Thursday, September 30, 2010

Water pricing in different sectors

My previous post linked to a new alarming/alarmist (potato, potahto) study of South Africa’s water pollution problems. I mentioned some economic elements that I feel need addressing if we’re ever going to provide the right set of incentives to ensure sustainable water use.

What completely glossed over didn’t really discuss was the fact that water has a multitude of different uses, which can make valuation very hard. With regards to pricing structures, can you apply the same set of rules to all different users (residential vs agricultural vs industrial)? I can see more than a few practical problems, but there are certainly those who believe that we can and should do so. Prolific water blogger – and recent addition to the job market! – David Zetland has long advocated a system of “all-in auctions”. In other words, very low prices for water aimed at meeting basic human needs, after which all comers are subject to compete against each other on price bids.*

Having been raised in agricultural country, I can think of of a number of farmers that aren't going to be too happy with this type of proposal. However, that's a practical obstacle that can be overcome - largely through greater dialogue and explanation of the actual procedures. Further to the point, a large number of farmers already control their own water sources in the form of small dams and so forth; you've obviously no need to submit to an auction if you already own the resource. In a similar vein, in instances where a bunch of farms are located along a river, the bidding could first be among that group of farmers. In cases where rivers flow to cities or industrial areas, up stream farmers could potentially make money by auctioning off "usage rights" to urban and industrial consumers.

On the subject of water usage by different consumers and sectors, I posted some relevant comments a while ago on a blog run by some Austrian friends (ideologically speaking that is, not geographically). With minor edits for style and following a discussion on the urgent need for a hike in (residential) water prices in SA:
One of the better articles on environmental issues published on this site. (Some of your climate and pollution arguments have been rather lacking in my opinion…)
[Editor’s note: For instance
Anyway, I certainly agree that water will be a defining issue for South Africa long before other crises and our current pricing structure is woefully inadequate. (As with many countries, the focus is on recuperating short-run average/operating costs instead of the economically sensible long-run marginal costs. While SRAC could be considered as constant, LRMC are typically increasing over time, so prices lie below their optimal value…)
However, the article does skirt around perhaps the most tricky issue with regards to water: There are MANY different uses for water and thus many different marginal values. Residential water consumption is fairly minute in comparison to agriculture and, to a lesser degree, industry. Thus – and although it may not agree with your definition of inflation (i.e. an expansion of money supply) – correct marginal pricing of water will certainly bring about an increase in general prices. Why? Water is a crucial factor of production for virtually everything we consume. Thus, an increase in price will carry through to all final products.
Not easy for society, but that is simply the bitter pill we need to swallow in order to establish sustainable use of what is perhaps our most valuable commodity.
After a fairly odd reply regarding my understanding of inflation**I ended an additional comment with:
[A]n increase in water prices will have much further implications than simply raised costs of showering or watering our gardens; it will affect prices for an entire host of economic goods.

* If you aren’t aware of it, I recommend David’s blog to anyone interested in water and water economics.
** Like all proud Austrians, they love to focus on inflation as a definitional good...


  1. Platinum also has numerous uses, yet this doesn't make valuations 'difficult.' Your valuation dilemma does, however, complicate matters for central planners looking for a 'fair' or 'equitable' distribution of water resources.

    On the impact higher water prices will have on a host of other goods: An increase in money prices for water cannot bring about an increase in the general price level in terms of money prices.

    Remove money from your analytical framework and think in terms of the exchange value of one unit of water to one unit of another good. An upward shift in the demand schedule for water, assuming the supply schedule remains unchanged for the time being, means that more non-water resources must be expended to gain the same amount of water resources than before. This we can call the increase in price of water, relative to other goods of course.

    This will mean that in order to obtain the same amount of water resources, one must spend more of other resources in exchange. The relative price of water to other goods therefore increases. The value of non-water resources fall.

    If this had to be measured in terms of money prices, the general price level could remain totally unchanged, as water prices increase and prices of non-water resources decrease.

    This is by no means either “inflation” or “deflation”, but a natural adjustment of resource pricing in response to supply and demand, in order for the market to clear at levels where no surpluses or shortages exist.

    But one thing is for certain, a much higher price of water relative to other goods will most certainly lead to a significantly more efficient allocation of water resources in the economy, something I would argue is long overdue.

  2. Croesus, thanks for your thoughts... And, I note, another ancient Greek at my door! (Might I enquire whether you have a fondness for gold coins?) Regarding your comments, I agree that variations in valuation are not necessarily problematic in of themselves, however...

    First, the very distinct properties of water make it dangerous to draw comparisons with other resources. This is both an economic observation and social observation. Platinum most certainly does have a variety of uses, but it also competes with a number of substitutes (e.g. palladium and rhodium in the case of catalytic converters, while you can take your pick for jewellery). Water, on the other hand, has hardly any in its innumerable applications... Including, most obviously, the irreplaceable role it plays in sustaining life on this planet. Similarly, many non-essential economic goods rely on water as a factor of production where no substitute is available. (Theoretically, desalination offers us substitution in supply, but there is no economically viable way of disseminating this technology on a significant scale.)

    Property rights are also much harder to establish for water than with other natural resources. Consider the case of a river that flows alongside various properties. What of the rights of downstream versus upstream users (and vice versa)? Think not only in terms of use, but also the capacity to sell on to others who aren’t adjacent to the river. Certainly, the auction system that I discuss above is an “artificial” property rights system, in that water running through my property (and on to someone else’s) at any given time would now not necessarily belong to me anymore. (I won’t even begin to discuss fish swimming in the stream...)

    That being said, I initially mentioned auction systems because I do think they are the best tool we have for overcoming the limitations of natural water property rights. (We see similar evidence with the effectiveness of sustaining various fisheries around the world via ITQ auctions.) However, again, there are very real social and institutional hurdles to overcome in trying to implement a system that probably runs counter to established norms of ownership and usage rights. Indeed, it is very hard to imagine the establishment of such an artificial property rights regime without a powerful government body at its helm.

    Regarding inflation, permit me to say that you are simply dressing up the same idea in different clothes. Rising relative prices necessarily amounts to the erosion of purchasing power next to that particular class of goods, which is the precise point that I was making with water. My additional input was that relative prices should rise for a vast range of goods, because water a) is used so extensively throughout the economy, and b) has little or no substitutes.



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