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Why the economics of water is so hard


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The Future Dams Research Consortium (originally known as DAMS 2.0) hosted a public lecture by Prof Michael Hanemann of Arizona State University on the economics of water.

The lecture discussed ‘why the economics of water is so hard’ providing a historical and contemporary US overview of the issues that make water challenging to price.

Published in: News & Politics
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Why the economics of water is so hard

  1. 1. Why the economics of water is so hard. Michael Hanemann Arizona State University
  2. 2. Water: an exceptionally difficult commodity • Compared to other things (e.g., land), water is exceptionally difficult (i) to conceptualize and (ii) to manage/allocate. • This is because it has some distinctive physical and economic features that make it different. • It moves around – it flows. • The same molecule of water can be used sequentially by different people. • The same molecule can be used simultaneously for multiple purposes by multiple people. • It functions as both a private good and a public good. • Its quantity is variable . • Its use – especially agriculture – is intermittent. • It is essential for life and, often, for economic production. • These features make water difficult in rich countries, not just poor ones. 2
  3. 3. Water is heterogeneous – not a standardized commodity The value of a unit of water depends on its • Location • Timing • Quantity • Quality • Ex-ante predictability/certainty • Its property right (who else has a claim or an interest in how it is used) • It is meaningless, therefore, to talk of “the” price of water. 3
  4. 4. Water is an entangled commodity • The entanglement occurs because of externalities associated with the use of water. • E.g., return flow; downstream pollution; aquatic habitat; multiple-use reservoirs. • It occurs because of the nature of the legal property right to water. • “Unlike almost every other form of property, water has always been vied as something in which the community has a stake and which no one can fully own.” (Sax, 2008) • It occurs because the supply of water (especially surface water) involves shared infrastructure with joint costs that are collectively financed. 4
  5. 5. Compare water with land • Two owners cannot simultaneously use the same piece of land – they cannot each locate a building on the same piece of land. • A plot of land is a discrete resource with given boundaries. • For this reason, a property right associated with land – the right of first possession – works poorly for water (see below). 5
  6. 6. Compare water with electricity • Water is easy to store but hard to transport. • It is bulky. • It requires conveyance infrastructure that is costly, highly capital intensive and location-specific. • Electricity is relatively easy to transport but hard to store. • Electrons move along a common-carrier network connecting many potential suppliers with many potential users. Water moves along a private conveyance typically connecting a single supplier to a specific set of users. • Electrons can be obtained from the grid in 15-minute increments; water transfers require significant pre-arrangement. • Compared to electricity, water supply is highly fragmented. 6
  7. 7. A water transfer as a diplomatic negotiation • The extent of the entanglements varies depending on the particular circumstances. But, some degree of entanglement is always present. • Including some degree of externality • Without suitable connectivity, a transfer cannot be effectuated. • It is a mistake, therefore, to think of a transfer as a contract with just two parties. It is more like a diplomatic negotiation with multiple parties, each with important and legitimate interests that have to be satisfied. 7
  8. 8. Water as a source of contention • The fact that multiple uses, and multiple users, can benefit from the same stream is an abundant source of conflict. • Also, over time, new uses of water emerge. Often, the population that would like to exploit a water resource grows over time. • Conflict over water, and property rights to water, is endemic in human society. • Conflict is more endemic with water than with land. • Much of the disagreement over water is disagreement over what the property rights are, or what they should be. • Resolving these property rights dispute is often politically fraught. 8
  9. 9. The following is an excerpt from an op-ed in the Wall Street Journal by distinguished Stanford Labor economist Ed Lazear 9
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  11. 11. • The farmers who use water in California do not actually own that water. • As specified in the California Constitution, all water is owned by the people of California. • The farmers have a right to use the water, subject to certain conditions, which can be modified retroactively. • Including modification to meet public trust needs. • In many cases, the right to abstract water is owned by the water district that supplies the farmers, not by the farmers themselves. • The general welfare requires that the water resources of the State be put to beneficial use to the fullest extent of which they are capable. • Multiple uses are favored; reserving water for a single-purpose use is disfavored. • The California water rights agency is expressly directed to determine whether proposed water transfers will have unreasonable effects on fish, wildlife, or other instream beneficial uses. 11
  12. 12. The variability of water • Water is variable in location and timing. It is not always available where it is needed, and when it is needed. • In California about 2/3 of the precipitation occurs north of Sacramento, while 2/3 of all the water use occurs south of Sacramento. • In California, 80% of the precipitation statewide occurs October-March, while 75% of all water use occurs April-September. • Average annual runoff in California is 71 million acre feet (MAF). • Annual runoff has ranged from 15 MAF (1977) to 135 MAF (1983). • The variability of supply generates a natural incentive to want to exchange water. • But, it also complicates the concept of a property right. • What is the property right to a variable resource? • Is there an obligation to share in a time of scarcity? 12
  13. 13. 13 Water is not like land as a form of property • “Unlike real property rights, usufructuary water rights are limited and uncertain. The available supply of water is largely determined by natural forces.” (Robie) • “Water rights are a unique form of property, because the property right in water is limited (or rendered less certain) by a variety of factors, both physical and legal, that seldom affect real property and other property rights: • The common nature of the resource which is shared not only by water rights holders but also by fish and wildlife and other environmental uses. • Hydrologic variability and consequent uncertainties re availability • Ambiguities in quantification and priority • Tensions between privatization of the resource through the water rights system and declarations of state ownership of all water resources
