Dr. David Sunding and Josue Medellin-Azuara on the economics of drought

At the San Gabriel Valley Water Forum held at the beginning of October in Pomona, Dr. David Sunding gave a presentation on the costs of shortage in urban water systems. Afterwards, Josue Medellin-Azuara discussed the impact of drought on agriculture and food prices.

Dr. David Sunding

Dr. David Sunding’s presentation to the forum dealt with the economics of shortage and how the concept of reliability can be incorporated into capital budgeting and investment analysis for urban water utilities.

Pic SundingLet me start by asking a straightforward question,” Dr. Sunding began. “Suppose you are choosing between two water supply investments to enhance water supplies, and one would have a unit cost of $1300 per acre-foot, and another would have a unit cost of $1000 per acre-foot, but those two supply sources have different levels of reliability. In particular, suppose the $1300 source of water is very reliable. Maybe it’s recycling. And then the $1000 water is less reliable; in some dry years, it’s not going to be available to you. How would you trade those things off? How would you put those investments on a equal basis so you could make a rational economic decision?

We know how to do this in economics,” he said. “We know how to value short-term shortages, so I’m going to distinguish between long term conservation measures and short-term shortages or mandatory rationing.”

In the past, economists would try to determine what consumers were willing to pay to avoid shortages by doing surveys, but it turns out there is more to it than that, he said. “In terms of what your ratepayers are ultimately willing to pay to avoid shortages, or the cost of unreliability in your supply portfolio, there are three basic elements to it:

  1. Consumer preferences: Consumer preferences or the demand for water is one element of the cost of unreliability. For example, when comparing Temecula and San Francisco, Temecula is an inland area with very large lot sizes, and a lot of outdoor water use, while San Francisco has virtually no outdoor water use because density is very high, it’s a cool area, and most people live in multi-family units, so a 10% shortage in Temecula is going to be less consequential than a 10% shortage in San Francisco, because you’re entirely cutting back on indoor use, he said.
  2. The utility’s rate structure and how it covers costs: The second element of the cost of unreliability is the utility’s rate structure. In California, there are a large number of urban water utilities and they all have very different rate structures. “For example, the rates in Santa Monica are quite a bit higher than they are in Anaheim, and the fact that water is already expensive means that further cutbacks are more consequential,” he said. In particular, most utilities are covering fixed costs with a volumetric charge, so in the event that there’s not water to sell, besides the quality of life impact to consumers who would like to purchase that water but can’t, there ’s also a fiscal impact to the utility. “If you don’t have the units of water to sell, your bondholders still need to get paid. Well what do you with that? You either dip into a reserve account or you have to increase rates. So that’s a second element, more of a public finance element, and it really stems from the fact that most utilities engage in average cost pricing in some form when covering fixed costs with volumetric charges.”
  3. The source of unreliability: This also matters, he said. “Most urban water utilities have multiple supply sources,” he said. “Some are very cheap; there are legacy systems, others are very expensive, things like the Carlsbad project in San Diego. That’s more of a marginal source in that it’s the most expensive element of their supply portfolio. The consequences of Carlsbad going out for some period of time would be different than the consequences of Met water going out for some period of time because Met water is substantially less expensive than Carlsbad, so the source of the unreliability also matters.”

Panel4-1-Sunding_Page_04I would lose my license to practice economics if I didn’t show some form of a graph like this,” Dr. Sunding said, presenting a slide of the demand-supply curve. “Basically what this is showing is that there’s a demand for water and people are willing to pay a certain amount for a certain amount of consumption,” he said. “A shortage is essentially a situation where demand exceeds the available supply, so at the going rate, what consumers would like to purchase exceeds the amount of water that is available to the utility and so there has to be some sort of mandatory or voluntary rationing.   You could have media outreach where you are trying to get people to cut back. There’s still an economic cost to that, even though you didn’t force them to cut back. But there are a number of mechanisms that can be used to get the supply reduction.”

