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.

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The Myths of Market Prices and Efficiency

In my two previous posts I described a pair of prevalent myths regarding how economists think about the environment: “the myth of the universal market” ­– the notion that economists believe that the market solves all problems; and “the myth of simple market solutions” — the notion that economists always recommend simple market solutions for social problems. In response to those two myths, I noted that in the environmental domain, perfectly functioning markets are the exception, not the rule; and that no particular form of government intervention is appropriate for all environmental problems.

A third myth is that when non-market solutions are considered, economists use only market prices to evaluate them. No matter what policy instrument is chosen, the environmental goal must be identified. Should vehicle emissions be reduced by 10, 20, or 50 percent? Economists frequently try to identify the most efficient degree of control — that which provides the greatest net benefits. This means that both benefits and costs need to be evaluated. True enough, economists typically favor using market prices whenever possible to carry out such evaluations, because these prices reveal how people actually value scarce amenities and resources. Economists are wary of asking people how much they value something, because respondents may not provide honest assessments of their own valuations. Instead, economists prefer to “watch what they do, not what they say,” as when individuals reveal their preferences by paying more for a house in a neighborhood with cleaner air, all else equal.

But economists are not concerned only with the financial value of things. Far from it. The financial flows that make up the gross national product represent only a fraction of all economic flows. The scope of economics encompasses the allocation and use of all scarce resources. For example, the economic value of the human-health damages of environmental pollution is greater than the sum of health-care costs and lost wages (or lost productivity), as it includes what lawyers call “pain and suffering.” Economists might use a market price indirectly to measure revealed rather than stated preferences, but the goal is to measure the total value of the loss that individuals incur.

For another example, the economic value of some parcel of the Amazon rain forest is not limited to its financial value as a repository of future pharmaceutical products or as a location for ecotourism. Such “use value” may only be a small part of the properly defined economic valuation. For decades, economists have recognized the importance of “non-use value” of environmental amenities such as wilderness areas or endangered species. The public nature of these goods makes it particularly difficult to quantify the values empirically, as we cannot use market prices. Benefit-cost analysis of environmental policies, almost by definition, cannot rely exclusively on market prices.

Economists try to convert all of these disparate values into monetary terms because a common unit of measure is needed in order to add them up. How else can we combine the benefits of ten extra miles of visibility plus some amount of reduced morbidity, and then compare these total benefits with the total cost of installing scrubbers to clean stack gases at coal-fired power plants? Money, after all, is simply a medium of exchange, a convenient way to compare disparate goods and services. The dollar in a benefit-cost analysis is nothing more than a yardstick for measurement and comparison.

A fourth and final myth is that economic analyses are concerned only with efficiency rather than distribution. Many economists do give more attention to aggregate social welfare than to the distribution of the benefits and costs of policies among members of society. The reason is that an improvement in economic efficiency can be determined by a simple and unambiguous criterion C an increase in total net benefits. What constitutes an improvement in distributional equity, on the other hand, is inevitably the subject of much dispute. Nevertheless, many economists do analyze distributional issues thoroughly. Although benefit-cost analyses often emphasize the overall relation between benefits and costs, many analyses also identify important distributional consequences. Indeed, within the realm of global climate change policy, much of the economic analysis is dedicated to assessing the distributional implications of alternative policy measures.

So where does this leave us? First, economists do not believe that the market solves all problems. Indeed, many economists make a living out of analyzing Amarket failures@ such as environmental pollution in which laissez faire policy leads not to social efficiency, but to inefficiency. Second, when economists identify market problems, their tendency is to consider the feasibility of market solutions because of their potential cost-effectiveness, but market-based approaches to environmental protection are no panacea. Third, when market or non-market solutions to environmental problems are assessed, economists do not limit their analysis to financial considerations, but use monetary equivalents in benefit-cost calculations in the absence of a more convenient unit. Fourth and finally, although the efficiency criterion is by definition aggregate in nature, economic analysis can reveal much about the distribution of the benefits and the costs of environmental policies.

