As Reservoirs Fall, Prices Should Rise

Last week, California Governor Arnold Schwarzenegger declared a state of emergency and warned of possible mandatory water rationing as the state struggled through its third consecutive year of drought. This well-intentioned response to the latest water crisis should not come as a surprise.

Whenever prolonged droughts take place — anywhere in the United States — public officials can be expected to give impassioned speeches, declare emergencies, and impose mandatory restrictions on water use. Citizens are frequently prohibited from watering lawns, and businesses are told to prepare emergency plans to cut their usage. A day after the restrictions are announced, the granting of special exemptions typically begins (as in Maryland a few years ago, when car washes were allowed to remain open even if they were not meeting conservation requirements).

The droughts eventually pass, and when they do, water users go back to business as usual, treating water as if it were not a scarce resource. Water conservation efforts become a thing of the past, until the next drought, until the next unnecessary crisis. Isn’t there a better way?

The answer is yes — if we are willing to treat water as a valuable resource and price it accordingly, so that people have incentives to use the resource wisely, especially in times of need.

In 1776, Adam Smith described in The Wealth of Nations the apparent paradox that water is absolutely vital to human existence but is sold for no more than a pittance. More than two hundred years later, I can refill an eight-ounce glass 2,500 times with water from the tap for less than the cost of a single can of soda. Under these conditions, it is hardly surprising that we have so little incentive to conserve our scarce water supplies.

Throughout the United States, water is under-priced. Efficient use of water will take place only when the price reflects the actual additional cost of making that water available. Lest one fear that higher water rates would mean that Americans would go thirsty, take note: On average, each of us uses 183 gallons of water a day for drinking, cooking, washing, flushing, cleaning, and watering, but less than 5% of that is for drinking and cooking combined. There is plenty of margin for change if people are given the right price signals.

Fifty years of economic analyses have demonstrated that water demand is responsive to price changes, both in the short term, as individuals and firms respond by making do with less, and in the long term, as they adopt more efficient devices in the home and workplace. For example, when Boulder, Colorado moved from unmetered to metered systems, water use dropped by 40% on a sustained basis.

But prices are typically set well below the social costs of the water supplies, since historical average costs are employed, rather than true additional (marginal) costs of new supplies. Although water scarcity typically develops gradually across seasons of low rainfall and low accumulations of snow pack, pronounced droughts are usually felt in the summer months of greatest demand. The economically sensible approach is to charge more at these times, but such “seasonal pricing” is practiced by less than 2% of utilities across the country.

A reasonable objection to jacking up the price of water is that it would hurt the poor. But we can take a page from the play book of electric utilities who subsidize the first kilowatt-hours of electricity use with very low “life-line rates.” Indeed, the first increment of water use can be made available free of charge. What matters is that the right incentives are provided for higher levels of usage.

Other innovative possibilities exist. For instance, we have learned that the generation of electricity can be separated from its transmission and distribution — and that generation is a competitive business. Similarly, the supply of water to municipal systems can also be made more competitive, and hence more efficient. The Western states have been the first to innovate with water markets because of their greater scarcity concerns.

An example much in the news in recent years in California involved the sale of water conserved by Imperial Valley farmers to the water authorities in Los Angeles and San Diego, following a blueprint pioneered 20 years ago by Thomas Graff, then a staff attorney with the Environmental Defense Fund and now a living legend in the environmental community. These markets can address water shortages in droughts without mandatory restrictions on use or rationing, and without the need to construct new, expensive, and environmentally damaging dams and reservoirs.

Droughts, like so many public policy dilemmas, present both challenges and opportunities. Inevitably, citizens and businesses do their best to cope with mandatory restrictions. And with equal inevitability, once droughts have passed and the restraints are lifted, they return to their previous habits of water use and abuse.

The next water “crisis” when it comes will therefore present an opportunity to refuse to return to business as usual when the drought has passed. Instead, the affected areas can introduce progressive water pricing reforms that will send the correct signals to individuals and businesses about the true value of this precious resource. In my next post, I will focus on some specifics of implementing better water pricing, drawing on work I’ve done with Professor Sheila Olmstead of Yale University.

8 thoughts on “As Reservoirs Fall, Prices Should Rise”

  1. Dr. Stavins, thanks for the cogent summary of water costs and water usage patterns. As a rural NE Texas resident, I’d like to add that enormous (and I believe unnecessary and unsustainable) rates of water usage in my region are injuring my community and communities in this region. As the Dallas-Fort Worth metropolitan area grows, the demand for water for necessities and luxuries increasingly affects communities outside the immediate “Metroplex” area.

    Not far from where I live is an artificial lake sometimes called Cooper Lake, sometimes Jim Chapman Lake. It lies about 75 miles from the Metroplex and covers tens of thousands of acres. But the water it holds is pumped to water lawns all those miles away. During the winter, 3 million gallons a day are pumped out of the lake; in peak times (July and August) five million gallons are pumped out. That land was once farmland and wilderness. Now it is a water farm for cities whose wasteful water usage is an embarrassment. In the last drought, the lake almost went dry, and yet at its construction it was promoted as an economic engine for the impoverished area that borders it.