The cost of unreliability or the value of reliability has a lot to do with how water systems are financed, he said. “In particular, there is frequent use of average cost pricing where a volumetric charge gets used to cover a cost that’s not related to the level of service or to the level of output – something like bond payments on a wastewater treatment plant.”

Because water is primarily provided by municipal entities, water rates are frankly a political choice in most places around California,” he said. “This is why water rates for municipal systems aren’t regulated by the state Public Utilities Commission – because they are ultimately regulated through a democratic process. If voters in a city are unhappy with their water service, they can vote out the City Council or the mayor and get a new group in.”

Panel4-1-Sunding_Page_07There is an interesting phenomena in water unlike any other utility where prices are all over the place, he said, using a graph of the distribution of prices in the Bay Area for wholesale customers on the Hetch Hetchy system as an illustration. He noted that the horizontal axis represents price per ccf, and the vertical axis is the number of utilities that fall in that range. “What’s interesting about this is if you look at it, you are going from $1 per ccf to $9 per ccf, and these are all entities that have the same marginal cost of water; they are all on the same system. They can all get water from the Hetch Hetchy system, but for whatever reason, either having to do with capital investments they’ve made that they have to pay for, or political choices where they are subsidizing water costs through property taxes or other mechanisms, there is this tremendous disparity in the price of water from one city to another.

This is a political choice, but it matters for planning the value of reliability,” Dr. Sunding continued. “The cost of a shortage in a utility with a $1 per ccf price is less than in a utility with a $9 per ccf price. Because when water is expensive, people have already conserved, and further cutbacks are more painful, and you have a bigger budget hole if you can’t see the water you need to sell to cover your fixed costs.”

Panel4-1-Sunding_Page_08He then presented a slide where he worked through some examples. “The top row is a water utility with an average typical price of somewhere in the middle of that distribution and a typical elasticity, so typical demand curve for water and a typical marginal cost of service. What is the cost to ratepayers of a 10% shortage? The number is something like $1600 an acre-foot. That would be a typical number, so if you invest in a supply that has a 10% chance of a 10% shortage, you should take the unit cost of that supply and add $160 to it. Just roughly speaking, that’s the kind of hidden cost of unreliability that you should factor into your capital budgeting.

What’s really cool about this is with the knowledge of the rate structure, you can infer something about demand from the way people have behaved in the past,” he said. “You can take a look at your books and figure out the marginal cost of service; you can figure out your overall supply portfolio and how it will vary with weather, earthquakes, and Delta disruptions, and things like this; and you can figure out an implicit cost of unreliability that you can then include with the engineering costs and be able to incorporate concepts like this into your reliability planning. In other utilities like electricity in particular, this is absolutely normal; the cost of periodic brownouts or blackouts is factored into capital budgeting and investment decisions virtually on a daily basis.”

Panel4-1-Sunding_Page_09He then presented a graph titled ‘Characterizing the customer losses under increasing levels of shortage. “I took the numbers off of here because I didn’t’ want to get into too much detail. The blue line is the cost of various levels of outage from 10% to 60% and the red line is the cost of those same outage percentages but in 2035, as opposed to today. The cost of unreliability for almost every utility that I’ve looked at is going up over time and the reason is that demand is going up and supplies are getting tighter, as conservation goes on, there’s demand hardening, so the more conservation programs you put into place, the more inelastic that demand curve gets and the higher the cost of shortage. So when we’ve applied this method to different utilities to evaluate investments, this is a very important factor to keep in mind – that the implicit cost of unreliability is expected to grow over time and so investments that are reliable consequently have a greater value over time.”

Utilities are in the business of satisfying ratepayer demands for water, electricity, or whatever, but other metrics sometimes come into play, such as employment impacts of periodic shortages in the urban sector. “There are methods available to figure that out,” he said. “Again, to the extent that investment decisions or rate structures or political decisions, job losses are something that a lot of political types want to know about.”

