Determining the Economic Value of Water

Concepts and Methods

Robert A. Young, John B. Loomis

• Publisher: Routledge
• Year: 2014
• ISBN:
  9781135040512
• Edition: 2
• Topic: Commerce
• Subtopic: Industrie des services

Water provides benefits as a commodity for agriculture, industry, and households, and as a public good such as fisheries habitat, water quality and recreational use. To aid in cost-benefit analysis under conditions where market determined price signals are usually unavailable, economists have developed a range of alternative valuation methods for measuring economic benefits.

This volume provides the most comprehensive exposition to-date of the application of economic valuation methods to proposed water resources investments and policies. It provides a conceptual framework for valuation of both commodity and public good uses of water, addressing non-market valuation techniques appropriate to measuring public benefits - including water quality improvement, recreation, and fish habitat enhancement. The book describes the various measurement methods, illustrates how they are applied in practice, and discusses their strengths, limitations, and appropriate roles.

In this second edition, all chapters have been thoroughly updated, and in particular the coverage of water markets and valuation of ecosystem services from water has been expanded. Robert Young, author of the 2005 edition, has been joined for this new edition by John Loomis, who brings additional expertise on ecosystem services and the environmental economics of water for recreational and other public good uses of water.

Part I

Concepts and theory

Chapter 1

Water, Economics, and the Nature of Water Policy Issues

Economists are interested in the subjective values associated with the sources of individual satisfaction because of their concern with the economy’s ability to allocate resources and coordinate production and distribution so as to create the greatest benefit to society. For many needs and desires, competitive markets are a relatively good means for determining and responding to individual preferences. There are limits to this solution, however, because not all sources of satisfaction go through markets, and markets may fail in other ways as well. National product and income estimates as measured by market transactions are therefore incomplete, and inadequate measures of overall welfare. Correcting for this by estimating values uncounted by the market can help, although this is often difficult, and at times virtually impossible.

(Tibor Scitovsky 1993)

Public policies relating to water supply and quality can have significant economic consequences for households, communities, farms, and business firms. In many parts of the world water is allocated to less valued uses, water quality continues to decline, groundwater basins are overexploited, water-related ecosystem services receive inadequate attention, and floods and droughts take an unnecessarily severe toll on life and property. If climate change projections are reasonably accurate increased temperatures are expected to result in greater water demand and increase the variability in water supply. Future population increases, coupled with climate change, are likely to exacerbate current water resource management challenges. Thus it will be even more important for water managers and government agencies to understand the economic values of water in alternative uses in order to make the most of limited water supplies, i.e. efficiently allocate the available water to maximize its value to society.

Descriptive statistics illuminate broad water use and consumption patterns and place water allocation issues in context. In the United States, crop irrigation continues to be the major user of water, accounting for 31 percent of withdrawals (Kenny et al. 2009) but 80–90 percent of consumption (Schaible and Aillery 2012). (Withdrawal refers to an amount of water diverted from a surface source or removed from a groundwater source for human use, while consumption is understood as that part of water withdrawal that is transpired through plants, evaporated, incorporated into products, consumed by livestock or humans, or otherwise removed from the immediate water environment.) The domestic-commercial category represented 12 percent of withdrawals (Kenny et al. 2009) and 7 percent of consumption, while industry withdrew 4 percent of total withdrawals. Thermoelectric power (e.g. cooling) accounted for 49 percent withdrawals but only 2 percent of consumption (Schaible and Aillery 2012). Elsewhere, water withdrawal and consumption patterns reflect climate, degree of economic development, and other factors. However, as in the United States, crop irrigation represents the major consumptive use of water in the world. (See Rogers 1993 or Solley et al. 1998 for national and regional data on water withdrawals and consumption by sector for the United States, and see United Nations World Water Assessment Program 2012 for an global overview.)

This chapter begins with a review of some of the physical, economic, social, and political characteristics of water that are important for designing water policies. Then it describes the significant issues that confront analysts and policymakers. Finally, it addresses the broad approach to economic appraisal of public policies.

