Frederick Cannon

Ronald H. Schmidt

English

Research Papers in Economics

FABSF WEEKLY LETTER
Number 92-03, January 17, 1992
Investment Decisions in a Water Market
The West is struggling with a water problem.
Growing urban populations and mounting con-
cern about the environmental effects of water use
have focused attention on the problems inherent
in the administrative control ofwater allocation.
An earlier Letter (Schmidt, 91-11) presented argu-
ments for using more market forces in allocating
water in California. Because market prices reflect
the value that users place on the resource, indi-
viduals are better able to adjust their behavior in
the least-cost way to put the water to its best
uses. In contrast, administered allocations often
are unable to create individual incentives that are
consistent vvith social values. Economists advo-
cate giving more control over water delivery to
the private market, while keeping in mind the
government's role in defining and enforcing
property rights and environmental standards.
Although economists almost uniformly point to
the lack of a market-oriented system for water in
California as the source of bottlenecks and ineffi-
cient use patterns, policymakers are a good deal
less enthusiastic about the creation of a water
market. One major reason for their reluctance
stems from concern about how a market would
determine infrastructure investments-invest-
ments that traditionally have caused large public
debates, such as the bitter political battle over
the construction of a peripheral canal in Califor-
nia. In this Letter, we attempt to illustrate how a
private market would determine infrastructure in-
vestments by applying the analysis to a proposed
project in the Sacramento/San Joaquin Delta re-
gion of California's water system.
The setting and the issues
The Delta region lies in the center of California's
extensive water system, covering much of the
area between Sacramento, Stockton, and San
Francisco. Through the state-operated State
Water Project and the federally operated Central
Valley Project, large volumes of water from stor-
age facilities in the northern Sierra Nevada range
and from Lake Shasta pass through the Delta re-
gion to be pumped to users south and west ofthe
Delta.
Interest in newwater transfer facilities has emerged
for several reasons. One is concern about water
quality. Water entering the Delta is free of most
foreign matter, containing less than 50 parts per
million of dissolved salts. After passing through
the peat bogs and agricultural runoff that occurs
in the Delta, water quality deteriorates signifi-
cantly and dissolved salt concentrations can be
many times that of the water entering the Delta.
Recent problems have emerged in some areas,
where dissolved salts have reacted with chlorine
to form trihalomethane, a potential cancer-
causing substance in the water, and salinity lev-
els have begun to reduce agricultural yields.
In addition, pumping stations in the south part of
the Delta can worsen water quality drastically.
During periods of low flow and high demand, the
pumps can cause "reverse flow;' in which salt
water from the San Francisco Bay is pulled into
the Delta by the force of the pumps. The pumps
also can do ecological damage, because they
can trap and kill large quantities of marine life.
Another problem with the current system is the
danger of earthquake damage. A major earth-
quake could destroy the Delta's levee system and
much of California's water supply for a consid-
erable period oftime. Because the land in the
region has subsided following the construction
of the levees, an earthquake that destroyed the
levees could cause water from the San Francisco
Bay to fill much of the Delta, forming a large salt
water lake in the middle ofthe state's fresh water
supply system.
The Delta region has been at the heart of the on-
going debates about water policy in the state. A
peripheral canal approach was (and continues to
be) supported by interests largely in the south
part of the state, and opposed by interests in the
north part of the state that fear that such a system
would make it possible for southern California to
acquire more water at the cost of destroying the
fragile Delta environment. In 1982, after a bitter
campaign, California voters defeated Proposition
9, which would have provided funding for the
construction of a peripheral canal. The canalFABSF
would have diverted water from the Sacramento
River around the Delta, ultimately delivering it
to the pumping stations south of the Delta. The
project would have called for releases from the
peripheral canal to each of the tributaries to the
Delta to maintain water quality.
The defeat did not kill the issue. In 1984, Gover-
nor Deukmejian proposed a more modest project
to achieve the same goal. It, too, was defeated in