  14. 14. The property right to water: key distinctions • Distinguish the property right to divert water from the contractual right to receive water from a water supply organization. • About 20% of the water used in California is obtained through supply contracts with the two large water projects in California, the federal Central Valley project and the State Water Project. • Contractual rights are governed by commercial law. • Distinguish surface water from groundwater, since they are subject to different legal regimes. • The right to abstract water is a usufructuary right. It is a right to use water from a water source. It does not convey ownership of the water resource. • The water in California is owned by the state of California in the interest of the people of California. 14
  15. 15. Two types of surface water right: riparian, appropriative Riparian right • Adopted by all eastern states, taken from English common law. Also adopted by California. • Riparian rights entitle the owner of land bordering a surface water body (“riparian” land) to use the water flowing past his property. • Riparian right applies only to the water that would naturally flow in the stream. • It does not allow the water to be put to use on any non-riparian land. • Riparian rights remain with the riparian land regardless of changes in ownership. • Nonuse does not terminate the right. • It thus combines ownership of (riparian) land with access to water. • No specific quantity attaches to a riparian right. If a riparian originally applied X, this does not preclude him from applying 5X later. • There is no recording of the volume diverted. • No institution administers the riparian right. • Riparian right requires the issuance of no permit or license. • The right is shared equally among all riparians: they own access to the stream as “tenants in common.” • They can divert water as long as this does not impair the rights of other riparians. • Disputes are resolved through litigation among the riparians – including at a time of drought. 15
  16. 16. • The riparian doctrine was logical where it originated, in a humid region with plentiful streamflow. • It is ill-suited to an arid region like California, where rivers can run dry by the late summer and annual streamflow can vary by an order of magnitude. • There needs to be a specific mechanism for allocating limited streamflow. The riparian right lacks this. • It was ill-suited to hydraulic mining in the gold country of California. • The land was not owned by water users – it was owned by the federal government. • In many cases, they were using the water to mine at some distance from the stream (i.e., not on riparian land). • Starting around 1851, a new type of water right emerged in California known as an appropriative water right, adapted from the rules developed by miners for the right to a mining claim. 16
  17. 17. Appropriative water right (the right of first possession) • The right to divert water is based on the time and quantity of the initial diversion creating that right. • As with a mining claim, one obtained the right by posting a sign at the point of diversion stating the details (date, volume, identity of diverter). • This would be nailed to a stick in the ground, or a nearby tree. • The locations of water diversion and application can be different. The link between ownership of land and ownership of water is severed. • If there is too little streamflow, the senior appropriators divert their full quantity until the stream is exhausted, while the remaining (junior) appropriators receive nothing. • To perfect the right, the water user has to initiate the diversion with diligence and the water must be applied to beneficial use. • Disagreements are resolved through litigation 17
  18. 18. • The point to note: riparian rights and appropriative rights are, in principle, not self-enforcing. • In the riparian system, and originally in the appropriative system, there are no water police. • What, then, is the enforcement mechanism? • Answer: At least in the beginning, private litigation offers the only mechanism for resolving disputes among property owners, as with other types of property (e.g., land). • When it became time to act, there was a strong tendency in many Western states to favor the courts rather than an administrative agency as the forum for dispute resolution. 18
  19. 19. While the appropriative water right was modeled after the right to a mining claim, there were some crucial differences which made the appropriative right problematic for water. 1. Different spatial interaction among rival claimants. • Rival miners would be seeking to explore the same piece of land. You would know it if someone else had posted a claim there. • Rival water users diverting water from the same river could be 100 miles apart and they would not see the claim posted by other users. 2. Different use of the resource • Miners primarily interested in determining whether the claim was valuable. Most claims weren’t, and the miner would move on. The focus was not so much on regular production, as with irrigation. 3. No mechanism for enforcing rights and resolving conflicts • The miners relied on local mining camps as a forum to resolve differences. There was no analog for water claims. Instead, disputes resolved by litigation. 19
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  21. 21. The challenge of modifying/re-allocating property rights. • Over time, new uses of water emerge – in California, the sequence of uses was: hydraulic mining, then agriculture, then urban use, then hydropower, then instream uses (ecosystem services). • Also, often, the population that would like to exploit a water resource grows over time. • Thus, new uses and new users emerge over time. • The challenge is how to accommodate the new uses and the new users who would like to take advantage of the water resource. • Demsetz has a nice theory that property rights emerge when it is economically efficient for them to emerge – when the benefits of establishing a system of property rights outweighs the costs. • But, do property rights become modified/reallocated when that is economically efficient? 21
