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“Water, water, get yourself in the clear, cool, water”

May 24, 2015

Our soggy last weekend in Columbus reminded me of California and its severe drought. Naturally, being an economist and policy analyst at heart, I believe the solution to the crisis is a surprisingly simple market-based one. However, California being among the most heavily regulated (and taxed) states and having generally anti-market politics and sentiments will avoid solutions that involve markets and worse still “evil profit seeking traders”. After all, Hollywood’s idea of traders was portrayed in the ” Wolf of Wall Street” which does not exactly portray the protagonists in a flattering light.

However, if I were California’s water czar and could design a new water usage system from scratch, I would heavily employ the markets and market pricing using trade-able market water rights.  I would set this up in several steps:

  1. I would determine a minimum level of consumption that would be “free” which would only be for drinking water, bathing, cooking and toilets. (i.e. minimum residential and commercial use). Notably, this would probably only amount to be 10% or less of California’s current consumption of water for economic purposes (e.g. used by residences, business, industrial or agriculture) since agriculture alone uses about 80% of California’s currently available water supplies.
  2. The exact details as to how much and how to distribute these “free” water rights does not particularly matter for the efficient functioning of the water market. My own preference would be for a system where residences and businesses would get a certain amount of “free” water that would correspond to basic drinking water, cooking , bathing and toilet needs assuming a very efficient use of water. ( “free” water means that they would only pay a low nominal rate per cf of water consumed covering the regulated annual operating costs of the water utility serving them. Very similar to what California charges now for ALL water use.)
  3. These free water rights would be allocated directly to the water utility serving these customers and the water utility and per above would charge a regulated rate commensurate with the costs of operating the water system.
  4. Next, an additional amount of water rights would be sold in the market (perhaps initially thru a periodic auction) which would correspond to the amount of available additional supply in a ‘normal’ rainfall year. ( with ” normal” being defined as the LOWER of a long run average rainfall or the previous year’s rainfall.) Additional water rights also could be sold from additional supplies to the extent new aquifers, new supplies from desalination or recycled water become available.
  5. However, agriculture, industrial or other business uses would NOT get “free” water rights. Nor would residential/ commercial usage ABOVE the minimum “free” usage. As noted, this would amount to about 90 percent or more of California’s usage. They instead would pay the market price for additional water usage or the price of the additional water rights.
  6. Finally and most importantly, ALL these water rights could be bought and sold in the market.

This last point is the most important. As farmers begin to have to pay fairly high prices for water, they might, for example, stop growing the very thirsty, alfalfa crop in California and substitute lower water-using crops. They would also start using water much more efficiently in all their crops. This in turn would free up water rights to be used for other purposes.  Further, the higher prices would also induce more supply to be brought on into the market as it becomes cost-effective, including the greater use of reclaimed or recycled water,  or even desalination. Though less important overall in the market, the price of water for water utilities serving residences and businesses, will provide the utilities and the consumers with key incentives to stop wasting water or using it for non-essential needs such as watering lawns. It would also induce consumers (and the water utilities) to install water saving devices such as low flow shower heads, or low water usage toilets.

To be sure there are many other issues that California needs to wrestle with to make such a system fully workable and to end drought problems permanently in the state. First, it has to deal with the current water rights structure which has allocated water to various uses for decades typically based on land ownership. This is a hugely political issue of the haves and the have-nots. One way would be to transition to a fully market based system by starting with current water allotments (as “free”) which are then given a haircut consistent with truly available supply. (As I understand it, actual water rights in California currently exceed available supplies. Directionally, the recent announcement of an agreement with some major California agribusinesses to cut back these allotments by 25% is a good start.) Importantly,  ALL these rights would be immediately trade-able resulting in a true market price for water, and the positive impacts and incentives noted above. Then over time, the existing “free” water rights would be gradually reduced thru new state legislation.

Lastly, California needs to make more appropriate trade offs when it comes to water use and needs of the environment. There are a wide variety of estimates that suggest that a significant amount (perhaps on the order of 20-30%) of water that could be available for economic uses in California is set aside for the “environment” ranging from rivers/streams that are allowed to run out to the sea (and protect wild salmon and other wild habitats), or are not dammed up  to protect the snail darter or are used to keep existing wetlands intact. To be sure, these purposes have their own value to the environment that should not be ignored and remain protected, BUT perhaps not EVERY environmental instance should take precedence over the broader water resource needs of the state.

Overall, a market-based water system would be surprisingly simple to implement, would result in the most efficient use of water in the state and virtually end the drought problems we have seen in California in recent years. I have worked on markets for various externalities (most notably air pollution credits or allowances) for almost 35 years now and currently am chairman of the International Emissions Trading Association, so I know a quite a bit about this topic.  My experience is that tradable emission or resource rights have ended up being the lowest cost, most efficient, and most equitable way to allocate public goods (such as water) or externalities (such as limitations on air pollution). Markets do an excellent job of allocating scarce resources, driving out inefficient uses and incentivizing efficient uses. Market prices would almost certainly signal to farmers that some crops simply don’t make any sense in California given the true cost of water, and that other crops would require more efficient use of scarce water resources. They would also signal to consumers that water saving devices in the home are well worth the investment.

Of course, California could just continue on its current path of rationing of supplies along with voluntary exhortations of better water usage which typically don’t work well and of course are subject to the whims of politics. Such a system will most assuredly result in worsening of the current drought situation unless California gets a flood of rainfall this fall/winter. OR it could finally realize that markets and yes, “capitalism” can be a powerful ally in ending the drought in the most equitable and economically efficient way. Otherwise, it will be sad and more than ironic if the Beach Boys refrain in the song California , “Water, water, get yourself in the clear cool water” begins to ring empty.

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