Palo Alto may soon reduce its street-sweeping services, raise garbage rates and begin charging for recycling as part of its effort to stabilize its volatile and financially troubled refuse operation.

The City Council Finance Committee took its first look Tuesday night at the staff's ambitious plan to revamp the rate structures in its Refuse Fund. Among the city's most critical decisions is whether to maintain its current policy of "conservation pricing" -- giving residents a financial incentive to reduce waste.

The policy, which includes free recycling and composting services for residents, has been wildly successful on the environmental front, with more residents switching to smaller cans and seeing their bills shrink. But it has also been financially devastating for the city, which has seen its revenues drop. Palo Alto's refuse operation faced a $6 million deficit last year and had to raise rates, scale back its Zero Waste program and resume accepting commercial waste at the city-owned landfill.

"As we become more and more successful at eliminating waste, our revenue goes down," said Phil Bobel, the city's interim assistant director for Public Works.

"We need a different structure because of the phenomena that we're charging for the thing we're trying to eliminate namely, waste," he later added.

The main objective of the rate-structure overhaul is to bring the city in compliance with Proposition 218, which requires cities to set rates that match the services provided. A new Public Works analysis shows that the city's expenditures on residential customers exceed its revenues by 79 percent. Commercial customers, by contrast, pay more than their fair share. The city's revenues from commercial customers exceed its expenditures on these customers by 42 percent.

"Our top priority is to try to address this parity between classes," Bobel said.

Senior Assistant City Attorney Cara Silver said the numbers represent a "snapshot in time" and that the model is still being refined. But early indication, she said, is that commercial ratepayers are overpaying.

Committee Chair Greg Scharff said the numbers make it clear that in order to comply with Proposition 218, the city would have to increase its residential rates.

"We can't increase commercial rates because we can't be moving in that direction -– that would make the disparity worse," Scharff said. "The only thing we can do is increase residential rates."

Brad Eggleton, the city's solid waste manager, said the city is still refining its forecasting model. The new model is expected to be in place in 2012. Eggleton said staff expects to achieve parity between the different customer types somewhere in the five-to-10 year timeframe.

"The conclusion we get is that the structural changes would have to be implemented not at once but over a number of years," Eggleton said.

Proposition 218 isn't the only reason for the proposed overhaul of trash rates. The city is also looking to bring financial stability to the Refuse Fund with the hopes of ultimately achieving a $3 million operating reserve in the fund.

While considering rate changes, staff is also looking at possible expense reduction in the Refuse Fund. These include reductions in street-sweeping services, scaling down of the Zero Waste program and deferral of capital projects at the landfill site, Eggleton said.

Conservation pricing is just one of several factors behind the Refuse Fund's financial woes. The city is still operating its own landfill in Byxbee Park while also shelling out for long-term "legacy contracts" with SMaRT Station in Sunnyvale and Kirby Canyon. The city's landfill is expected to reach capacity in July, Interim Public Works Director Michael Sartor told the committee Tuesday.

While the landfill costs will soon drop, the city's refuse operation is still projected to have years of deficits. Last year, the council raised rates for residential and commercial customers by 6 percent and 9 percent, respectively. Though these rates are scheduled to expire in the fall, staff said further rate increases would be necessary to balance the books.

Even if the city were to raise rates for all customers by 8 percent next year, it would still face a deficit of roughly $500,000 in fiscal year 2012. By 2014, however, the city would reach its goal of a $3 million operating reserve.