    Of course it never was anything of the sort. All the shore line is publicly held land. There can never be any private development on the lakefront. Anyhow, who wants a lakefront lot that’s 600 yards of mudflats from the water half the year?

    And now there are calls for more lakes in this region to slake the suburban thirsts of lawns and pools. We are experiencing a species of colonialism in which the suburbs and cities to our west want to claim to our land to satisfy their wasteful water-usage habits.

    I look forward to your next post on this topic.

  2. Good post Rob!

    I have been thinking about this issue and I expect that many people have already thought about it and finally have taken position. I am not yet, I am still thinking.

    I have had a natural luck to be born and live for long time in Ethiopia, which is also called the “water towers of east Africa” and as recently as the last summer where water is sold at a constant price per unit by a oligarchic government monopoly. I also have chance to live in Norway where water is freely provided to the public by a democratic government.

    I came to note that despite the price tag, it was almost impossible to get water during most days and since the water is supplied by the monopoly, private firms are explicitly or implicitly excluded from supplying. On the other hand, we get clean water for 24 hours without a slight interruption here in Norway. Again there is no private investment in supplying water.

    In both countries, endowments are nearly the same and both countries are mountainous. While Ethiopia charges price Norway doesn’t charge. But there is a better water delivery in Norway relative to Ethiopia despite the market price. This is the puzzle.

    Are we alluding the better resource allocations by institutions–say well functioning democracy vs oligarchy– to markets? Does population size has something for success and failure of economic instruments? If price tag fails to offer a better delivery, at least in this case, what do we expect from grand reforms in line of price tags?

    The other problem, I believe, with using economic instruments to change the consumption of the basic necessities is that they are price inelastic. Prices will usually become source of government revenue without changing the resource allocation too much at least from the experience of these two countries.

  3. Torben, thanks for your comment. The social and political context certainly affects the identity of the “optimal” policy instrument in any sphere, including the environment. My arguments regarding better pricing of water supplies were made in the context of the United States.

  4. I thought that the idea in the bible, so to speak, , has been still believed to be appropriate by many economists. But your response to my puzzle seems to contradict the conventional belief, or wisdom if you want to phrase it that way. One can have alternative belief than the one proposed by Stigler-Becker as it, again so to speak, is a belief.

    But we need to be explicit on the primitives, I think. What sort of model do you have in mind when you suggest optimal instrument is a local property? One kind of explanation that easily pops up is political feasibility but again it is a contradiction to the conventional believe once established even before I came to this world. Can you be explicit of the model you have in mind?

  5. While Prof Stavins is spot on in claiming that “efficient use of water will take place only when the price reflects the actual additional cost of making that water available”, it is far too simple to assume that price mechanims can allocate water most efficiently and fairly.

    Especially in view of the Chilean (NYT has this excellent article about Chile and other experiences from across the world, any market based allocatory mechanism has to be under-pinned by and effective and enabling regulatory framework that will police the expected market failures. For a start, given the essential nature of water use and competing claims with industries and other uses, market based allocation should have clear and unambiguous first charge on water resources for domestic use. Among domestic users, it is possible for price signals, “life-line prices”, and increasing block tariff (IBT) based approaches, to allocate water in a fair and efficient manner. Further, at the upstream, it is important that water extraction be subjected to all the required environmental safeguards so as to ensure that the negative pollution related externalities of industrial water extraction and use are left to be incurred by the society.

    Of equal importance are issues related to riparian, especially lower, rights which are vital to ensuring that local communities are not denied their traditional right of water usage for their domestic and livelihood (agriculture and animal husbandry) purposes. It is easy to get carried away by the logic of property rights and price signals and construct market mechanisms that effectively overlooks these traditional claims and excludes (or prices out) all such categories. Needless to say, all such arrangements are unsustainable and recipes for disaster.

    Further, the effectiveness of market-based systems, especially to manage the upstream supply-side of water, by using property rights and trading meachnisms may be of questionable value. Such arrangements presupposes the presence of a competitive market, with enough depth and breadth in traders and quantity supplied/traded. However, from countless experinces across the world, it has been found that three issues come in the way of such arrangements – consumption demand varies across seasons; supply is subject to vagaries of the weather; and supply generally declines with each passing year as the scarce available resource invariably gets allocated among an increasing number of users, each of whose demand in turn keeps growing.

    It is for the same reason that un-bundling of water supply systems, similar to the example of electricity sector, and as suggested by Prof Stavins, may be counter-productive. As the experience of California with electricity suggests, the un-bundling of water systems and embracing of market based mechanisms, are no guarantee to ensuring that supply of water to bulk users like municipal suppliers can be made competitive.

    I have blogged on this here

  6. If there were more binding laws established for consumers-water use rights and responsibilities on a large planned effort for a scheduled period of time. I believe each American can learn to sustain the sensitive measures required to provide homes and businesses with clean water programs and practices? Without clean water, the environment and it’s people won’t survive in all vital areas-food, shelter, health, and universal functions-life and vitality.

  7. While Prof Stavins is spot on in claiming that “efficient use of water will take place only when the price reflects the actual additional cost of making that water available”, it is far too simple to assume that price mechanims can allocate water most efficiently and fairly.

    Especially in view of the Chilean (NYT has this excellent article about Chile

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