Having identified and sought to dispel four prevalent myths about how economists think about the natural environment, I want to acknowledge that my profession bears some responsibility for the existence of such misunderstandings about economics. Like our colleagues in the other social and natural sciences, academic economists focus their greatest energies on communicating to their peers within their own discipline. Greater effort can certainly be given by economists to improving communication across disciplinary boundaries. And that is one of my key goals in this blog in the weeks and months ahead.

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Opportunity for a Defining Moment

The inauguration of Barack Obama as the forty-fourth President of the United States is a defining moment in American history. For most Americans and countless others around the world, this is an inspiring political transition. The question we must face, however, is whether compelling inspiration will lead to effective action. As I wrote in a Boston Globe op-ed (November 12, 2008) one week after election day, environment and energy issues — particularly climate change policy — provide a microcosm of the forces that are shaping and will shape the actions of the new Administration and Congress.

About eight years ago, President-Elect George W. Bush promised to be President for all the people, not just those who had voted him into office. Bush’s ability as Texas Governor to bridge differences across the political aisle provided cause for optimism.

But hope for a centrist and sensible Presidency dissolved under the influence of White House political operative Karl Rove and Vice President Dick Cheney. The Bush Administration moved not to the center, but toward solidifying its base on the political right. Nowhere was this more apparent than in energy and environmental policy, with Vice President Cheney running energy policy, and EPA Administrator Christie Whitman virtually driven from office.

Will the environment and energy team of President Obama respond effectively to the serious challenges that lie ahead? Or will we find that the corporate lobbyists who filled so many key environmental positions in the Bush Administration have simply been replaced by strident advocates from the other end of the political spectrum? In other words, will ideology trump reason?

The first sign of trouble will be if the Administration issues an “endangerment finding” for carbon dioxide, as promised by the Obama campaign, thereby pleasing and solidifying President Obama’s political base, but also playing into the hands of those who oppose climate policy action, tying up progress with litigation, driving up costs, and accomplishing little or nothing.

Ultimately, will the Obama White House work with Congress to develop climate strategies that are scientifically sound, economically sensible, and thereby politically pragmatic? Will the new President –with impressive Democratic majorities in both houses of Congress — take on the difficult task of crafting meaningful climate legislation?

The only politically feasible approach that can make a real dent in the problem is a comprehensive, upstream cap-and-trade system to reduce carbon dioxide emissions 50 to 80 percent below 1990 levels by 2050. The declining cap will increase the cost of polluting, thereby discouraging the use of the most carbon-intensive fossil fuels and providing powerful incentives for energy conservation and technology innovation.

The system could start with a 50-50 split of auctioned and free allowances, gradually moving to 100% auction over 25 years. To establish political support in the short term, free allowances should be targeted to sectors that are most burdened by the policy. And the auction revenue — which will increase over time — can be used to compensate low-income consumers, finance research and development, reduce the federal deficit, or cut taxes.

The best option may be to make the program revenue-neutral by returning all of the auction revenue to citizens through direct cash dividends or annual tax credits. This can go a long way towards making the legislation palatable to Republicans and Democrats alike who are reticent to take any actions that even resemble a tax increase.

By making the overall emissions cap gradually become more stringent over time, costs can be greatly reduced by avoiding premature retirement of existing capital stock, reducing vulnerability to siting bottlenecks, and ensuring that long-lived capital investments incorporate appropriate advanced technology.

Still, the costs of meaningful action will be significant, with impacts on gross domestic product eventually reaching up to 1 percent per year. But the longer the world waits to begin taking serious action, the more ambitious will emission reduction targets inevitably become, as atmospheric greenhouse gases continue to accumulate.

The bottom line is that getting serious about global climate change will not be cheap and it will not be easy. Beware of claims to the contrary. In the midst of a significant economic downturn, with businesses closing and unemployment on the rise, it makes sense for the new Administration to give its greatest attention to economic recovery. There is nothing wrong with sequencing policies. But if current predictions about the consequences of another few decades of inaction are correct, this defining moment provides an important opportunity for serious and sensible action.

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