Dr. Jeffrey Michael and Jerry Meral discuss the economics of the Bay Delta Conservation Plan

At the State of the Estuary conference held at the end of October, economist Jeff Michael and Deputy Secretary of the California Natural Resources Agency Jerry Meral discussed the economics of the Bay Delta Conservation Plan in a panel discussion that was moderated by Executive Officer of the Delta Conservancy, Campbell Ingram.

The session began with Dr. Jeffrey Michael and Jerry Meral each giving a presentation, after which they would be able to question each other.  Following that, the panel took audience questions.

Dr. Jeffrey Michael, economist, University of the Pacific

I want to pose an initial question,” began Dr. Jeffrey Michael.  “I understand that I’m not a scientist but I definitely understand the advantages of adding a diversion point to the north Delta and reducing reverse flows and the potential for that to help with the threatened fish in the Delta.  However, in order to implement those north Delta diversions, we’re talking about a $15 billion infrastructure project, the most expensive water infrastructure project in California history that will be paid for through water sales.  And that changes the dynamic a little bit if I ask the question, is building the tunnels going to decrease or can it actually increase the conflict between water exports and threatened fish?

1320MichaelSOE_Page_02He then presented a table of annualized costs per acre-foot of water, noting that economist Rodney Smith had generated the table of costs per acre-foot to convey the water to Tracy based on the incremental yield, or how much more water could be exported with it.   “The thing that to note from the table is how dramatically different the costs are as the yield goes up and how this relationship puts a lot of pressure to increase pumping from the Delta,” said Dr. Michael.  “The debt service has to be paid.”

These costs are very high, Dr. Michael pointed out.  “The tenable costs for agriculture for a project like this are in the nature of $200 an acre-foot and you really don’t reach that under any level of water exports, so that has some implications on how costs are going to have to be distributed between water agencies,” he said.

State officials have often explained this year that if the tunnels had been in place, another 700,000 acre-feet could have been exported.  “Well, using this table suggests that if 700,000 acre-feet of water is what we can expect every year from the Delta, which isn’t necessarily true, the cost of that water would be on the order of $1300 an acre-foot before it’s been transported to wherever it’s going to be used.”

Dr. Michael said that back in 2012, he took a ‘first-cut’ at a benefit-cost analysis of the tunnels, relying on the information in the draft environmental documents for the costs.  “The goal was with the state dragging its feet on a benefit-cost analysis, I wanted to put something out there that might be motivating to them.”

The state has completed more economic analysis led by the Brattle Group and Dr. Sunding.  “Most importantly, Chapter 9 Appendix A of the BDCP released on May 2013 looked at benefits and costs from the water agency perspective, and importantly it introduced a new no-tunnel alternative that assumes that without BDCP, water exports are going to drop below 4 million acre-feet as soon as the year 2025,” said Dr. Michael.  “That’s something very different between that and the EIR assumptions and the assumptions I had used for the future.”

In the Statewide Economic Impact Report released in August, they included additional economic assessments such as greenhouse gases impacts, fishery impacts, in-Delta impacts, and some job analysis to what was in Chapter 9, said Dr. Michael.  “But the no-tunnel baseline is completely different,” he said.  “It goes back to the EIR baseline of 4.7 MAF for the environmental analysis, and then the water export analysis is using an assumption that without the tunnels, we’d have less than 4 MAF, and so that’s my first question for Jerry.

DWR guidelines, federal government guidelines, or any textbook on the topic will talk about the problem when people try to bundle too many things in with their benefit-cost analysis,” said Dr. Michael.  “A fundamental principle is that the tunnels really need to be justified independently.  There’s nothing in the Endangered Species Act that says you have to comply with it by building tunnels.  A lot of the BDCP habitat projects we can reasonably expect will be implemented without the tunnels and without the BDCP, and so we should include those in our no tunnels scenarios.”

The no action alternative is also very important.  “You can justify any project as long as you compare it to an ugly enough dog,” said Dr. Michael.  “You have to make sure that you’re looking at a good no-project alternative.”

Another important issue relates to valuing the environment, particularly the endangered and threatened fish species, he said.   “My preferable way is that if we can look at alternatives, if I can lean on scientists … on the understanding that there’s some uncertainty but give me a no-tunnel alternative and a tunnel alternative that we think are equally likely to restore species to some goal and that helps me avoid the sticky questions of what’s a Delta smelt worth.  Now if we can’t do that or we don’t do that, then we have to explicitly deal with that in terms of environmental resources and I won’t get into that today.”