  22. 22. • The notion of modifying or re-allocating property rights may itself be controversial. • One view is that a property right should be forever, and immune to modification. • In this view, the only way to modify or re-allocate a property right should be by purchasing the right or compensating the owner of the right to obtain his consent. • In this view, there can be no involuntary modification of a property right. • The other view is that, in certain circumstances, the involuntary modification or re-allocation of a property right may be socially desirable and legally appropriate. • Property rights should change as circumstances change. • This is related to the legal concept of equitable apportionment. • These conflicting views can apply to any property right. But the conflict arises with special force for the property right to water. 22
  23. 23. Problematic Cost Structure • Compared not only to manufacturing but also other public utilities, surface water supply is exceptionally capital-intensive. • In the US, operating costs are only about 10% of total costs for water supply, 32% for natural gas, and 57% for electricity. • Volumetric pricing of water came about after WWII. Electricity was priced volumetrically from the beginning. • Marginal cost pricing won’t raise enough revenue to cover costs. • There are significant economies of scale. • The capital assets cannot be used for another purpose or moved elsewhere. • The physical capital in surface water supply is exceptionally long- lived. 23
  24. 24. • Almost no scope for modularity in surface water development. Essentially the entire system – storage, diversion, transmission, treatment, & local distribution – has to be in place before a single drop can be delivered to users. • Unlike groundwater, which can be developed one well at a time. • But capital has to be raised up front before construction can start. Interest has to be paid before a single cent of revenue comes in. 24
  25. 25. Cost structure complicates financing • The capital intensity and longevity of physical capital create problems of cost allocation and make financing hard. • Financing is the Achilles heal of water supply • If the costs were mainly operating cost it would be very simple to rely on “the user pay principle” and pay-as-you-go financing. • As it is, the capital intensity and capital longevity mean make it very hard to have “user pay.” • One ends up relying heavily on transfers: • between one group of users and on other • between one generation and another • between non-users (the developed countries) and users. 25
  26. 26. Water supply is highly fragmented • Wherever humans have settled, they developed a (local) water supply. • Today, in most countries, water supply is one or two orders of magnitude more fragmented than that of electricity. • Because of the physical features of water conveyance systems (aqueducts, city pipe systems etc.), consolidating and integrating water supply systems is very difficult. • They remain largely unintegrated. • In the US, the management of water supply systems is largely uncoordinated. • Sewer systems, while larger in scale than water systems, are typically managed separately from water systems. 26
  27. 27. Water as a human right • There are well established notions not just that water is a human right but also that there is a moral obligation to share water in times of scarcity. • In effect, there is a universal service obligation for water. • This has implications for economists’ focus on efficiency versus equity. • It also has implications for the pricing of water. • The notion that one should price to allocate water during a shortage is widely seen as morally repugnant. • There is tremendous opposition to raising the price of water, even in rich societies. • Political pressure keeps water prices low – and below cost – in most public water systems in the US. 27
  28. 28. The price of water • Water is often under-priced. The price of water typically reflects – at best -- the cost of the infrastructure associated with its supply, but not the scarcity value of water. • It often reflects the operating cost but not the capital cost. • It would be desirable, therefore, if the use of water also reflected its scarcity value. • How to bring this about? • In my experience, it is not easy to raise the price of water. This requires skill, and finesse. 28
  29. 29. The difficulty of sending a price signal • Economists freely assert the importance of setting the right price to signal scarcity. • For water in practice, this is easier said than done. • Sam Goldwyn said: “If I wanted to send a message, I would send a telegram” • People strongly resent your manipulating the price they for water just to send them a signal. • In practice, you need to justify a price increase in terms of expenditures that need to be financed. • In California, I have argued for an assessment of the state’s water infrastructure and financing needs as a precursor to improving the pricing. 29
  30. 30. The invisibility of water • For residential users of both water and electricity, there is no easy way to know how much they are using at the time of use. • Consequently, it is hard to see how they can respond to a price signal. • Moreover, water infrastructure – the pipes in the street – are out of sight, and out of mind. • When pipe systems were first introduced in the 19th century, they raised property values. • This made is easy to finance water infrastructure in cities. • But as pipe systems age and fail now, this has no impact on property values. 30
  31. 31. Equity and bargaining vs efficiency and optimization • Because of the strong ethical and emotional issues raised by water, it is stupid – and counterproductive – to conduct an economic analysis of water that focuses on aggregate efficiency and ignores distributional concerns. • Conventional efficiency analysis in economics acts as though it wishes to inform an omnipotent social planner. • No such being exists. • Water projects and policies are inherently political and they come about through a political process. • Bargaining, not aggregate optimization is the correct lens through which to conduct an analysis of water. 31
  32. 32. 32 The Paradox of Water • Precisely because water is essential for life, everybody does have some sort of existing access to some water. • The same is not true of electricity, for example. • The result can be that a relatively low value is placed on improved water supply -- the incremental benefit of improved access, not the benefit of access versus no access. • There often appears to be a higher willingness to pay for electricity than for improved water supply.
  33. 33. The challenge • The challenge is to balance the competing interests in water, with finite supply, growing needs, and not unlimited financial resources. • Social justice, ecosystem protection and climate change make this a vital need. • If people are going to pay for an improvement in their water supply, they have to perceive some benefit in that improvement which renders paying for it worth their while. • This is the challenge for successful policy reform. 33