Never Waste a Good Crisis: What Can We Learn from California?

California’s extreme drought continues to make headlines. No doubt Canada will feel the ripple effects, for example, through potential shocks in our commodity markets. But is there anything we can actually take away from this disaster? Our perception of Canada as a water wealthy country has lead to fairly low levels of water risk literacy here at home.  Indeed, we consume more water per capita than many other countries across the world. But water scarcity isn’t just a California problem. Ask the folks in Western Canada, they’ll tell you. We’d be wise to pay close attention to what is happening down south, and what lessons we might draw, particularly about the importance of water pricing.

Why We Need Water Pricing

In response to the water emergency, Californian Governor Jerry Brown has mandated the State to reduce water use by 25%. This translates to targets at the county level that range from 8 to 36%. The governor further called county utility managers to create new incentives for water conservation.

This is a classic ecofiscal approach to water: if you want people to use less of something, put a price on it. But how can we put a dollar figure on the value of water? What does water pricing really mean?

From Source to Tap

There are two broad components of a comprehensive water pricing. The first is the “private” cost of provision. This is getting the water from a watershed, through water filtration plants and to our homes and businesses. This water pricing component is either buried in property taxes, as a fixed component on municipal bills for property owners. Alternatively it can be a volumetric rate or varying block rates for buildings equipped with water meters (for a discussion about both types of marginal pricing see here). Only the latter two price structures provide an incentive to reduce consumption, as fixed water pricing has a zero marginal cost for increased consumption.

The Risk of Running Dry

The second—and less discussed— component of water pricing is based around the environmental costs associated with currently free or nearly free access to water intake. Even if users paid all the correct fees for the infrastructure of provision, this cannot fully recognize the state of the watershed being used. Once the water provision infrastructure is set, the private marginal cost of the first and last liters should not be much different. However, once it is empty, drawing on higher marginal cost provision like desalination of water will significantly increase the cost of provision. Hopefully, we could properly manage our use of current water sources instead of running them dry.

Fifteen years ago, to fight a threatening drought, the New Mexico State county of Santa Fe increased the cost of water use for its residents and created steeply increasing block rates. The heavy users paid three to four times more per gallon than the low users. As a result, water consumption per capita has fallen in Santa Fe since the introduction of the pricing system in 2001. So coming back to California’s drought problem: how could water pricing help with conservation?

Absorbing the Real Costs?

Like in Santa Fe, water rate structures that charge more for water use would give Californian water users a greater incentive to conserve water. Yet two thirds of water utilities in California already use increasing block rates structures. Seemingly this has not been enough! In order to increase the incentive, one might argue that these rates should be increased.

However, water pricing has recently suffered a big set back in California. In April, a Californian court ruled for a group of ratepayers that the San Juan Capistrano’s tiered water structure was unconstitutional because it charged more than the actual unit cost of water. Even if the county had good intention with its rate levels to incent conservation, Californian local government (similarly for Canadian municipalities) must set service charges equal to the cost of provision, and hence must be able to provide the evidence for its level.

Stanford economics Professor Frank Wolak has been working on a detailed water use pricing model that could help Californian water utilities structure their water rates to increase incentives for conservation while ensuring they respect the private cost of provision constraint. By defining specific household-level water demands by household demographics (such as lot size, number of people and vehicles), his model can be used to map precisely the cost of provision of the utility to specific customers, hence reducing revenue uncertainty.

Testing the Waters in Canadian Cities

However, above and beyond the private cost of provision, there still remain the environmental costs attached to free access to watersheds. While it seems that in California including such costs in the rates would require some legal battles to justify as a “cost of provision”, Canada might already have the structures to design water pricing policies with this in mind.

Canadian municipalities can implement user fees, but not taxes. However, analysis suggests that user fees could still include the cost of environmental externalities. The Supreme Court of Canada ruled that: “courts will not insist that fees correspond precisely to the cost […] as long as reasonable connection is shown”. The ongoing California drought is an opportunity to put water pricing to the test and better understand how it can contribute to conservation efforts. In order to do so, Californian county water utilities need to properly justify the rates they charge and there exists resources to do this.

Hopefully, in time, we’ll hear more discussion about how to account for the tangible costs associated with depleting our freshwater resources. Water pricing is a solution that neither Californians nor Canadians can afford to ignore.