1320MichaelSOE_Page_05Dr. Michael then presented a table that compared his estimates of the benefits and costs against those calculated by Dr. Sunding for the BDCP.  Looking at the net benefits, Dr. Michael said “This is my conclusion.  Both of these are using a 3% discount rate.  …  I concluded net benefits of negative $6.3 billion and a benefit-cost ratio of 0.5 using the BDCP and Dr. Sunding’s numbers.  In May of 2013, the report that came out said there were net benefits of $5 billion and a 1.35.”  The big difference is in the valuation of export water supply.  There were other differences, but they are all relatively small, he noted.  “All the difference is due to the export water supply,” he noted.

There is a difference in the environmental benefits and costs and that may be important,” said Dr. Michael.  “I placed the 0 there and my justification for that is my reading of the EIR that I was helped through with some scientists said that the tunnels themselves alone, if you compare them to a no-tunnels baseline and then with tunnels baseline, it increased exports by 600,000 acre-feet, but the totals themselves did not produce benefits for fish.  Now if I’m incorrect in that, please let me know afterwards, but I’ve been informed it’s fair to put a 0 in there.  And that’s my way of trying to sidestep this question of what’s a Delta smelt worth.”

The BDCP analysis just doesn’t look at that, but I don’t think it can say 0 either, actually I think it’s a negative number, it’s a cost, because of what they’ve done with the baseline assumption,” he added.

Michael #2 (2)The huge difference in water supply benefits comes from the baseline assumption.  “The environmental impact report says that it expects full implementation of the biological opinions and roughly 4.7 MAF of exports in 2025, and some loss due to sea level rise thereafter,” said Dr. Michael.  “The BDCP reports have a different scenario for no-tunnel.  They’ve constructed a scenario in which the constraints on the south Delta pumps are imposed to benefit the fish species, but the north Delta intakes are not introduced with the result of that being water exports of 3.4 to 3.9 MAF.  …  There’s no environmental analysis that was released with that statement so I cannot evaluate it.  In formal consultations that I’ve had, it’s suggested that this no-tunnel alternative is better for fish than the BDCP.”

In both of our estimates, I used BDCP estimates and I’m borrowing Dr. Sunding’s valuations,” said Dr. Michael.  “I emphasize that even mine have some pro-tunnel biases in them.  Water valuation is based on rapid growth scenario in southern California.  We have about 5 million more people consuming and demanding water in Southern California than the current Department of Finance forecasts, and that increases the value of export water.  We’re assuming no construction cost overruns, no delays, no risks from that, and we’re assuming no development of technology between now and 2075.  This is really important, very different to how we think about water compared to how we think about energy and global warming and other policy issues in California.”

It’s hard to compare when people have different baselines,” said Dr. Michael.  “So the conclusion from the BDCP analysis is that it is very costly for the water agencies in a world where we would restrict water agencies severely and that would be costly to them, so the BDCP is better for them than that.”

“I can accept that analysis but it really begs the question, what’s the breakeven point?” asked Dr. Michael.  “If that’s too much water to take away from them, that’s worse than building the tunnels, my question is how much water can we take away from the water agencies, how much can we increase flows and have the costs of that be lower for the water agencies than the cost of building the tunnels?

1320MichaelSOE_Page_08Dr. Michael said that he plotted the points out and concluded that the breakeven point is in the range of 3.85 to 4.45 MAF, depending on whether the low outflow or the high outflow case is used.  “So the argument I am making is that we ought to be looking at a no-tunnel BDCP,” said Dr. Michael.  “Where should exports be?  I don’t know.  Let’s look at this, but I think somewhere in the neighborhood of 4 MAF, we may be able to reach with a no-tunnel BDCP deal that’s less costly for water agencies than building the tunnels.”

