed within the framework of a three-part tariff (3PT), consisting of a fixed fee, an initial free-consumption block, and a positive marginal price above a specified consumption threshold. Although these tariff structures are often justified on social and environmental grounds, their implications for efficiency, equity, cost recovery, and sustainability remain insufficiently examined.

Introduction

This study investigates the analytical properties, policy implications, and limitations of 3PT in pursuing multiple objectives in public utility pricing. The paper argues that relatively simple and transparent tariff structures, such as uniform pricing or tariffs with fewer consumption blocks, may offer important advantages over more complex pricing schemes in terms of implementation, consumer understanding, and policy effectiveness. Nevertheless, the performance of the 3PT in achieving objectives beyond efficiency depends critically on the calibration of key design parameters, including the fixed fee, the size of the free-consumption threshold, and the marginal price.
The study first develops a theoretical framework to examine the efficiency properties of 3PT. The analysis demonstrates that, under a purely efficiency-oriented objective, the optimal free-consumption threshold converges to zero. In other words, the existence of a free initial consumption block cannot be justified solely on efficiency grounds. The introduction of free consumption therefore requires additional policy objectives, such as redistribution, affordability, minimum access guarantees, demand management, or political feasibility.

Methods and Material

To evaluate the broader performance of 3PT, the paper employs a simulation model based on the framework developed by Céline Nauges and Dale Whittington (2017). The simulations include 5,000 households whose utility consumption follows a log-normal distribution correlated with household income. Two alternative correlation scenarios between income and consumption (0.1 and 0.8) are examined, together with multiple combinations of tariff parameters. To distinguish the contribution of this study, it should be noted that while Nauges and Whittington (2017) provide the simulation framework, they do not evaluate the performance of 3PTs. this paper extends Nauges and Whittington's analysis by incorporating a theoretical examination of 3PTs, thereby providing an analytical foundation for examining the conditions under which such tariff structures may be justified and their implications for efficiency and redistribution.
Tariff performance is evaluated along two principal dimensions: (1) equity, measured by the share of subsidies allocated to lower-income households, and (2) economic efficiency, measured by welfare losses relative to a benchmark uniform tariff. The performance of 3PTs is also compared with conventional increasing block tariff (IBT) structures commonly used in utility pricing.

Findings

The findings indicate that 3PT can substantially improve the distributional targeting of subsidies toward lower-income households. In several simulation scenarios, approximately 42 percent of total subsidies accrue to the lowest income quintile, whereas the corresponding share under IBT structures remains below 15 percent. The redistributive effect becomes stronger as the free-consumption threshold increases and the fixed fee remains moderate. Under these conditions, higher-consumption households effectively finance part of the minimum consumption needs of lower-income groups.
However, these distributional gains are accompanied by significant efficiency losses. Expanding the size of the free-consumption block increases welfare losses by distorting marginal consumption incentives and reducing allocative efficiency. The simulations further demonstrate that the trade-off between equity and efficiency is highly sensitive to tariff design. Relatively small adjustments in the fixed fee or threshold level can substantially alter both the distribution of subsidies and overall welfare outcomes.

Conclusion

The study concludes that 3PTs may serve as a flexible policy instrument for balancing equity, affordability, efficiency, and sustainable consumption in public utility sectors, particularly in contexts where alternative instruments for achieving redistributive objectives are limited or unavailable. Nevertheless, the performance of 3PT requires gradual adjustment and careful monitoring of policy outcomes following changes in tariff parameters. Overall, the findings suggest that free-consumption thresholds are justifiable only when policymakers explicitly prioritize broader social and distributional objectives alongside economic efficiency and do not have access to lower-cost policy alternatives. Even in such cases, careful tariff design remains essential, as neglecting the trade-off between equity and efficiency may result in substantial welfare losses and compromise the achievement of policy objectives.