Targeted subsidies reduce prices for only a subgroup of customers. In practice, targeted and untargeted subsidies are often combined: there may be an across-the-board price subsidy for all customers, but some customers are targeted to receive greater discounts than others.

A recent survey by Global Water Intelligence, covering water utilities in 132 major cities worldwide, revealed that underpricing of water services is widespread (GWI 2004). The survey compared estimates of the average tariff that would be needed to achieve varying degrees of cost recovery to average tariffs actually charged for a large number of utilities. The conclusion was that all surveyed water utilities in South Asia and Eastern Europe and Central Asia, and more than half in East Asia, the Middle East, and North Africa, charged average tariffs below what would normally be required to even cover ongoing operation and maintenance costs. A similar study of electricity tariffs (Foster and Yepes 2005) found that the average tariffs in nearly a third of electricity utilities in Eastern Europe, Central Asia, East Asia, South Asia, and Sub-Saharan Africa were likewise probably too low to fully cover probable O&M costs. Cost recovery was higher among both water and electricity utilities in Latin America, with half of the water and electricity utilities appearing to charge enough to recover all O&M and a portion of capital costs from consumers. The two studies together suggest that any targeted water and electricity subsidies that may exist are combined with untargeted general price subsidies in virtually all water utilities and many electricity utilities in the developing world.

The targeting of subsidies can occur in two ways. The first is through implicit subsidy structures – elements of utility pricing or practice that have distributional consequences, but that do not represent an explicit conscious attempt to reduce the cost of service or of connection for particular customers. Common implicit subsidies include the practice of charging a flat fee for service rather than using volumetric charges. Flat fees do not distinguish between consumption levels and thus subsidize large-volume customers. Illegal connections and inaction in the face of non-payment of bills are two other forms of implicit subsidies, which benefit those with illicit connections and those who do not pay their bills respectively.

The second form of targeted subsidy, which we focus on in this article, is targeting through an explicit subsidy mechanism. The most common type of explicit targeted subsidy in water and electricity utilities is the quantity-based consumption subsidy. Increasing block tariffs (IBT) – stepped tariffs that charge an increasingly higher price per unit to all consumers as their consumption increases into subsequent blocks – are a common example. Some (primarily electricity) utilities apply another form of quantity-based subsidy, termed here a volume-differentiated tariff (VDT). VDTs are composed of two or more different tariffs (e.g. the first highly subsidized and the second less or not at all) to which consumers are assigned based on their total volume of consumption. Our recent survey of water and electricity tariff structures in Latin America, 4