The main economic argument being made to the water agencies is the value of regulatory assurances, and there’s a question about how much regulatory assurance comes with a habitat conservation plan, he said.  “I think some of the regulatory risk reduction benefits have been overstated, but understand that this is an agreement that reduces risk and as you increase or strengthen assurances to one of the stakeholders in the Delta, you aren’t necessarily reducing risk as a whole; you’re shifting risk between parties.  The Statewide Economic Analysis focused on regulatory risks for the contractors and is not accounting for regulatory risks that are shifted to other parties, and my list of them are in-Delta users, upstream users, potential risks to the environment through their assurances, as well as taxpayers who may be asked to spend money to augment Delta flows.”

There is still more work to be done to prove financial feasibility, said Dr. Michael.  “You need to show the benefits exceed the allocated costs for every single agency that’s participating in it, particularly agricultural agencies, and so that hasn’t been done yet and doing that is going to involve a cost shift from ag agencies to urban agencies.”

View Dr. Jeffrey Michael’s complete power point presentation by clicking here.

Jerry Meral, Deputy Director of California Natural Resources Agency

Jerry Meral began by saying he was assuming everybody in the room was familiar with the BDCP so he wouldn’t spend much time going over it.  “Suffice it to say it’s a Habitat Conservation Plan that covers the entire Delta and 57 species,” he said.

Meral 1We’ve done a lot of remarkable economic work in analyzing the economic impacts of this program and we’ve looked at it from a variety of ways,” he said.  “The first way that we looked at it was to examine what we thought the benefits might be to the people who actually use the water from the Delta via the state and federal water contractors.  They go all the way from Santa Clara County, Alameda, San Joaquin Valley, and almost all of Southern California, and our conclusion to that study was that this would be a good investment.  They, of course, are the ultimate judges of that.  The state is not using your tax dollars to build this project, at least not this part of it … it’s up to them whether they want to do it or not.  They felt that was a good analysis, they’ve used it extensively, and they do see the benefits to themselves in doing it, and they are probably the best judges of that.

The second analysis was the statewide benefits analysis, which was a little harder, he said.  “Of course we have an overwhelming number of benefits coming from whatever assurances the water supply people feel they are getting out of the program,” he said.  “Are they really getting a more reliable water supply as the legislature said they should or not? But we do believe there are some pretty extensive other statewide benefits in the Delta, especially, and really most of those are related to ecological conservation.  The easy ones to analyze are more recreation days, better attendance at the Central Valley birding symposium, things like that, but some of the harder ones are the economic benefits of actually moving these various species away from jeopardy and more towards recovery.  That’s pretty hard to analyze.”

A third economic analysis that was done was in Chapter 9 of the BDCP, the Alternatives to Take, he said.    “In the analysis, you have to look at both the economic benefits and costs of all the alternatives you want to analyze, but also make sure that it passes the ecological test of an HCP, and in our case, the NCCP standard – avoiding jeopardy, contributing to recovery and those kinds of things,” said Mr. Meral.  “We show that if you’re just interested in economics, you’ve probably are best off building the biggest project you can because the larger you build it, we think, the greater the economic benefits and the greater the net benefits, but of course, those projects have to pass other tests.  One test is meeting the ecological standards in the ESA and the NCCP Act because if you don’t, then no matter what you build, you’re not going to get a permit so forget it.”

The legislature established another test, that of treating the Delta as an evolving place, he said.  “We have to pay special attention to the Delta communities, and we have many, many people who live inside the legal Delta, half a million; inside the interior Delta, tens of thousands, maybe, and so that’s another impact we have to take into account when trying to come up with a proposed alternative,” said Mr. Meral.  “But that chapter, really, I think, does the best job of comparing projects on an equal basis.”

Chapter 8, the finance chapter deals with these things in a less direct way, he said.  “To make it clear, the state and federal water contractors feel like they are willing to pay for the tunnel project if it’s selected as the proposed project – that certainly hasn’t been done yet, but also the mitigation for that project, and those mitigations are not small,” he said.  “We don’t know exactly what the final costs will be as we haven’t done that much engineering, but in the $14 to $15 billion range, and we can expect that the mitigation for that project, just the footprint mitigation, to be in the high hundreds of millions of dollars.  And that’s another obligation the state and federal water contractors would have to take on.”

It’s not just a strictly economic question, said Mr. Meral.  “There are a lot of things the agencies have to consider.  One is the employment aspects.  It may be that a small, economic hit, in their service area has some pretty significant employment losses.  Well, those aren’t losses to the water contractors directly but as a community, they’d be worried about that, and so that’s a concern.  It may not show up exactly in the benefit-cost ratio, but it’s important.”