the legislature. Nevertheless, the current five-year
drought has helped spark other plans for build-
ing such a facility. Among these is a proposal to
create storage facil ities south of the Delta to ad-
dress the problems created by reverse flow and
salinity. By creating a storage facility, water can
be shipped through the Delta at times when
flows are high (and demand is low), and water
could be drawn from the reservoirs when flows
are low ana demand is high. Regardless of the
specifics, however, any such project would re-
quire public funding and public support in the
current framework of administrative water alloca-
tion in the state.
A market approach
If water were traded in a market, the set of
choices would be enlarged. Market-determined
prices for water would provide private decision-
makers the incentives to consider investing in
new facilities. For example, if water is in greater
demand during summer months, prices will be
relatively high. If prices for water are consider-
ably lower during other times of the year-be-
cause demand is lower-it may be worthwhile
for investors to consider building facilities to
draw and store water when prices are low to
avoid higher priced water when demand is high.
Using a market to price water does not obviate
government's role in the process. To protect the
state's public interest, the state must intervene
in the market in at least two areas. First, it must
limit water shipments through the Delta to quan-
tities that protect the region's environmental
quality. In any market system, it is necessary to
establish and enforce environmental baselines.
Second, the state has the responsibility to ensure
that new facilities do not have detrimental social
costs that are not fully compensated.
To achieve those goals, the state would not allow
excessive pumping during periods of low flow,
while it would allow more activity during periods
of high flow. As a result, during periods of low
flow water would be more scarce. Achieving the
second goal requires strict adherence to the en-
vironmental impact assessment process.
in response to this set of government policies,
private investors or their agents (such as water
agencies) might have an incentive to build new
storage facilities. Since changes in the scarcity of
water would lead to seasonal price swings, the
system would generate incentives to smooth
those price fluctuations. One response would be
for large water districts south of the Delta, indi-
vidually or jointly, to build storage facilities to
minimize their cost of acquiring water. A de-
cision to build the facility could be made on
economic grounds, taking into consideration the
benefits-avoiding high costs during the peak
summer demand-and the costs of constructing
the facility-including costs of complying with
the environmental impact process. Furthermore,
if a facility made economic sense, water districts
might find it advantageous to finance such pro-
jects, rather than depending on state funding.
Other agents also would be encouraged to adjust
their water use practices. Water districts north
of the Delta might build storage facilities if they
found they could profit by selling the water when
prices were higher, thereby increasing water
availability at times when demand is high. More-
over, individual farmers that buy water might
find it cheaper to buy more water in the spring
months to put into storage (including holding
tanks or ponds) for the summer months, again
avoiding the higher cost in the summer. Finally,
farmers (and other consumers south of the Delta)
would be encouraged to find ways to conserve
on water use, particularly during periods when
costs were high, such as during the low-flow pe-
riods.
Water quality and reliability
While new storage facilities might help improve
water quality, other alternatives may also be
evaluated by the market. For example, a small
peripheral canal might prove cost-effective to
transfer higher quality water to the San Francisco
Bay customers, or to provide higher quality water
to blend with Delta water shipped to the south
part ofthe state. The cost of such a system would
be borne by the consumers ofthe higher quality
water, ifthey were willing to pay for construction.
Approaches such as these would not threaten the
environment. The state could continue to enforceConclusions
Changing to a \vater market vvould involve fun-
damental changes in the way investment deci-
sions are made. Markets do not preclude new
water projects. Rather, unlike the present system,
market discipline would require a potential pro-
ject to be justified on financial grounds. More-
over, prices that emerge in a market aid this
process significantly by providing good estimates
of the potential value of a given project.
Finally, market-based solutions possess the desir-
able characteristic of being self-funding. While