1.1 Why is Economic Valuation Needed?

Water is distinguished from most other resources and commodities by a number of special characteristics that pose significant challenges for the design and selection of water allocation and management institutions such as markets (see Young 1986). Water’s unique characteristics are described below under four headings: hydrological and physical attributes, water demand, social attitudes, and legal–political considerations. These considerations explain why water is for the most part a good not traded on regular markets, why nonpriced side effects frequently accompany water use, and when and why some configuration of a governing institution setting the rules in use are needed. These governing institutions range from informal or formal “user associations” such as irrigation or water districts to different levels of government, e.g. local, state and/or national (Ostrom 2010). One factor often raised in government resource allocation decisions is the economics of those decisions. For uses of water involving government decisionmaking, it is often necessary to estimate simulated market prices or what economists call shadow prices to guide efficient water allocation and investment decisions.

1.1.1 Hydrologic and Physical Attributes of Water

Water is Mobile

Typically found in liquid form, water tends to flow, evaporate, and seep as it moves through the hydrologic cycle. Mobility presents problems in identifying and measuring specific units of the resource. Primarily because of this attribute, water is what economists call a “high-exclusion cost” resource, implying that the exclusive property rights which are the basis of a market or exchange economy are relatively difficult and expensive to establish and enforce.

Supplies Tend to be Highly Variable

As a generally renewable natural resource, basic raw water supplies are mostly outside human control; they are typically variable and unpredictable in time, space, and quality. Local water availability usually changes systematically throughout the seasons of the year (with climatic variations) and over longer cyclical swings. Significant global climate changes are forecast, with a majority of the models suggesting reduced snowpack in snow dominated watersheds (Barnett et al. 2005) resulting in less water availability in summer when crop water demand is the highest and stream flows are naturally low (further impacting instream ecosystem services). Some models of climate change suggest the extremes of the probability distributions of supply—floods and droughts—will increase with resulting problems for humankind. Flooding imposes significant human toll and interruption of economic activity, and most governments have undertaken programs for mitigating the risks of floods. At the opposite extreme, droughts can devastate local economies, particularly those heavily relying on agriculture.

Water is a Nearly Universal Solvent

Water—when in plentiful supply—provides (from the private perspective) an inexpensive capacity for absorbing wastes and pollutants, and further for diluting them and transporting them to other locations. Managing the assimilative capacity of the hydrologic system should, then, be understood as the management of a scarce collective asset. In many situations, water quality considerations are as economically important as are direct use and other public benefits.

Interdependency among Users is Pervasive

Water is rarely completely lost to evaporation in the course of consumption or production activities. So-called “water uses” generally result in return flows to surface streams or aquifers. In crop irrigation, for example, it is not unusual to find that 50 percent or more of the water withdrawn from watercourses is returned, in the form of surface runoff or subsurface drainage, to the hydrologic system. An even larger proportion is typically returned from municipal and industrial withdrawals. Downstream users or those depending on the same lake or reservoir are affected (usually, but not always, for ill) by the quantity, quality, and timing of releases or return flows by upstream users. These interdependencies lead to effects called externalities (or “spillover” or “third-party” effects), which are uncompensated side effects of individual economic activities. The presence of externalities implies that the full costs of economic activity are not recognized in the upstream individual producer or consumer decisions. In this case the outcomes for the society will be less than optimal unless some sort of governing institution (e.g. user association or government) can set rules of use that lead to economically efficient outcomes.

Supply Facilities Exhibit Economies of Large Size

The capture, storage, and delivery of water (especially surface water) typically exhibit economies of scale (i.e. falling unit costs). When costs decline over the range of existing demands, a single supplying entity can be the most economically efficient organizational arrangement. For example, the least-cost approach to capture, storage, treatment, and delivery of residential water supplies in an urbanized area is usually by a single public utility: a classical “natural monopoly.” Accordingly, public ownership or public rate regulation of water supply industries is often invoked to avoid monopolistic pricing.

Groundwater Supplies Have Distinctive Attributes

Groundwater deposits, or aquifers, supply much of the world’s water. Unlike surface water, groundwater flows slowly, and it is difficult to assess the potential yield and quality of an aquifer. Most size economies are achieved at relatively small outputs. Moreover, these may be partially or completely counterbalanced by increased pumping costs and rising third-party spillover costs due to water table drawdown.