If you’re an elected member of a board of directors of a water district, the last thing you want to do is have the notices go out to your customers asking to please stop flushing your toilet or stop watering your lawn,” he continued.  “It causes a lot of stress and reduces the credibility of your agency as a water supplier, so typically these agencies are willing to invest a lot of money in projects that maybe might not pass an economic benefit cost test.  It’s kind of hard to say in some cases.”

“If you look at what San Francisco’s done over the last few years, the voters did approve it, they’ve invested 4.5 billion in making their system earthquake safe,” said Mr. Meral.  “Is there any new water in that? No.  So you might say if there’s no new water, was it a good investment?  They are just trying to avoid shortages caused by an earthquake and that’s a really important thing.  How do you evaluate it economically?  I’m not sure they did a benefit-cost analysis of that.”

He also noted that the East Bay Municipal Water District constructed a diversion on the Sacramento River, but it’s not a facility they use a lot.  “They anticipate that they will have to, maybe due to growth or maybe due to an earthquake interrupting their supply, but it is a backup supply, and so they found that to be a good investment.”

Water districts are often willing to invest to avoid shortages caused by natural disasters, regulatory problems, and so on, he said.  “I think a lot of economists would look at those decisions and maybe question them, but as elected officials or water managers, they are thinking, we really don’t want to have those kinds of shortages and we’re not going to look real hard at whether this exactly pencils out.  It’s something important to our community not to go through that kind of trauma.”

Meral 2That leads to two philosophical questions, said Mr. Meral.  “Dr. Michael had mentioned that we and he and one analysis used a discount rate of 3%, something the Corps of Engineers proposes.  If you haven’t done these economic analysis, the discount rate is pretty simple; it says what the project is worth in today’s dollars – in other words, a dollar of benefits 50 years from now, with inflation and so on, is really not worth the same as a dollar of benefits today, but with projects like this that are intended to last two, three hundred years, they are not really being built or developed to benefit just ourselves.  We have in mind future generations, and you can see that.  There are Roman water systems today that are still working and certainly our state and federal projects are still working as well.  So anything we do has got to last the long, but the benefit to the grandchildren and great-grandchildren really isn’t there, because the discount rate kind of washes that out, so as a non-economist, I could ask this question, is this discount rate the right way to look at these projects?

Mr. Meral agreed with Dr. Michael that we want to avoid trying to value endangered species.  “What is the Delta smelt worth? What is a clapper rail worth?  What are these species worth?  Often economists say it is the public’s willingness to pay to know that it is there, or willingness to pay to go see one or something,” he said.  “Those are very weak valuations.  I don’t think the public isn’t willing to pay a lot to see the right kind of spartina and things like that. … With this project, we have 57 species that we believe we can move in some cases to perhaps delisting if we’re lucky, and in many other cases, at least much further away from jeopardy are headed in that direction.”

You can’t think of this project in terms of its economic valuation, argued Mr. Meral.  “The idea of preserving those species to me is not strictly an economic one; it’s a moral one, it’s an ethical one, and we shouldn’t be saying that this species didn’t pass the test, let’s kick it off the list … That is not the approach the endangered species act really asks for or that  legislature expected when they passed the NCCP Act.”

That’s not to say the water agencies shouldn’t consider their economics because their ratepayers will have to pay it, he said.  “The Metropolitan Water District says that this project will cost about $5 per household per month in Southern California.  They view that as an affordable rate; most of the people I’ve talked to in Southern California feel they could pay that to secure a better water supply and so they find it reasonable.”

The cost to the farmers is about $150 an acre-foot, said Mr. Meral.  “That’s different than Jeff’s numbers and there’s room for different opinions on what the final costs will be but they feel that’s what they can expect,” he said.  “It’s a much bigger deal to farmers because it is a huge part of their economic input with respect to their farm budget and so they have to be pretty cautious.  And they are saying that they are right on the edge of their ability to pay, and so that’s important.  We have to take that into account.  We have to try to keep the costs as low as possible, but our overall economic analysis needs to respect the value of species as well as the sensitivity of the ratepayers.”