the state might build new facilities, there is no
reason why the state needs to take the lead. New
storage facilities could be constructed by individ-
uals, water districts, or combinations of such in-
vestors. Moreover, payment for the facility could
come directly from the beneficiaries of the pro-
jects, and there would be little need to burden
taxpayers with costly water projects.
Third, markets also can encourage the develop-
ment of new facilities that are consistent with
environmental quality concerns. Since the state
would be required to reserve sufficient quantities
of water to assure environmental quality stan-
dards, financial decisions to build a new facility
would be made conditional on those standards.
That is, investments would be judged on the
basis of market prices for water that take as given
the amount reserved by the state to achieve stan-
dards. Prices would reflect the relative scarcity of
the residual water supplies.
environmental quality standards throughout the
water delivery system, so potential diversions
would not exceed the levels needed to sustain
the Delta's ecosystem. Under such a system,
water prices would vary to reflect availability.
Concern about reliability in the event of an
earthquake also could be addressed more easily
in a market setting. Costs of building a periph-
era! canal could be balanced against efforts to
reinforce existing levees and Delta facilities.
With benefits reflected in prices for water, it is
possible to measure the relative benefits and
costs of alternative approaches by projecting the
impact of various disasters on the resulting mar-
ket price-calculations that are not that different
from those used by the insurance industry to
determine catastrophic insurance premiums.
Advantages of a market
Several advantages of a market are apparent in
these.approaches. First, and most importantly, a
market creates incentives to solve problems at
the lowest cost. By facing all market participants
with the private cost of using water, they can
make rational choices about use patterns. Unlike
administered approaches, a market encourages
innovation. Consumers, both agricultural and
urban, find appropriate ways to conserve.
Second, the timing problem of water delivery is
mitigated by the potential for corresponding
price movements. Since prices would reflect sea-
sonal variations in supply, both suppliers and
consumers would have incentives to find ways to
adjust their storage and use behavior to reduce
their total water costs. Large new reservoirs or
transfer facilities still may be cost-effective, but
the ultimate size needed may be considerably
smaller than would be indicated by today's use
patterns that result from pricing that ignores rela-
tive scarcity.
Ronald H. Schmidt
Senior Economist
Frederick Cannon
Vice President and
Senior Economist
Bank of America
Opinions expressed in this newsletter do not necessarily reflect the views of the managementof the Federal Reserve Bank of
San Francisco, orof the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author.•.. Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
Phone (415) 974-2246, Fax (415) 974-3341.
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Index to Recent Issues of FRBSF Weekly Letter
DATE NUMBER
6/14 91-24
7/5 91-25
7/19 91-26
7126 91-27
8/16 91-28
8/30 91-29
9/6 91-30
9/13 91-31
9120 91-32
9127 91-33
10/4 91-34
10/11 91-35
10118 91-36
10/25 91-37
1111 91-38
11 /8 91-39
11115 91-40
11/22 91-41
11/29 91-42
12113 91-43
12/20 91-44
1/3 92-01
1110 92-02
TITLE
Free Trade with Mexico?
Is the Prime Rate Too High?
Consumer Confidence and the Outlook for Consumer Spending
Real Estate Loan Problems in the West
Aerospace Downturn
Public Preferences and Inflation
Bank Branching and Portfolio Diversification
The GulfWar and the u.s. Economy
The Negative Effects of Lender Liability
M2 and the Business Cycle
International Output Comparisons
Is Banking Really Prone to Panics?
Deposit Insurance: Recapitalize or Reform?
Earnings Plummet at Western Banks
Bank Stock Risk and Return
The False Hope ofthe Narrow Bank
The Regional Concentration of Recessions
Real Wages in the 1980s
Solving the Mystery of High Credit Card Rates
The Independence of Central Banks
Taxpayer Risk in Mortgage Policy
The Problem ofWeak Credit Markets
Risk-Based Capital Standards and Bank Portfolios
AUTHOR
Moreno
Furlong
Throop
Zimmerman
Sherwood-Call
Walsh
Laderman/Schmidt!
Zimmerman
Throop
Hermalin
Furlong/judd
Glick
Pozdena
Levonian
Zimmerman
Neuberger
Pozdena
Cromwell
Trehan
Pozdena
Kim
Martin/Pozdena
Parry
Neuberger
The FRBSF Weekly Letter appears on an abbreviated schedule in june, july, August, and December.

Investment decisions in a water market

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Investment decisions in a water market

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