Pic Sunding AzuaraSo the first thing you need to figure out is how the shortage is going to be imposed – whether it will be imposed on the commercial or industrial sector. If it gets big enough, there may not be capacity in residential demand to absorb all of the shortage and you’d have to cutback businesses.” He noted that there are some well-known surveys that have asked business owners how they would respond to a shortage – layoffs, reduce output, increase efficiency, or other means. “There are relationships between commercial and industrial shortages imposed by sector of the economy – manufacturing, retail, on and on like this, and then employment effects and output effects. We’ve used those in a number of different cases to figure out what would be the perspective employment losses that would result from urban water shortages.”

So this is the world I think we’re all living in where we have to think about periodic shortage and reliability, and having a system that is completely bullet proof and impervious against droughts and earthquakes and regulation in the Delta and Colorado River conditions maybe more expensive than most agencies can afford,” Dr. Sunding said. “But figuring out what is it worth to pay to avoid a future shortage – I think that’s going to be an increasingly important question as agencies are asked to make way off investments in different water supplies.”

So I’ll leave it there.

Josue Medellin- Azuara

Pic AzuaraFollowing Dr. Sunding, Josue Medellin- Azuara, a researcher at the Center for Watershed Sciences at UC Davis, then reviewed the results of a recent study analyzing the impacts of the drought on agriculture and food prices.  “Droughts occur in California over yearly scales, decadal scales, and longer time scales,” he said. “This is not the worst drought in terms of precipitation … but what is different in this drought is that the amounts required for consumptive use are at historic highs.”

Three different models were used for the study, he said.

Panel4-2-Medellin_Page_04Mr. Medellin-Azuara presented a slide titled ‘Water Shortage and Changes in Groundwater’ and noted that shortages estimates were based on announced shortages and expectations of deliveries by the districts. “In terms of shortage, so we were overall expecting a shortage of surface water of about 6.5 MAF in the Central Valley, and 6.6 MAF for the state overall, so a smaller shortage here for agriculture here in Southern California.”

He explained that the first column shows the breakdown by region, the second column shows how much is being replaced with groundwater, and third column is the cost. “Once again, groundwater is taking us through this drought but it won’t be for free,” he said. “It will have a cost, and we are expecting an increased cost of about $450 million for increased pumping. Most of the shortage of surface water is in the Tulare Lake Basin and also a lot of the pumping is occurring there.”

Panel4-2-Medellin_Page_05The study estimated that 410,000 acres of 4.5% of the irrigated area in the Central Valley will be fallowed at a cost of $800 million in crop revenue losses, he said. Losses from the livestock and dairy sectors is estimated at $200 million, and the increase in pumping costs of $450 million. “When we account for the multiplier effects, which is just a fancy way of saying that agriculture requires goods and services from other sectors, it factors in to $2.2 billion for the study area.”

The most painful part is of course the jobs,” he acknowledged. “We estimate about 17,000 jobs lost due to drought throughout the state, so there will be some pockets of deprivation in some places of the state.”

As for the effects on consumers, Mr. Medellin-Azuara said first we have to ask ourselves a few questions. “Is the source of the water for that particular area threatened by drought?,” he said. “Some areas on the coast are less susceptible to drought this year than others. Some areas in the inland Southern California are not affected by this drought as hard as is the Central Valley, so it’s a matter of which commodities groups are grown there, and also the demand for the crop.”

Panel4-2-Medellin_Page_08This is the reality; these are food price index projections,” he said. “2.7% of aggregate of all food. The largest increase is in the order 8.5% for livestock products. … For the crops that are important for California which is fresh fruits and vegetables, we have not seen that price increase yet. We don’t know what’s going to happen next year once some urban areas start to suffer from drought. If there’s no storage or groundwater, they may need to trade water from agriculture, so we don’t know what is going to happen next year, but so far the price increases are mainly on the livestock products.”

The study estimated total economic losses, $2.2 billion and 17,000 jobs with about 430,000 acres of idle land, he said. “The big story here again is groundwater,” he said. “We’ve been using it in this state as an unlimited bank account and we don’t balance the checkbook; we just have been using very old water, remember groundwater is nothing but very old surface water, and we’re just pumping it and using it … we have been successfully managing it in other areas of the state, but this is something we really need to protect in the future.”

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