This project is really not about some vast new water supply – that’s not going to happen,” he said.  “I think everyone accepts that, the water contractors certainly accept it.  The project is really about trying to stay where we are at best, given the unbelievable impacts we expect climate change to have in the Bay Delta ecosystem and the watershed.”

The project is mostly about climate change, said Mr. Meral.  “Sea level rise is going to impact the ability of people to divert water in the Delta, it’s going to make it harder to preserve the current configuration of the islands, we have temperature impacts on the species, and in the fact of that impacts of climate change, we’re trying to hold our water supply, so we’re trying to maintain these species as best we can.”

Dr. Jeffrey Michael and Jerry Meral question each other

At this point, Dr. Jeffrey Michael and Jerry Meral were then given the opportunity to pose questions to the other.  Dr. Michael began by asking why there were different baselines (or no-tunnel alternatives) used for the different analyses?

Jerry Meral replied that differing and inconsistent regulatory requirements were the reason.  “Under the CEQA , you are essentially prohibited from using future conditions in establishing your baseline.  You have to have your baseline same as today, the time at which you develop your project, which is as crazy in a long-term project as anything I’ve ever heard of,” he said.  “So you can’t have climate change in your baseline, you can’t have increased demand, you can’t have different island configurations, and you can’t have anything but what you have today.  Today is better than it’s going to be the future and so inevitably, we’re going to have higher export levels under today’s conditions than under that no-project alternative.”

Switching over to the NEPA, it much more sensibly says that you can look at things like climate change and so on, so the NEPA baseline is different than the CEQA baseline, and this is going to drive people to endless confusion,” said Mr. Meral, “but we follow both of them and of course the baseline results are quite different when you have climate change and so on built in.”

The analysis for Chapter 9, the Alternatives to Take, is completely different, he said.  “What we said was in order to be fair to the public, we want to treat all these alternatives equally, and we want to treat them in the way we think is likely the biological agencies will want us to and that is by adopting what we call the high outflow scenario – the high outflow is another way of saying ‘save the longfin smelt’.  And so, we assume very high outflows in the spring for the longfin, high outflows in the fall for Delta smelt, and those of course drive down naturally the exports that you can have, and so that chapter is much different.  …  We felt that these kinds of analyses are not only required by law but clear to the public. … That’s why we have so many different baselines.”

Jerry Meral asks Dr. Michael, how can we get rid of the discount rate?

JMx2Understand why discount rates are important,” said Dr. Michael.  “The 3% that is being used is actually pretty low, and I think to be more consistent with other analysis, you could argue, including high speed rail, for using something along the lines 5 to 7%, but I’m generally okay with 3%.  I wish the state would use 3% for HSR and for all sorts of projects.  But the important of discounting, what you’re controlling for is that you’re making an investment and you need to control for the alternative uses of that investment in the rate of return that you would receive from those alternative uses of investment.  And so if we’re talking about spending public dollars on BDCP project, those are public dollars that aren’t available to be spent on education projects, transportation projects, and energy project, a health project or something else.  All of those projects have a rate of return.  So when you’re thinking about your BDCP project, you want to count the rate of return in the benefits from your project, but if you use a 0% discount rate then you are assuming there is no alternative use of those funds and that you’re ignoring the benefits from the other use of the funds. … the discount rate is intended to reflect what economists call opportunity costs of capital and there certainly is an argument that I agree with for using lower rates for environmental projects. I think that’s what’s being done with BDCP.  … but it’s not necessarily consistent with what the state is doing in other policy venues.”

Dr. Michael then asks Jerry Meral a follow-up question to his first question.  In the Statewide Economic Impact Report, that was not done for regulatory purposes, Dr. Michael said.  In that report, there is one baseline used for looking at water supply benefits and another for the benefits for fish or greenhouse gases.  Is that going to be revised and are we going to have a consistent baseline in that?, he asks.

The statewide benefits study was not for regulatory purposes so we had more flexibility there,” responded Mr. Meral.  “We put that study out as a draft; … the issue you are raising may very well be correct; we haven’t decided yet, but we’ve spent quite a bit of time analyzing it and we’ll have a response in the final report.  We’re not taking that question lightly.

Audience questions

The first question was from Dennis McEwan, Department of Water Resources.  He asked Dr. Michael why it would be reasonable to assume that the habitat restoration projects will likely be undertaken and implemented in the absence of the BDCP.