Water as a Bulky Commodity

Although there are exceptions (bottled drinking water, for example), the economic value per unit weight or volume of water tends to be relatively low, placing water among commodities which economists call “bulky.” Capital and energy costs for transportation, lifting, and storage tend to be high relative to economic value at the point of use. For example, in irrigated agriculture, much of the raw water used on crops may yield direct economic values—roughly speaking, the return net of nonwater production costs available to cover the costs of supply—of less than $0.04 per ton. Even water intended for urban residential uses—after being captured, filtered, treated, stored, and delivered by municipal water supply systems—typically costs the user less than US $0.50 per ton. Extensive waterconserving technologies (closed conduits, recycling, metering) as well as incentives for conservation (marketable property rights, increasing block pricing) are presently found only where water is recognized as scarce and valuable. Although water is generally a low-valued commodity, it nevertheless may still be underpriced relative to the cost of supply or opportunity costs.

1.1.2 Water Demand: Characteristics from Users’ Perspectives

Because the different benefits obtained from water usually call for specialized management approaches, it will be useful to group the types of values into different categories.

One typology of water demands separates water demands by end uses: (a) municipal; (b) industrial; (c) irrigation (usually agriculture); and (d) environmental (instream flows for recreational fishing and boating as well as to maintain a natural environment—what are increasingly referred to as water-related ecosystem services). The demand for municipal water, especially indoor water uses, is fairly stable and predictable over time. This contrasts with out of home use of water, mainly for lawns, which varies seasonally. The needs of agriculture oscillate in response to temperature and rainfall patterns over the seasons of a year and over longer cycles. Industrial water demands also vary depending on weekday versus weekend, and seasonal considerations. Both storage and conveyance systems and management institutions must be prepared to satisfy peak loads in high-demand periods.

Some distinctions will be helpful regarding the commodity-type uses of water. The commodity benefits are those derived from personal drinking, cooking, and sanitation, and those contributing to productive activities on farms and in commercial businesses and industries. These types of human uses of water that normally take place away from the natural hydrologic system may also be called offstream uses and usually involve withdrawal of water from a river or lake/reservoir. Since these uses typically involve at least partial consumption (evaporation or transpiration), they may be further distinguished as consumptive uses.

Other types of economic commodity values associated with water may not require it to leave the natural hydrologic system. This group may be labeled instream water uses, hydroelectric power generation and waterways transportation being important examples. Since instream uses often involve little or no physical loss, they are also frequently called nonconsumptive uses. Although instream uses do not “consume” much water, in the sense of evaporating it to the atmosphere, they do on occasion require a change in the time or place of availability. This is, for example, the case with reservoir releases for hydropower or navigational purposes. So these uses exhibit some aspects of the rivalry of a private good.

No categorization can capture all the many dimensions of water, however. In Chapter 4 we map specific water uses according to the ecosystem goods and services they provide. Here we map water into demand and supply categories and type of good following a classification scheme presented in Table 1.1, adapted from Brown et al. (2007). These are (a) private commodity benefits for municipal, industrial, and agricultural uses, and (b) instream flow uses for waste assimilation benefits, public (but sometimes private) aesthetic, recreational, and fish and wildlife habitat values.

In Table 1.1, the term rival means that one person uses up some or all of the resource or reduces the amount available to others. Ostrom (2010) calls this subtractability, while Baumol and Oates (1988) call it depletability. A nonrenewable groundwater deposit usually involves one landowner’s withdrawal resulting in less water available for others. Nonrival means one person’s use does not reduce the amount available to others. Instream flow uses such as rafting or run-of-the river hydropower is characterized by being nonrival use of water as one use does not diminish the amount of water available to another user downstream. For example in the case of rafting the marginal cost of allowing another boater on a given river is zero in terms of water use.

If the marginal cost of allowing another person to use the water is zero, then the price should be zero. This efficiency condition arises from the well known principle in welfare economics that in the absence of externalities, an economically efficient price occurs where the price equals the marginal cost. This simply means that the marginal value of using another unit (e.g. its price) is equal to the opportunity cost to society of producing another unit. This condition occurs with perfect competition but not monopoly or when there are positive or negative externalities.

Table 1.1 Economic Categorization of Water Supply and Demand Use Values

Hydrology/Supply	Characteristics	Type of Good
Withdrawal
1. Surface Water	Rival
	(Riparian: Nonexcludable)	Common Pool
	Appropriative: Excludable	Club Good
2. Ground Water	No...