I think it would be incorrect to say that the entire BDCP habitat restoration program would be implemented without it, but I do know that a significant number of them would,” replied Dr. Michael.  “I think we’ll have a Yolo Bypass restoration project, with or without the tunnels.  I also know that if BDCP is not implemented, that the coequal goals still exist, and so we will see some of those projects of BDCP be implemented without the tunnels.  It’s speculation to know how many of them. I think the good projects we’ll still want to do and we need to account for that when we’re talking making with or without comparisons.”

I would say that the ecological restoration projects that are required by the various biological opinions should and will go forward, and some of them are extensive,” responded Mr. Meral.  “There’s a lot of work in the Yolo Bypass and elsewhere, but BDCP contemplates a lot more than that. $4 to $5 billion of investment in ecological restoration, and some of those projects will go forward if the legislature eventually approves the bond and voters approve it.  We don’t want controversy over BDCP, but that will be an influence on what bond funding is provided.  If there is no BDCP and there’s no obvious water supply benefit from ecological restoration as some people think, that will reduce the motivation for additional public funding, so it’s hard to say how much would go forward outside of the biological opinions.  I think with BDCP in place and with an effort to meet the coequal goals of water supply and ecological restoration, our chance of getting funding for these programs will go up.”

The PPIC’s Ellen Hanak asked that given the cost of the project and the likely constraints, why not look at something in between the portfolio alternative of 3000 cfs and the 9000 cfs that you’re proposing now?  It might be the compromise that’s needed, she said.

We thought we were in the middle ground,” replied Mr. Meral.  “Another project that was proposed in the Delta that had about 25,000 cfs associated with it; we came down 3 or 4 years ago to 15,000 cfs, and then for both cost efficiency reasons and reduction of impact on Delta communities, we ended up at 9,000 cfs, which we thought was the break point where the curve flattens out a bit in terms of the benefits.  If you go further down … as you begin to go below 9000 cfs, you begin to see the costs of the right of way, the costs of mobilizing equipment and so on, becoming a larger and larger component as compared to the size of whatever facility you are building.  If you get down to 3000, you end up being in a facility that’s a third of what we are proposing today in terms of capacity, but 2/3rds the cost.  Still, nothing has been selected.  Part of this is a political discussion with people in the Delta, part of this is that the contractors have to pay for it, but the most important part is with the fish agencies that have to permit it.  And if they see an operation that exports the kind of water that we’d like to see exported in terms of current supplies, but not producing ecological benefits, we won’t get a permit. … It’s definitely still open, but we thought at least that we were coming into the middle ground at the 9000 level.”

Bruce Herbold, member of the public, then questioned Jerry about the BDCP accounts for climate change.  “You said that this project is mostly for climate change, which is nice to hear but I don’t see it in there except for sea level rise.  …  So when you said that this project was actually going to be benefiting our grandchildren’s grandchildren over the course of 200 to 300 years and spread the costs out over that, it made me have even more difficulty wrapping my brain around that.  Given the scope of this project in time, 50 to 300 years … something’s going to happen, I think, that’s going to render this project less useful, especially as a dual facility.  And since a lot of the water in dry years is being taken out of the south Delta, once the south Delta becomes nonoperational for whatever reason, how does that pencil out?  You’re really down to the number that Jeff was saying of maybe 3 million AF in wet years, because you can’t take anything in the dry years. …

Really if the worst scenario you are painting came true and in fact the south Delta was unavailable for export due to mussels or earthquakes or whatever, then that might be an argument for at least maximizing the size of the north Delta facility,” responded Mr. Meral.  “What would be the operational constraints under those scenarios is really hard to say.  I guess my feeling is that if you are going to build something, you’re only going to build it once and probably will be a long time before you build something else, then build it so that it’s flexible, so that whenever these scenarios take place, Delta islands, quagga mussels or whatever, you will have the maximum flexibility.  If climate is going to drive us towards larger and larger rainfall events and less and less snow runoff, that would argue probably for a larger facility.  Will it produce the benefits we think we’re going to get out of it today under those horrible scenarios?  Maybe not.  Maybe we won’t be able to export the 4.7 to 5.6 MAF, but at least you’ve got something that’s flexible when you’re trying to operate under those adverse conditions.”

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